Is China Serious about Currency Reform? (Milton Ezrati)

Wednesday, April 18th, 2012

by Milton Ezrati, Lord Abbett

04.16.2012

Recently, China’s central bank governor, Zhou Xiaochuan, made comments that drew less attention than they deserve. First, he suggested that market forces would play a bigger role in setting the value of China’s currency, the yuan (or renminbi). He also mused that the yuan should rise further against the dollar and on foreign exchange markets generally. An announcement Saturday, April 14, by the People’s Bank of China relating to increased flexibility in the trading band of the currency would appear to confirm Zhou’s serious intent. There is room for two responses to this seemingly new Chinese positioning, one cynical and the other much more positive and hopeful.

On the cynical side, there is history. China has long strived to promote its exports by keeping its yuan cheap to the dollar and other major currencies. The global pricing advantage this policy has given Chinese goods has enabled the country famously to raise its share of global exports from nearly zero in the early 1990s, when it initiated the policy, to upwards of 12% more recently. The accompanying business and employment opportunities have propelled China to enviable aggregate growth rates throughout this time.

For these two-plus decades, China’s relentless adherence to this policy has led Beijing to resist all pressure for yuan appreciation, whether from by the United States, the European Union, or others. Beijing’s leadership set the tone in the early 1990s. In 1993, when under secretary of the Treasury, Larry Summers, demanded currency revaluation on behalf of President Clinton, Beijing, far from bowing, devalued the yuan within six months, and by a massive 60%. It then locked in the currency at that cheap price against the dollar. The move undercut pricing in most of the rest of Asia and ultimately contributed to the Asian crisis of 1997–98, referred to more commonly as the “Asian Contagion.” It was not until 2005 that Beijing allowed some upward movement in the yuan’s foreign-exchange value, and even then it kept tight control, allowing only frustratingly slow and slight appreciation.

Such a backdrop makes it easy to dismiss Governor Zhou’s comments as just so much rhetoric. After two decades of tight control, it is hard indeed to see China accepting much market influence on its currency. And since the yuan today remains 11% cheaper against the dollar than it was before China’s first grand devaluation, Governor Zhou’s speculation about whether market forces might raise its value further looks less insightful than obvious. The yuan’s modest depreciation so far this year raises still more questions about such a market-oriented commitment. Of course, market forces always move in uneven patterns, but it is nonetheless suspicious that, in 2010 and 2011, when Beijing aimed to slow the country’s growth rate, the yuan appreciated gradually, in its usual controlled way, but now that Beijing wants to promote growth, it has suddenly gone the other way. The pattern certainly speaks less to market forces than to Beijing’s usual currency management.

Still, cynicism aside, Governor Zhou’s comments may also contain a more positive, forward-looking aspect. Most encouraging is the link he made between the yuan’s value and China’s now-clear efforts at internal development. Beijing has come to recognize the vulnerabilities of export-oriented growth policy, especially during the 2008–09 global recession. Accordingly, it has begun to think increasingly about internal development as a second engine of growth, but also as a way to spread the benefits of economic development and avoid social unrest. As papers posted on China’s central bank and other government websites also make clear, Beijing realizes that the country cannot expect to increase its global export share over the next 20 years at the same rate it has in the past. China’s great success with its 2008 stimulus package has further encouraged the domestic development decision by proving the huge potential returns it offers. But Governor Zhou’s remarks are the first time Chinese officials have publically recognized that the shift requires a rise in the yuan’s foreign-exchange value.

Matters surely will unfold slowly. For the sake of jobs and incomes, China will continue to support its exports until it has achieved a critical mass of internal development, including a broader consumer sector, to support aggregate growth. But the governor’s comments should build conviction here in the United States and elsewhere in the world that China clearly plans to move along this path. Because broad-based domestic development will have more difficulty than exports in generating rapid growth, the picture offers reason to expect that China will exhibit slower growth going forward than it has in the past. But at the same time, the prospect promises increased opportunities for producers in the United States and elsewhere in the world to sell into a growing domestic Chinese market. It also promises that, in time, global trade patterns will find relief from the imbalances previously imposed by China’s once single-minded focus on exports.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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Copyright © Lord Abbett

Tags: Aggregate Growth, Asian Contagion, Asian Crisis, Bank Of China, Central Bank Governor, Chinese Goods, Currency Reform, Currency Revaluation, Cynical Side, Foreign Exchange Markets, Global Exports, History China, Larry Summers, Lord Abbett, Milton Ezrati, S Central, Secretary Of The Treasury, Serious Intent, Yuan, Zhou Xiaochuan
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3 Trends to Watch for Global Investors

Thursday, April 5th, 2012

Bloomberg announced over the weekend that China’s manufacturing grew at the fastest pace in a year. We follow the government’s Purchasing Managers’ Index (PMI) closely, as we believe it is a better indicator of China’s domestic demand than the HSBC PMI. Whereas HSBC PMI surveys 400 small and mid-sized companies, which are typically export-oriented, the government’s PMI surveys 820 mostly large, state-owned enterprises across 20 industries.
Though manufacturing activity exceeded analysts’ estimates, some China bears focused on the fact that the March 2012 number is lower than the average during the third month from 2005 through 2011. What’s important for investors to consider is that the trend is your friend: It is the fourth month in a row where the PMI landed above the three-month PMI, and shows the economy is on the right path.

