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Chinese yuan appreciation The Chinese yuan has appreciated approximately 3% per year since the launch of exchange rate reform in 2005, appreciating from 8.25 to 6.15 versus the U.S. dollar. The Chinese Central Bank “pegs” its exchange rate to the U.S. dollar—though it has allowed its currency to appreciate against the U.S. dollar more aggressively since 2005, as reflected in the below graph.
Economists differ on the extent to which the Chinese Yuan might appreciate should this currency “peg” be terminated, and the currency be allowed to “float” and be traded without restriction in the International Money Market (the IMM). Some economists estimate that the Yuan should be 30% stronger than its current level. However, the Chinese Yuan appreciated a mere 1.5% in 2012, as current global macroeconomic issues introduce greater uncertainty into Chinese economic growth rates, and thereby into the historical rates of Yuan appreciation.
The Chinese trade surplus puts upward pressure on the yuan, as Chinese exporters must ultimately sell dollars to buy yuan, which they use to run their factories in China. Any dollars not repatriated to cover costs in China can stay in the United States, typically in the form of U.S. Treasuries. While the Chinese central bank has “pegged” the yuan-dollar exchange rate to mitigate yuan appreciation and nurture Chinese exporters in the past, the Chinese Central Bank has also allowed the yuan to appreciate more aggressively since 2005, as noted above.
Japan yen weakens against the U.S. dollar and Chinese yuan
While the above graph reflects the relatively smooth appreciation of the Chinese yuan versus the U.S. dollar, it also reflects—by virtue of its “peg” to the U.S. dollar—the volatility of the dollar and yuan against other currencies. Most notable is the recent yen weakness against the U.S. dollar, which—by virtue of the yuan-dollar peg—reflects in weakness against the Chinese yuan. The yuan has thereby appreciated rapidly against the Japanese yen as well as the Korean won, in sync with the U.S. dollar. If this trend continues, China will face intensifying competition from the highly productive Japanese export machine, and perhaps more so from Korea as well. Japan simply needs a weaker currency associated with its high productivity to recover its export strength and return to a more positive level of economic growth.
By pegging the yuan to the U.S. dollar, and perhaps by managing the yuan from appreciating too rapidly against global currencies, the Chinese economy has benefitted from a fairly weak and stable currency. Such a managed and stable currency has been a great asset in attracting foreign direct investment (FDI), building a significant base of domestic capital formation, and thereby building the modern Chinese manufacturing machine. However, as we look to the future, we must also note the downside of maintaining a currency peg with the U.S. dollar. While a stable or appreciating currency can attract foreign investment, as it has for China in the past, a strengthening currency may not attract as much investment as it used to when investment opportunities provide lower returns, due to a higher cost base. Should the dollar continue to strengthen as a result of the expectation of future higher interest rates, this could also put further appreciation pressure on the Chinese yuan, and historical rates of appreciation against the dollar could be muted for some time.
Should the Japanese yen continue to weaken against the U.S. dollar, and (by virtue of the associated yuan peg to the dollar) also continue to weaken against the yuan, the Chinese export machine could face increased competition from Japan and Korea, which would see its domestic price levels decrease relative to China. After years of flat GDP growth and currency appreciation, this is a welcome relief for Japan, though a potential source of intensifying competition with its regional export competitors such as China and Korea. As such, the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs could continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and possibly Korea’s iShares MSCI South Korea Capped Index Fund (EWY).
© 2013 Market Realist, Inc.