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Effects of RMB Revaluation
GFIA
September 2005


The most visible effect of the recent revaluation of the RMB was a dramatic increase in the volume of macroeconomic ramblings from financial analysts globally, and a rash of "special bulletins" in our in-boxes.

Our summary is that the revaluation is at the same time immaterial and massively significant. It's immaterial in that it was expected, it was small, and has few discernible short-term effects. It's massively significant as it's the watershed point at which the PRC begins its transition to the world's largest economy, by engaging with global capital markets.

Generally, the revaluation is of more immediate political and diplomatic significance that commercial. While it may accelerate the flow of speculative money into the PRC in the near term, it is part of an ongoing continuum of capital flows. It's also not impossible that it marks a peak in the current cycle of capital inflows ("buy on guns, sell on trumpets").

Realistically, looking at the strength of the Chinese economy and its exports, a 2.1% increase is not sufficient. From an economic standpoint, it makes sense to expect China to continue with their revaluation process. We expect that, while the PRC will definitely let the RMB appreciate (although the question over what period, remains), it will likely to be in small increments such that the immediate impact of the adjustment will not be significant (as they have shown with this initial revaluation). The banded float against a trading basket (pioneered most effectively in Singapore) allows the Chinese central bank a good chance of managing its currency at least expense with least vulnerability to speculation.

However, in the near term, there are dangers. The situation that China is facing right now is one of "internal troubles (socio-economic problems)" and "external threats (hot money)", which therefore requires them to move very carefully on the currency front. While the Chinese economy looks strong as a whole, internally, the Chinese government is treading a fine line as economic robustness is disproportionately contained within a few cities; the wider and ever-present challenge of feeding and housing the world's most populous nation remains. Sudden moves such as a significant appreciation of the RMB may trigger movements of hot money (Morgan Stanley's Andy Xie estimates that there is currently US$700 billion of hot money in Asia with roughly half of it in China). There are 1.2 billion mouths to feed in this country; the repercussions of an exodus of hot money taking profits, on the Chinese domestic economy, would be hugely negative. One other reason why the Chinese will move very slowly is also because of the number of hedge and other investment funds that have set up to play the China-story (at least 11 new China-themed hedge funds have emerged over the past 12 months. That's roughly one new China fund per month. 20 years of experience in investment, most of it in emerging markets, tells us that a rash of me-too fund launches is a sure prelude to a mess. Be afraid…be very afraid!)

With the removal of the currency pegs on the RMB and MYR, the US$ may be in for a downward trip since both China (and inevitably Malaysia, and probably the majority of Asian countries) will decreasingly be buyers of massive amounts of US$ sovereign debt. In fact, they need to diversify out of their existing holdings. Looking at the Bank of Korea's stance, one would expect them too to start shedding some of their US$ holdings following this revaluation and other Asian countries are also likely to follow suit.

So what does the revaluation mean for Asian hedge funds? In its simplest form, China-themed hedge funds investing in Chinese companies will probably benefit from the appreciation. Assuming that there is no hedging in the portfolios, then 2.1% of this month's gain in the long book should be due to the appreciation of the RMB against the US$. We can also expect investors and speculators to continue to invest in Chinese equities (both China and foreign-listed) in the short term thereby creating a positive upward momentum. Overall, we think that Asian hedge funds stand to gain as the other Asian currencies allow themselves to strengthen against the US$ whereas they were previously kept artificially depressed because of the MYR and RMB pegs. Looking forward, we'll have to take rather more note that we have done historically, of the currency positioning of the managers we follow.

Economically, the revaluation may not affect most Chinese industries except perhaps some exporters operating on thin margins. Looking at many of the key holdings of the long-short equity hedge funds, thin margins may be one criterion when choosing potential candidates for shorts (so may be a source of profit but conversely would not have been likely grounds for a long purchase). We doubt there will be a great deal of net effect on underlying valuations and corporate prospects. However industries that were in the danger of facing protectionist actions by importing countries are less at risk, although we expect these complaints to resurface regularly over the next decade. A more immediate result may be that bullish foreign investors bid up the prices of the better known stocks, regardless of fundamentals.

 
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