Comment on Chinese decision to revalue Yuan from Charlemagne Capital, BaringAsset Management and AberdeenAsset Management Asia

Experts from Charlemagne, Baring and Aberdeen comment on the impact and significance of the long-awaited move by China to realign its currency.

Charlemagne Capital: Last week China made the long awaited but nevertheless unanticipated step of de-linking its currency from the US Dollar. The Chinese authorities will now manage the Yuan or Renminbi (RMB) with reference to a currency basket, the compsition of which will remain secret, as is typical of such arrangements. This move has been carried out at a central parity rate of RMB8.11, an effective revaluation of 2.1%.

The RMB will trade within +/-0.3% of each day’s central rate. Shortly after China‘s announcement, Malaysia announced that it would remove the peg on its currency, the Ringgit (MYR). The Ringgit appreciated by approximately 1% in trading on the day following the announcement.

The Chinese action is the first significant move since January 1994 when the RMB was devalued 30% from 5.8 to 8.7 to the US dollar. Since then, China was applauded by some analysts for not further devaluing when other Asian currencies went into a tailspin in 1997. More recently, however, there has been foreign (largely American) pressure to revalue to currency as China‘s trade surplus has surged to over $100bn per annum, 150% of which is with the US.

This revaluation is a canny political move. The timing has taken the market by surprise but it was well flagged that China was preparing to liberalize its foreign exchange markets and that it would probably do so in a series of small steps. China has therefore reduced US pressure caused by the huge trade surplus. The timing is a little strange, coming at a time when China‘s domestic demand growth seems to be slowing and the US Dollar is recovering, but will make President Hu Jintao’s forthcoming trip to the US somewhat more comfortable.

Economically, the change is so small as to pass unnoticed – except in the case of those firms operating on razor-thin margins. We do not anticipate any noticeable impact on our Chinese portfolio. Longer term, however, this move sends a signal that China is continuing, as it has since 1978, to open up to the world as the private sector becomes ever more important. Eventually, this is likely to lead to a stronger RMB.

Observers have drawn parallels to the continuous rise in the Japanese Yen in the years and decades following its de-pegging in the early 1970s. Whether or not this is an accurate comparison remains to be seen. Most commentators in the last 24 hours have described the inevitability of the RMB’s rise in the coming years, while few have mentioned the dire state of the banking industry and the uncompetitive nature of much of China‘s economy. Furthermore, even if (as is likely) the currency does gain ground, history shows that the long term in China is measured in years and decades rather than weeks and months.

Aberdeen Asset Management Asia Ltd: Flavia Cheong, senior investment manager, said: "A revaluation of renminbi was always the most likely and appropriate option for the Chinese authorities to take. Despite the progress the Chinese economy has made it is not yet in a position to be able to free float its currency. A two percent appreciation will not have a huge impact on our companies. A peg to a basket of currencies is also good as it would mean less volatility and less room for speculators as has been demonstrated by Singapore.

"In the longer term, we believe that a flexible exchange rate policy can only benefit the Chinese economy, as it will give it some monetary policy autonomy. In addition, foreign participation may be needed to capitalise the banking system, which is deeply embedded in bad debt. Exchange rate distortion also prevents proper pricing of capital; state-owned banks have yet to show significant improvement in their lending decisions with the average non-performing loan ratio still high. Inefficiency in capital allocation will not only threaten the sustainability of China‘s growth but also raise financial risks in coming years.

"We believe that the economy will continue to expand at a robust pace, with an increasingly higher reliance on domestic demand to spur growth – as opposed to fixed asset investment. At the stock level, we will continue to tap the mainland’s growth potential via Hong Kong stocks, where valuations continue to appear less demanding, and with better corporate governance and transparency."

Baring Asset Management, Hong Kong: Khiem Do, Head of Asia Pacific Equities, welcomes the news that the Chinese Yuan will no longer be pegged to the US dollar, but that it will be allowed to float in a tight band against a basket of foreign currencies, describing it as the start of a process which will see value unlocked in a whole range of Asian assets, including currencies and equities.

Khiem Do says: “Although the timing of this change is slightly earlier than many market participants expected, which was to see the change happening ahead of Mr Hu Jin Taio’s visit to President Bush in September, the size and extent of the revaluation was what we have been predicting for the past twelve months.”

Effective immediately, the Yuan has been revalued by 2%, and will be allowed to trade in a tight 0.3% band against a basket of foreign currencies, said the Chinese government, without specifying which currencies.

He continues: “Ultimately, we believe, this was a political decision, as China wants to avoid a potential trade war with the US. Had it not been for the political pressure from the US, it seems likely that China would have kept the exchange rate unchanged. Although we expect the currency to continue to appreciate over time, we do not expect to see another re-valuation any time soon. Our thesis has always been that they will allow the Yuan to appreciate in baby steps over a long period of time, and we expect plenty of time for this adjustment to be absorbed by industry before further changes are made.

“We believe this policy change is positive because it will encourage assets to flow into the region. Already, the Yen has risen by 2% and the Indian Rupee has strengthened as investors respond to the news on the Yuan.”

Baring Asset Management has long argued that not only are Asian equities undervalued, but that Asian currencies are undervalued too.

Khiem Do adds: “What is also welcome is that this change in policy by the Chinese authorities should encourage Asian central banks to allow their money supplies – and their currencies – to rise.  Historically, these banks have sought to keep their currencies stable by balancing inflows into their financial systems with matching deposits offshore – a process known as “sterilisation”. We do not expect this to change overnight, but we should start to see a gradual move in the direction of greater currency freedom.”

“In the short term, the immediate reaction in the market is likely to be that a number of Asian or global manufacturers which have production facilities in China or buy significantly in China may be adversely affected. This is likely to be seen in the automobile industry, amongst textile and consumer durable manufacturers, and in a number of Taiwanese downstream technology companies, as well as in companies such as Wal-Mart. At the same time, companies exporting to China are likely to benefit.”

“As far as the Chinese equity markets are concerned, the “H” share index has been rising strongly for the past two days, including many of the likely beneficiaries, so perhaps a number of investors had started to anticipate this change. Whether the immediate reaction by investors is going to last is questionable. We suspect that, as always, the reaction will be exaggerated, then revert back to a more normal level as the fundamentals reassert themselves.”

“As far as our current portfolio positioning is concerned, we believe the overall impact will be neutral. On the one hand, the currencies of countries in North Asia, where we are overweight, should appreciate more than the ASEAN ones where we are more cautious, which should be positive. Against that, some of the manufacturing companies we are positive on in the region that have production facilities in China may be impacted in the short term, although the value of their assets will rise. Overall, we believe the effect will be neutral, but is a very positive development for investors in the region as a whole.”