Market Overview

Is the Chinese Yuan Setting Up to Trade Higher?

For the past few years, many have argued that a great currency trade was setting up: buy the Chinese yuan against the US dollar.

The trading thesis generally goes like this: the Chinese currently suppress the value of the yuan to such a degree so as to make their exports the most competitive. However, this has the unfortunate effect of weakening of their own internal consumption.

At some unknown future date, the Chinese will recognize that this is an unsustainable path and will move to pull the yuan off of the dollar (or at least weaken the peg so as to allow the yuan to appreciate). Chinese officials have slowly implemented this policy over the past decade, strengthening the yuan. They have not changed the peg recently, but have made statements to indicate that they are planning to do so in the future.

Hedge fund manager Bill Ackman announced last fall that he was undertaking a similar strategy, except that he was going long the Hong Kong dollar rather than the yuan, although his thesis was nearly identical.

This is a policy US officials would happily accept, as it may make American exports more competitive on the global market compared to Chinese-made goods, which would become significantly more expensive when priced in a stronger yuan.

Some market commentators have alleged that the Federal Reserve Chairman Ben Bernanke has been taking active steps to encourage the Chinese to alter their peg. In fact, earlier in the week, when Bernanke was addressing college students, he stated that the Chinese may experience unfortunate side-effects due to their peg, including inflation.

As the Fed has been expanding the money supply through various programs in the wake of the financial crisis, the Chinese have likewise been forced to expand their money supply to maintain their peg. With a current peg near 6 to 1, for every dollar the Fed prints, the People's Bank of China must also print roughly 6 yuan.

As inflation rages in China, it would become more attractive for the Chinese to weaken the peg or even remove it entirely. This is a key scenario yuan bulls may be betting on.

Still, recent events may make this unlikely to occur.

The Chinese economy has shown marked signs of contraction, with its most recent PMI printing below 50, indicating that economic conditions may be deteriorating. For its part, while it may not be indicative of the underlying economy, the Shanghai composite has produced poor returns over the past few years.

The Chinese have been making inroads in terms of becoming a more consumption-based economy, but are still very much dependent upon exporting to other markets.

In fact, if economic conditions in China accelerate to the downside--playing out the so-called “hard landing” scenario, the Chinese may be more likely to actually strengthen their peg, weakening the yuan further in an attempt to export their way out of economic decline.

If China's economy manages to shrug off recent weakness, it may be wise to be bullish on its yuan, as a growing Chinese economy may make it easier for officials to end their peg. However, if China's economy struggles, the yuan may not appreciate anytime soon.

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