China’s inscrutable currency strategy

Purpose: Identify opportunities for intelligent investors

The move by the Chinese central bank to unpeg the yuan from the dollar on the day I returned from a three-week trip to Asia left a lot of questions unanswered. The basket of currencies that will reportedly determine the future value of the yuan has not been disclosed. In what band the currency is allowed to fluctuate is not at all clear. The currency’s 2% appreciation on Thursday, followed by a slight strengthening into Friday’s week, could fuel further short-term speculation as most economists believe the yuan is undervalued by around 10% to 20%. With US$1 trillion in trade transactions per year and hot money inflows of 5% of GDP, uncertainty surrounding the Chinese currency is high.

Not on the mainland

In the short term, this uncertainty offers investors an opportunity to benefit not only from the expected strengthening of the Chinese currency, but also from the general appreciation of Asian currencies against the dollar. In early 2005, I advised my clients that the euro’s rise against the dollar was over and that Asian currencies would be next to appreciate against the dollar. It may turn out that many of your best investment opportunities in China do not involve investing in mainland Chinese companies at all.

Direct Currency Approach

The cleanest direct currency play on the expected appreciation of the yuan (also known as the renminbi) is to open a renminbi currency account with Everbank. Everbank is a leading online bank, ranked “Best of the Web” by Forbes. It offers a variety of world currency accounts, as well as FDIC-backed three and six month CDs with attractive interest rates.

Direct iShare approach

Another direct equity market in China is the China iShare (FXI), which tracks the FTSE/Xianhua China 25 Index, which consists of 25 of the largest and most liquid Chinese names. FTSE is a UK-based index company and Xianhua is a China-based media company.

All 25 stocks included in the China iShare are listed on the Hong Kong Stock Exchange. Some of them are incorporated in mainland China (H shares) and some of them are incorporated in Hong Kong (red chips). The total market capitalization of the index is $170 billion. The broadest Xinhua China Index includes 1,355 listed companies with a total market capitalization of US$550 billion.

For comparison, the average market cap of a company in the S&P Global 100 Index is $70 billion. That too is for a company. The China iShare offers good exposure to three key sectors in China: energy (20%), telecoms (19%) and industrials (18%). This concentration can be seen as a plus or minus depending on your perspective. For example, some savvy investors are betting more on China’s consumer markets. The top five companies make up 40% of the index. The annual operating costs of the China iShare are just 0.74%, compared to 2% plus for other alternatives, including actively managed Asia and Greater China funds. Keep in mind that most of these companies are still largely controlled and owned by the Chinese government.

Indirect Approach

Perhaps the best way to invest in China is through more indirect vehicles that benefit from Chinese growth and its currency movements. An example of an indirect investment in China is the Hong Kong iShare (EWH). It has sizeable allocations to Hong Kong real estate (33%), utilities (17%) and banks (16%). Having just returned from a trip to Hong Kong, it seems clear to me that property markets still have a long way to go before they become too expensive. Supply is inflexible and even if prices increase by 30% over the next 18 months as expected, price levels will still be around 50% below 1997 levels. As the last Asian currency to be pegged to the dollar, capital inflows should be encouraged. Additionally, the Hong Kong market has been much more successful than the Shanghai and Shenzhen stock exchanges, signaling that it will be China’s financial capital for the foreseeable future.

Indirect currency game

China’s move last week will also increase appreciation pressures on a number of other undervalued Asian currencies. To compete with China’s export machine, many Asian countries have resisted letting their currencies appreciate, but now they have some room to maneuver. The Malaysian ringgit broke free from its peg to the dollar last week, rising 0.7% on the first day. While currency appreciation will dampen export growth somewhat, they will also lower the cost of rising energy import costs, and analysts expect the economy to grow 5.5% this year. The easiest way to invest in Malaysia is through the Malaysia iShare (EWM), which tracks a basket of leading companies listed on its stock exchange. Another attraction – the annual fee for the Malaysia iShare is only 70 basis points.

The piece for the informed

Often overlooked by investors, Malaysia has quietly but remarkably transformed itself from a relatively poor commodity producer into a busy and broadly diversified middle-income country.

Located on the strategically important Straits of Malacca, Malaysia should be on every investor’s radar screen for the following reasons:

It has low external debt and healthy foreign exchange reserves. In terms of area, it is slightly larger than New Mexico.

  • Malaysia has a balanced economy with strong industrial and service sectors, important natural resources and openness to foreign investment.
  • It has a parliamentary system and shared powers between the central government and 16 states and federal territories.
  • Malaysia is well positioned to benefit from growth in the region, with Japan, China and the US being the key export and investment partners.
  • Natural resources include tin, petroleum, natural gas, timber, copper, iron ore and bauxite. Small but steady exporter of oil and natural gas.
  • It has a young and increasingly well-educated population with an average age of 24 and a 90% literacy rate.
  • Malaysia’s per capita income is approaching $5,000. Solid middle-income country with a growing middle class.
  • The Kuala Lumpur Stock Exchange, also known as Malaysia Bursa, has over 800 companies listed.

    Canada?

    Another smart China indirect play would be to invest in Canada’s iShare (EWC). The Chinese are shopping, investing in Canadian energy companies and recently invested $2 billion to build a thousand-mile pipeline from tar sands in Alberta to West Coast ports and on to Beijing and Shanghai. The Canada iShare tracks the MSCI Canada Index, which has 40% exposure to the Canadian Energy & Resources sector.

    Starbucks?

    And what about Starbucks (SBUX) as a China game? Starbucks has approximately 9,000 stores worldwide and in the first quarter of 2005 sales increased 27% and sales exceeded $100 million. It entered the Chinese market in 1999 and has about 300 stores that have exceeded expectations. The company hopes to expand to 30,000 stores and China is a key part of its expansion strategy. With 250 million Chinese approaching the middle class and millions of new affluent, status-conscious youth, Starbucks expects China to soon be its second most important market. During my recent trip to China, I visited ten Starbucks stores, and all were very busy, and many young Chinese were enjoying not only coffee products, but also the higher-margin specialty drinks. Do you think the Chinese will always prefer tea? Japan shows that consumers’ preferences change from tea to coffee when income levels reach certain inflection points. Starbucks always looks expensive, but many great companies always are. Starbucks investors made 43 times their investment in the 1992 IPO, and revenue soared 27% in July.

    China represents a tremendous opportunity for long-term investors, but an indirect approach may be the wisest strategy.

    Next week: Find out what the next great Asian bull market will be in the 21st century – Hint It’s not China!

    Carl Delfeld is the head of global consulting firm Chartwell Partners and editor of the Chartwell Advisor and Asia Investor Intelligence newsletters. He was a board member of the Asian Development Bank and the author of The New Global Investor (iUniverse:2005). For more information, visit or call 877-221-1496