Below are three additional constructive trends we see in China.

1. China Returns Poised to Revert to the Mean

Over the past few years, Chinese stocks have lagged compared to their emerging market peers. However, the Periodic Table of Emerging Markets perfectly illustrates how last year’s loser can be this year’s winner. Historically, every emerging country has experienced wide price fluctuations from year to year. Over time, though, each country tends to revert to the mean.

In the visual below, we highlighted China’s performance pattern over the past 10 years. Chinese stocks landed in the top half four out of 10 years—2002, 2003, 2006 and 2007. In 2003, China climbed an astounding 163 percent; in 2007, it was the top emerging market again, returning nearly 60 percent.
Since then, the country has fallen to the bottom half of the chart. If you apply the principle of mean reversion, history appears to favor China landing in the top half during this Year of the Dragon.

See the original Periodic Table of Emerging Markets here.

2. Liquidity Cycle Could Benefit Stocks

Yet China leaders won’t leave its success to pure luck. If the Dragon doesn’t breathe fire into markets, it may be a shot of liquidity injected by policy easing that could drive stock prices higher. Macroeconomic theory states that when a country’s money supply exceeds economic growth, the excess liquidity tends to drive up asset prices, including stocks.

BCA Research documented this trend in China over the past eight years. The research firm compared the difference between the change in money supply growth and nominal GDP growth and Chinese stock prices. In both instances when the change in excess liquidity fell to a low, so did stocks. Conversely, the rise of money supply growth compared to GDP growth “coincided with major rallies” for China’s stock market, according to BCA.

Today, it appears that the change in excess liquidity is just beginning to bounce off another low, as are stocks, indicating another potential inflection point.

3. Incentive to Maintain Growth

BCA hedges China’s possible stock advancement in the short-term if signs of economic improvement continue because they “reduce the odds of aggressive policy easing.” A few weeks ago, I discussed how investors seemed to overlook China’s focused macro policy strategy, with its actions deliberate and purposeful. This year, the government has extra incentive to sustain meaningful growth as it transitions to a new leadership by the end of the year. As President Hu Jintao and Premier Wen Jiabao depart, Xi Jinping and Li Keqiang are expected to take over.

Looking at historical GDP growth per year since 1978, Deutsche Bank finds there’s precedence for this idea. During the fifth year of the leadership transition cycle, “high or stable” GDP growth was maintained, with the exception being the Asian Financial Crisis in 1997.

These trends will be covered in my upcoming webcast on China with CLSA’s Andy Rothman. Join us as we discuss what investors should expect from China in terms of long-term GDP growth, fixed asset investment, exports and the housing market.

When I was in Singapore at the Asia Mining Congress last week, I was fortunate to be among a group of sharp and intelligent experts across the financial and mining industries. A China bull presenting an excellent case for the country was Jing Ulrich, JP Morgan’s managing director and chairman of China equities and commodities group. She’s the Oprah Winfrey of the investment world, as for the past three years, Forbes Magazine has ranked her among the 50 Most Powerful Women in Business.

Ulrich expressed similar views toward China and its political will in a recent “Hands-On China Report” following her attendance at the China Development Forum in Beijing. She said that the government ministers emphasized their commitment to rebalancing the economy toward consumption. While “fundamentals are currently sound, the nation must modify its ‘imbalanced, uncoordinated and unsustainable’ course of development,” says Ulrich. What investors should remember is that the government had the financial resources to effect this change and considered it important to maintain sustainable growth.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. The Purchasing Manager’s Index is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment. The Hang Seng China Enterprises Index is a capitalization-weighted index comprised of state-owned Chinese companies (H-Shares) listed on the Hong Kong Stock Exchange and included in HSMLCI index (Hang Seng Mainland Composite Index).

Tags: China, Chinese Stocks, Commodities, Commodity, Dragon, Economy, Emerging Market, Emerging Markets, Estimates, Global Investors, Gold, History China, India, liquidity, Loser, Mining, Pace, Periodic Table, Pmi, Price Fluctuations, Principle, Purchasing Managers Index, State Owned Enterprises, Surveys, Year Of The Dragon
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