You Know Yuan-t It!

There’s no doubting the motive behind China’s policy towards the Yuan. By keeping the Yuan undervalued, Chinese exports become effectively cheaper compared to those of their competitors, giving China a great advantage in international trade. Also, by restricting the amount of money that Chinese nationals can bring abroad, banks are allowed to keep rates at low levels, helping boost investment at the local scene.

Keeping tight control over capital inflows and outflows has also allowed China to isolate itself from the crazy ups and downs of the global financial landscape. Instead of getting rocked by the Asian crisis or the Great Recession in 2008, China has actually grown and is now the world’s 2nd largest economy!

But of course, times change and with China’s growing role in international relations, there have been calls for China to play nice and allow passage for capital to flow in and out of the country.

The first step? Allowing the Yuan to appreciate and float freely!

To the Chinese government’s credit, it has taken some initiative towards the internationalization of the Yuan.

In 2009, China implemented a trial program that would allow for the settlement of trade transactions to be settled in Yuan. In the past, imports and exports deals would always have to be settled in dollars. As of January 2011, 7% of China’s trade transactions were actually settled in Yuan!

Meanwhile, in Hong Kong, China has allowed yields on Yuan denominated bonds to be set by the market instead of marking it against the People’s Bank of China‘s benchmark rate. In Shanghai, government officials are in the process of allowing residents to bring their moolah abroad and invest in foreign markets.

Keep in mind though, these are just the first tiny steps toward allowing the yuan to appreciate freely. The Chinese government still has over $3 TRILLION worth of currency reserves to help devalue the Yuan. Chinese officials also reason that they cannot allow the yuan to appreciate too quickly because it would destabilize their markets.

The government’s intervention in the market shouldn’t stop you from looking at the Yuan as a speculative investment though. Over the past year, USD/CNY has dropped from the 6.8350 level to the current price at 6.4796, marking a 5.20% drop.

Moreover, our buddies over in Washington are insisting that the Yuan may be undervalued by as much as 40%. Now, I don’t know about that figure, but you can bet that we’ll be hearing more cat-calls from U.S. legislators shouting for more appreciation (of the Yuan that is).

Using interest rate parity theory, the rate for a one-year forward contract should be at 6.2879. What this means is that based on current interest rates, we should see the Yuan rise another 3.0%!

And let’s not forget that the big boys are putting their money on the table and betting on the Yuan. Word on the street is that there are more than a few financial institutions out there who are opening up their balance sheets to yuan denominated assets. The problem is there’s just ain’t enough supply to satisfy their cravings. If it’s good enough for the Goldman Sachs’ of the world, then it might be good enough for you!

Now, you may feel that a long Yuan position may be slow and steady and you would be correct. As I said earlier, it is very unlikely that the Chinese government will allow faster appreciation. But given the way the economic landscape is developing, if you don’t mind waiting it out, then perhaps buying some Yuan may not be a bad idea.