Why China Liberated Its Currency

How often does a 350-word statement make headlines around the world? Not too often unless there's a sex scandal involved, but The People's Bank of China accomplished the feat just this past week when it announced plans to "further reform the RMB exchange rate regime and enhance the RMB exchange rate flexibility" (and nobody had to sleep with anybody).

What the heck does this mean, why is it important, and what's China's reasoning for changing its course on the issue? I'm glad you asked.

What the heck it means
As I wrote back in April when I told you and Paul Krugman to chill out about China's currency, China has fixed the value of its currency, the RMB, relative to other world currencies at an artificially low value in order to subsidize its export manufacturing sector. The reason the government pursues this path is because export manufacturing has been an engine for economic growth and job creation in China for the past 25 years. The strategy has largely worked, with China putting up better than 10% annual GDP growth for the past 30 years.

By announcing plans to reform this fixed-rate regime, enhance exchange rate flexibility, and "enable the market to play a fundamental role in resource allocation," China is finally signaling a willingness to allow supply and demand to determine the value of its money. Given China's trade surplus and all of the investment dollars that are flowing into China, the consensus is that China's currency should appreciate quite a bit -- with some economists suggesting that a natural exchange rate is closer to 4 or 5 RMB to the dollar rather than the 6.8 RMB to the dollar rate that exists today.

Why it's important
Although it's unlikely that we will see a rapid 50% rise in the value in the RMB (for reasons I'll talk about below), this move does matter for both China and for the world. First, it signals a willingness in China to finally start weaning the economy off of the economic heroin that is the export manufacturing sector. While challenging for companies such as Nam Tai Electronics (NYSE: NTE  ) that have feasted on low-cost labor, it's better for the economy overall. Further, it suggests that China is confident that domestic consumption can pick up some of the slack that a slowdown in export manufacturing might produce and that China is serious about its plans to become the world's largest, most important economy -- both positive developments for anyone who has been investing in China.

Further, it means that Chinese consumers, enriched by a newly stronger currency, will be able to purchase more and more expensive goods from the U.S. and Europe. This could mean more jobs for U.S. workers as well as a new potential catalyst to help along the global economic recovery. Potential beneficiaries include luxury brands that are growing increasingly popular in China such as Luxottica (NYSE: LUX  ) and Coach (NYSE: COH  ) .

And finally, it means Paul Krugman has one less topic to whine about on The New York Times editorial page.

Why now
The question, of course, is why is China, a notoriously self-interested nation, now willing to set a new course on currency policy? Before I get to that, it should be noted that, despite mainstream media reports to the contrary, the RMB is not going to rise against the dollar overnight. In fact, The People's Bank went so far as to claim in its statement that "the basis for a large-scale appreciation of the RMB exchange rate does not exist." While I disagree with this outlook, the fact is that China, and The People's Bank said as much, will continue to manage the bands within which the value of the currency will float. As a result, any appreciation in the value of the RMB will happen slowly over time.

There are two reasons for this. First, the manufacturing sector employs more than 10% of the Chinese workforce and Chinese workers, many of whom have migrated to cities to find jobs, are notoriously cranky when they're left unemployed. A rapid revaluation of the RMB would cause many of these factories to become suddenly uncompetitive and shut down, resulting in unemployment that the Chinese government simply isn't willing to deal with.

Second, it's worth remembering that The People's Bank, the very body behind China's exchange rate policy, is currently long more than $2 trillion thanks to China's trade surplus. Should the yuan appreciate, it would do so at the expense of the dollar -- thereby devaluing China's reserves. As a result, one should expect RMB appreciation to proceed at roughly the same rate The People's Bank is able to unwind its position in the dollar.

My China conspiracy theories
With that as background, there are two self-interested reasons why China would proceed with this change. First, it's well-known that China has come under heat from the international community about its currency given the economic struggles and high unemployment in the U.S. and Europe. President Obama has made several fiery speeches on the topic and the U.S. has come very close to labeling China a "currency manipulator." By announcing this change to its currency policy now, China inspires some international goodwill ahead of the upcoming G-20 summit.

Second, China's artificially weak currency has given rise to inflationary fears. In fact, China's National Bureau of Statistics reported earlier this month that inflation in May was 3.1% -- ahead of the government's 3% target. As food and oil prices continue to rise in dollars, Chinese households would get squeezed if the RMB continued to be pegged to the dollar. By unpegging the RMB and allowing it to appreciate against the dollar, those imported goods become more affordable for Chinese citizens. This, in turn, makes them happier, wealthier, and more likely to remain supportive of the government.

