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Guinness Atkinson Asia Brief

June 2005
Edmund Harriss
Fund Manager Asia Focus Fund, China & Hong Kong Fund

Revaluing the Yuan

The revaluation of China's currency, the Renminbi Yuan, must be one of the most over-hyped themes in markets today. The perceived "unfairness" of the Yuan's value against the US Dollar is also being used as a smokescreen for old-fashioned protectionist policies.

The US trade deficit has grown sharply in recent years - from $378 billion in 2000 to $617 billion in 2004 - as demand for cheap imported goods has continued to rise. These cheap goods have been a boon to American consumers who, as a result of this increased outsourcing of manufacturing, have saved an estimated $600 billion over the past ten years.

The flipside to this increased demand for cheaper goods is a decline in domestic manufacturing. Wal-Mart, Home Depot, Dell and the rest are now only buying their goods from cheaper centers of manufacturing, such as China, in order to be able to provide products at a price the American consumer is prepared to pay.

And it is a lot cheaper to manufacture in China than it is in America; just as it is in India, Vietnam, Indonesia, Mexico, Turkey, Eastern Europe….the list goes on. The point here is that while politicians rage at China's "unfair" advantage and threatening to impose duties on Chinese imports to protect American jobs, they are being disingenuous. Cheaper goods are what consumers require and if they cannot get them from China then they will come from other low cost areas; and South Carolina is not one of them.

The scale of revaluation that is being called for - 10% or else - will come nowhere near to resolving the current US trade imbalance. According to the US Federal Reserve, China accounts for 10% Dollar's trade-weighted value. Even if the Yuan were to revalue by 25% this would only lower the Dollars exchange rate by 2.5%. According to HSBC (Hong Kong and Shanghai Banking Corporation), to bring the US current account deficit to 2-3% of GDP would require a trade weighted decline of 33% requiring the Euro to rise to $1.90 (from $1.23 currently) and the Yen to rise to ¥70 (¥106.90 currently) in addition to any Chinese move.

Politics aside there are however sound economic reasons for China to move from a pegged currency to a more flexible arrangement. This is something we expect to happen soon and will be to the long term benefit of both China and America.

For China:

  • Ever increasing engagement with the world economy makes China more vulnerable to external shocks which it would like to be able to absorb in part through its currency.
  • A flexible currency would allow China to develop an independent monetary policy and increase its range of options for managing its economy.
  • In the medium term it will moderate the relentless rise of foreign exchange inflows.

For America:

  • Economic stability in an increasingly important trading partner is as important for American industry as it is for consumers.
  • As a major buyer of US Treasuries, China has made a major contribution to a long period of American expansion through low interest rates and low inflation.

The most likely change would be from a pegged currency to a managed float relative to a trade weighted basket where the Yuan would be allowed to drift away from the US Dollar in line with trade-weighted movements in other currencies. If this were to happen we would expect the Yuan to appreciate against the US Dollar by up to 5% over the next year. If the Dollar were to strengthen however, we would expect to see the Yuan depreciate.

The benefit of this methodology from the Chinese point of view is that it would give exporters and banks time to adjust, since the move would be gradual and as well as predictable. It would not do anything to ease foreign reserve flows, and may in fact lead to increased speculative flows, in the short term; but currency flexibility has always been seen as a medium-term aim. Over the next 2-3 years the Yuan will likely appreciate further and greater flexibility could be introduced.

A greater currency move such as a revaluation by 10% followed by a move to a trade-weighted basket is also possible but less likely, in our view. A sudden move of this magnitude would hit exporters' margins before they had time to adjust and it is this sector that is the main driver of job creation and rising domestic affluence. We would not expect any move that could potentially destabilize such an important part of the economy; and for this reason we would rule out the possibility of a move of 25% as some have called for.

The conflicting messages coming from the US are baffling to the Chinese – the Treasury treats China as an economic super-power and key trading partner and advocates an early move as being in China's best interests while the Commerce Department and some in Congress treat China as a pipsqueak and are demanding an end to the cheating or else. If China is browbeaten into a more radical early move the consequences for American consumers could be severe, as they will also be for the Chinese economy and global growth could quickly come to a juddering halt.

In conclusion, we view the currency furor as being heavily over-played. China views a move toward a flexible currency as a necessary change to allow access to a greater range of tools for economic management. This is a medium term goal which should be achieved with minimal disruption in the meantime, which implies a gradualist approach to implementation. In short we do not expect the Yuan to appreciate by more than about 5% over the next year.

The Guinness Atkinson Asia Focus Fund and China & Hong Kong Fund invest in foreign securities which involves greater volatility, political, economic and currency risks and differences in accounting methods. The Funds are non-diversified meaning they concentrate their assets in fewer holdings than diversified funds. Therefore, these Funds are more exposed to individual stock volatility than diversified funds.

As of 5/31/05, neither the Asia Focus Fund nor the China & Hong Kong Fund held any shares of Wal-Mart, Home Depot, or Dell. Each Fund's holdings may change at any time due to ongoing portfolio management and should not be considered a recommendation to buy or sell any security.

Opinions expressed are those of Edmund Harriss and are subject to change, are not guaranteed and should not be considered investment advice.

This information is authorized for use when preceded or accompanied by a prospectus for the Guinness Atkinson Funds. The prospectus contains more complete information, including investment objectives, risks, fees and expenses related to an ongoing investment in the Funds. Please read the prospectus carefully before investing. Mutual fund investing involves risk and loss of principal is possible.

Distributed by Quasar Distributors, LLC (06/05).

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