Profit from the Yuan and the Growing U.S./China Trade War...

by Michael Checkan, Advisory Panelist, The Oxford Club

For the past 30 years, China has experienced unprecedented economic growth. It's exploded more than 10% each of the past four years alone...

And one of the biggest reasons for this growth - and the one that's now sparking a U.S./China trade war?

The artificial manipulation of its currency, the yuan.

You see, for years China has pegged its currency to the U.S. dollar. Simply put, the Chinese government allows the yuan to fluctuate only at a fixed distance from the U.S. dollar.

The result is that China has been able to fuel its explosive growth by having some of the lowest production costs and cheapest exchange rates in the world. It's resulted in huge profit margins and enormous demand for Chinese goods - especially from the U.S., the world's largest consumer nation.

But with renewed pressure from the U.S. and other trading partners with China, many expect to see a significant revaluation of the yuan. It's now estimated to be 30% to 40% undervalued...

And this is sending some investors scrambling to own the currency directly, before it takes off to the moon. But there are problems with that...

One, few people have access to yuan. And two, no interest is being paid on yuan deposits. It's an unattractive play no matter how you look at it.

Yet serious investors need to understand this situation - and how to profit from it. Thus the reason for this Special Report...

Unprecedented Trade Fueling China
For years now, the Chinese government has had the upper hand. Rather than let the yuan float freely,they choose to "manage" the revaluation.

And the result? Even as the Chinese economy grew by leaps and bounds, the yuan's value, as measured by other currencies, has not increased to reflect the growth. Since July, the yuan has risen a mere 0.6% versus the dollar.

So, as U.S. consumers take advantage of the bargains coming out of China, excess dollars continue to flow into China at unprecedented rates.

America's thirst for Chinese products resulted in a 30% increase in the trade deficit with China from 2004 to 2005. That 2005 surplus reached $162 billion. One year later, after another increase near 25%, the 2006 surplus rose to $201.6 billion.

Hence, it's easy to understand the increased protectionist rhetoric coming from Congress with regards to our Chinese trading partner.

Baby Steps from the Red Dragon
China's first step was to reset the peg on the yuan to the U.S. dollar. This was done last July when the yuan was allowed to appreciate 2.1 %. This was the first change in the value of the yuan relative to the dollar since 1995.

At the same time, China allowed for future controlled adjustments, not to exceed 0.3% in either direction per day. Hence the miniscule growth of the yuan.
According to the United States, 0.6% is nowhere near enough.

So, trade restrictions have been imposed, and threats are flowing regarding future, more stringent trade barriers.

Chinese officials maintain that the market is determining the value of their beloved yuan. In an interview in Shanghai in mid-January, central bank Assistant Governor Ma Delun said, "We're not manipulating the yuan. The small appreciation is decided by the market."

Many people believe that harsher sanctions against China are not in the best interest of the U.S. economy. Further, many also believe that, in the end, the Chinese will steadily allow the yuan to appreciate against the dollar and all major currencies.

The yuan still isn't an easy or attractive play, for reasons I've mentioned. But there's a much better opportunity in China for the average investor.

The Best Plays on the Yuan...
Profiting from the trade imbalance and the yuan comes down to answering one question... What has China done with all those dollars to date?

Clearly, the government has not pumped them back into the Chinese economy. To do so would be counter to the economic scenario that has yielded those double-digit growth numbers.

With a basically fixed currency value, if the Chinese allowed those dollars to flow into the Chinese economy by increasing the money supply, you would have over 1.3 billion domestic consumers - flush with yuan - buying Chinese goods.

The result would be skyrocketing prices and massive inflation. With price inflation would come the evaporation of foreign demand - the fuel in China's economic fire.

To date, the government has kept the dollars out of their economy by buying U.S. debt. The problem now, however, is that it has enough U.S. debt. The U.S. dollar has fallen in value to date and will continue to fall in value in the longer term. China has little interest in holding a declining asset.

This, coupled with flat yields and the prospect of severe overweighting to a single currency, makes U.S. Treasuries a less than attractive option.

More importantly for us, what will China do with all those dollars in the future?

According to China's leaders, they will put them to use in alternatives to the U.S. dollar. The result will be a better diversification of their reserve assets.

The Chinese have repeatedly announced its intentions to add:

One, the euro (and other currencies); Two, gold; and Three, oil to its reserves.

Most recently, on January 21st, Chinese Premier Wen Jiabao was quoted as saying that China would steadily push forward the foreign exchange rates reform and actively explore and expand the use of its foreign exchange reserves which now total nearly $1.07 trillion. A full 70% of that reserve is believed to be in U.S. dollars. According to Premier Wen, "We have enough."

Both Wen and the People's Republic of China Vice President Zeng Qinghong are on record of late suggesting that the dollars in the reserves should be used to purchase raw materials like oil, as well as considering the purchase of gold to hedge against the weakening U.S. dollar.

Understand the magnitude of surpassing $1 trillion in reserves. It is a world first, and this amount of money is greater than the annual GDP of many countries. It is a staggering amount of cash at their disposal, and it is growing by nearly $18 billion per month. OC

Reprinted with the permission of The Oxford Club

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