All told, the Chinese government has made a savvy move here that buys it time with international critics while also giving it flexibility to pursue a more measured exchange rate policy. It's not quite the groundbreaking development that many in the media made it out to be, but it is a milestone and good news for investors like me and our members at Motley Fool Global Gains who have been increasing exposure to the Middle Kingdom.

Get Tim Hanson's "Global View" column every Thursday on Fool.com, or by following him on Twitter.

Tim Hanson is co-advisor of Motley Fool Global Gains. He does not own shares of any company mentioned. Coach is a Motley Fool Stock Advisor recommendation. Nam Tai Electronics is a Motley Fool Global Gains selection. The Motley Fool's disclosure policy has never been involved in a sex scandal.


Read/Post Comments (9) | Recommend This Article (43)

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  • Report this Comment On June 24, 2010, at 1:47 PM, MegaEurope wrote:

    "Second, it's worth remembering that The People's Bank, the very body behind China's exchange rate policy, is currently long more than $2 trillion thanks to China's trade surplus."

    China is now running a small trade deficit.

    Their reserves are that large due to previous trade surpluses.

  • Report this Comment On June 24, 2010, at 2:55 PM, TMFMmbop wrote:

    Correct. A legacy of trade surpluses.

    Tim

  • Report this Comment On June 24, 2010, at 5:18 PM, nin4086 wrote:

    "Second, it's worth remembering that The People's Bank, the very body behind China's exchange rate policy, is currently long more than $2 trillion thanks to China's trade surplus."

    Hmm...but don't they have a lot more of their own currency as well? So overall the value of their currencly holdings should go up. I agree that China wants the change to be gradual to avoid disrupting the system but this point does not appear to be a factor.

  • Report this Comment On June 24, 2010, at 6:10 PM, brainbended wrote:

    ok china is learning how to play the currency game but who do you think is their teacher?

    conspiracy?

    inflation there you`re on track if china reevaluates

    dollar devaluation would be eased and china`s treasury notes will keep its value and america its face but no for long unless wall street is stoped

    and the comodity market aswell

  • Report this Comment On June 24, 2010, at 7:20 PM, woolibulli wrote:

    I'm wondering why it's whining to say that China has been manipulating it's currency. Because Krugman is a liberal? To me, this is not fair trade, along with other things that they do. What would they say if we charged tarrifs on their goods? Hear the whine then, eh? To me, it's the same thing. Just because we can make money investing there doesn't make it correct.

  • Report this Comment On June 24, 2010, at 9:02 PM, xetn wrote:

    Every economy in the world is manipulating their currencies including the US (the bigges manipulator of them all because the dollar is the settlement currency). The only real currency, that would eliminate the international trade issues (but no one will consider) is gold.

    Read:

    http://www.plata.com.mx/mplata/articulos/articlesFilt.asp?fi...

    It gives lots of evidence.

  • Report this Comment On June 25, 2010, at 10:32 AM, flau3388 wrote:

    If the value of RMB goes up, it stimulates our export and helps our employment, but it also mean that we have to pay more for our consumer goods. We might not see twenty dollars pair of jeans or low cost flat screen TV....

    I agree that we are also a currency manipulator, and also which country is not "self interest".

  • Report this Comment On June 28, 2010, at 10:07 PM, jadfasgfg wrote:

    m

  • Report this Comment On July 15, 2010, at 3:17 PM, marvman0 wrote:

    Yaun appreciation will hurt NTE as all costs from China

    Also -

    NTE - Interesting posts from From Yahoo msg Board:

    -------------------------------------------------------------

    Nam Tai - Koo's Plaything 15-Jul-10 11:39 am

    Do not like the portrait of Koo that emerges:

    Koo Founder and key management continuity - looks like everyone else churns.

    Koo giving himself (he is board Chairman) $1.2 million (incl apartment) a year to be CFO + perks (including golf course membership - what companies are still giving these type of perks)regardless of company performance and well above comparable CFOs - is this a company belt tightening?

    Moves AGM were fun/convenient for him - 2009 to Vancouver Canada, know of any other NYSE company that has their AGM here(Koo's previous and maybe current residence), 2010 California - were he buys Napa wine (do you believe this guy paid $200k for a 6L bottle of screaming eagle). Is the AGM not for the benefit of investors and should be held were best for them?

    Has Fun launching law suits and exercising his law degree thru Nam Tai(suing BofChina, UBS, PW, SSA, even previous employees).

    Described as smart and huge Rolodex by some scary crazy senile by others.

