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In an announcement on Dec. 9, the People’s Bank of China dropped a bombshell that went unnoticed by most U.S. investors.
The Chinese central bank said that it’s best not to peg the value of China’s currency – known as the renminbi or the yuan – solely to the U.S. dollar. Instead, it will peg the renminbi to a basket of its trading partners’ currencies.
The basket will consist of the euro, Japanese yen and 10 other currencies in addition to the dollar. The approximate percentages are believed to be:
- U.S. dollar: 26.4%
- Euro: 21.4%
- Yen: 14.7%
- Hong Kong dollar: 6.6%
- Australian dollar 6.3%
The remainder is divided up among the currencies of Canada, Russia and other commodity currencies.
Why Move Now
First of all, I believe the reason behind the move is straightforward.
The renminbi was recently admitted as a global reserve currency by the International Monetary Fund. China is asserting its financial independence from the U.S. It’s moving out of the shadow of the all-powerful U.S. dollar.
China’s central bank needs to set policy based on the Chinese economy and not have its policy set by the U.S. Federal Reserve. This is a key consideration as China makes trading in its currency open to the world.
The dollar peg was also acting as a major drag on the Chinese economy. Every time the dollar strengthened, the central bank would have to intervene in the currency market. That involved buying yuan from China’s banks – in effect draining money from the banking system and offsetting any monetary easing measures implemented by the central bank. Not what you want to do if your economy is slowing, as China’s is.
Another reason why the move is happening now is trade. Thanks to its peg to the dollar, the renminbi soared 35% versus its trading partners over the past six years. That is cutting into its competitiveness.
The chief economist at China’s Industrial Bank, Lu Zhengwei, told The Wall Street Journal, “The overvaluation of the renminbi is a root cause of China’s economic ills these days.”
The Currency Effects
The currency move by China is sure to have ramifications worldwide.
The first effect is obvious: there will be less demand for the U.S. dollar. Long term, that is bearish for the dollar.
As I’ve outlined before, China’s efforts to internationalize its currency are already lowering demand for the dollar. One way that’s happening is through the issuance of bonds denominated in renminbi – not dollars – and sold domestically in China. These bonds are nicknamed panda bonds.
For example, South Korea recently issued a sovereign three-year note denominated in the renminbi. With a 3% yield, it was hugely popular – five times oversubscribed – paving the way for more such bonds to be issued by other borrowers around the world.
Effect No. 2 is that the move to tie the renminbi to a basket of currencies will allow the Chinese central bank to slowly weaken the yuan. This will allow it to stay more competitive, increasing trade and bolstering its economy. I expect the central bank to continue to weaken the yuan slowly for the foreseeable future.
Normally, any move to weaken the yuan would be met with howls of protest from U.S. politicians. But now, China can show that its currency has actually appreciated versus most world currencies. That makes it a little harder to accuse China of deliberately cheapening its currency.
How to Play It
The intent of the Chinese central bank is, of course, to bolster the Chinese economy.
As an investor, my focus would be on the “new China,” not the heavy industry “old China.” The glory days for those industries are gone.
One easy way to do this is through the KraneShares CSI China Internet ETF (NASDAQ: KWEB). The top positions in the fund include: Tencent Holdings (OTC: TCEHY), Ctrip.com International (NASDAQ: CTRP), Alibaba Group (NYSE: BABA), Baidu (NASDAQ: BIDU) and JD.com (NASDAQ: JD). Many of these U.S.-listed Chinese tech shares were added to a number of the MSCI international indexes on Nov. 30.
Consumer stocks will also benefit. Sales of cosmetics in China, for example, are soaring, as are the number of moviegoers in China. Unfortunately, none of the solid consumer stocks trade on major U.S. exchanges. A good way to access some of these types of names is through the Matthews China Small Companies Fund (MCSMX).
For income investors, there are two ETFs that are worth a look. The first is the Market Vectors ChinaAMC China Bond ETF (NYSEArca: CBON); the second is the KraneShares E Fund China Commercial Paper ETF (NYSEArca: KCNY).
Bear in mind, a weakening yuan will eat into some of the gains in these ETFs. Over the long term, however, all of these funds will benefit as China moves out of the shadow of the U.S.
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