    What a portrait - we are relying on this guy to turn this company around!

    -------------------------------------------------------------

    Koo dumped half million shares between 2008 and now 15-Jul-10 01:04 am

    Koo has dumped half a million shares over the period of Nam Tai's business decline from 2008 to 2010 (I think mostly between 2008 and 2009) I guess he somewhat new the storm was coming.

    From 5720K shares in 2008 to 5,224K shares in 2010 - source proxy circulars.

    -------------------------------------------------------------

    Ready to DUMP this LOSER!!!!! 8-Jul-10 01:13 pm

    Additional info for your consumption:

    Lets say the company drives EBITDA of 4% of sales of annual $400M. This would be $16M x 11x multiple is $176M / 44.8M shares = about $4 stock price...roughly were it is. SO NAM TAI IS GETTING CREDIT IN ITS CURRENT VALUATION OF 4% EBITDA and at a 11x mutiple. It still has to do a lot of work to get to this profit level and a 11x multiple is very generous.

    So for the stock price to go up it has to get to 4% EBITDA and grow revenue significantly. The former is doable with hard work. To do better on margin is remotely possible. To grow top line will be very difficult and if done will take years (Sales cycle in EMS I think about 18 mths).

    There must be better options out there. Opportunity cost of ownership is VERY HIGH.

    -------------------------------------------------------------

    POSITIVE NEWS VERY UNLIKELY 11-Jun-10 03:29 pm

    I thought it worth while to re-post my analysis of Nam Tai which comes out as VERY NEGATIVE. I have tried to be objective, however, I would be very pleased to hear from anyone that has a positive business reason to invest in Nam Tai or point out something that I have missed:

    The negatives-

    Total Lack of Transparency - no quarterly conf calls (since YE 2008), no active IR activity, no analysts covering, AGM moved out of the US, no ability to ask mgmt questions directly. Beyond me how a NYSE board could allow this!

    Management Exodus (no competent management left to speak of...):

    2007 CEO lasted 6 mths - Warren Lee

    NA great CFO left end of 2008 - John Farina

    Japanese well connected New CEO left beginning 2009 - Yasukawa

    COO left end of 2009 - LP Wang

    New CEO (previous division CEO) left beginning 2010 (after 20 years w/ Co.) - Karene Wong

    Many others...acting CFO Anthony Chan, entire Legal Team, corp secretaries etc etc

    We are left w/ founder Koo +65 years old (Chairman, CFO, chief cook and bottle washer) calling all the shots.

    Deteriorating (significantly) top and bottom line WHEN ALL COMPETITORS POSTING BIG POSITIVE NUMBERS!

    In a very competitive industry - EMS and clearly one of the smaller players (Nam Tai had dropped from top 15 EMS to now not even 30th; of top five EMS number 1 is approx. over 100x and number 5 over 15x larger. Economies of scale, size (mfg & buying power), global customer solutions matter!

    No competitive advantage...the days when china cheap labor is an advantage are gone. All the major players are there and many moving to lower cost areas in Asia like Vietnam. Besides labor rates in China are increasing dramatically and also by 2012 tax rates will effective at least double (refer to Hon Hai's (Foxconn) issues in Shenzhen with many suicides having to raise labor rates and pass pricing increases to customers and moving production to Tiawan).

    Nam Tai FPC (where mainly applied to mobile market with Japanese technology) could falter significantly with other Asia tech taking over like the Koreans. Besides, Nam Tai has a deteriorating relationship with its Japanese customers (which I think are close to 75% or higher of the current revenue). (I am sure the X Japanese CEO who left in 2008 and is very well connected - his father is x chairman of Epson - is not singing Nam Tai's praise)

    LCD in the form factors and non touch that Nam Tai is in is not a winner.

    Both FPC / LCD have been low margins for the company and do not see how they will improve. Nam Tai has already maximized austerity measures e.g. 30% wage cuts for all staff and turfed anyone they could.

    Very disturbing is the disappearance of the company's Consumer business which has historically grown very well and had very high profit (company says getting out because low margins...this is a very curious statement...how did it go from very high to very low????? - how did this go to nothing????? Very Scary

    Expanding into capital intensive Flexible Printed Circuits w/ NIL previous experience...believe Wuxi Factory largely empty after significant investment (how does company destroy previous lucrative consumer business and invest here?????).

    The Positives-

    Very strong cash position with no debt.

    Stock currently trading at close to cash value so one may spouse limited down side

    This is the analysis which leads me to being a strong sell.

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