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China’s Inscrutable Currency Strategy
Purpose: Expose Opportunities for Smart Investors
The move by China’s central bank to abandon the yuan’s peg to the dollar on the day I returned from a three-week trip to Asia left a host of questions unanswered. The basket of currencies that will presumably determine the value of the yuan going forward is not disclosed. What kind of band the currency will be allowed to float within is not clear. The 2% revaluation in the currency on Thursday followed by a slight strengthening on Friday may actually encourage more short-term speculation as most economists believe the yuan is undervalued by around 10% to 20%. With $1 trillion in trade transactions a year and hot money capital flows equivalent to 5% of its GDP, uncertainty regarding the Chinese currency is high.
Not on the mainland
In the short term, this uncertainty gives investors the opportunity to take advantage not only of the expected strengthening of the Chinese currency, but of the general rise of Asian currencies against the dollar. In early 2005, I advised clients that the rise of the Euro against the dollar was over and that Asian currencies would be the next area to appreciate against the dollar. It may be that many of your best investment options in China do not involve investing in mainland Chinese companies.
Direct currency approach
The cleanest direct currency play on the expected rise of the yuan (also called renminbi) is to open a renminbi currency account at Everbank. A leading online bank ranked “Best of the Web” by Forbes, Everbank offers a variety of global currency accounts as well as three- and six-month FDIC-backed CDs that offer attractive rates.
Direct approach of iShare
Another direct China equity play is through the China iShare (FXI) which tracks the FTSE/Xianhua China 25 index which is made up of 25 of China’s largest and most liquid names. FTSE is an index company based in the United Kingdom and mental.
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 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 $550 billion.
To put that in perspective, the average market capitalization for a company in the S&P Global 100 Index is $70 billion. Again, it’s for a company. China iShare provides good exposure to three key sectors of China: energy (20%), telecommunications (19%) and industrial (18%). This concentration can be seen as a plus or a minus depending on your perspective. For example, some smart investors are making a bigger bet on China’s consumer markets. The first five companies represent 40% of the index. China iShare’s annual operating expenses are just 0.74% compared to 2% plus for other alternatives, including actively managed Asia and greater China region funds. Keep in mind that most of these companies are still largely controlled and owned by the Chinese government.
The best way to invest in China may be through more indirect vehicles that benefit from Chinese growth and its currency movements. An example of an indirect investment in China is through the Hong Kong iShare (EWH). It has considerable allocations to Hong Kong real estate (33%), utilities (17%) and banking (16%). After returning from a trip to Hong Kong, it seems clear to me that property markets have a way to go before they become too expensive. Supply is inflexible and even if prices rise as expected 30% during the next 18 months, the price level will still be about 50% below where they were in 1997. Being the last Asian currency pegged to the dollar should encourage capital inflows. In addition, the Hong Kong market has been much more successful than the Shanghai and Shenzhen stock exchanges which indicate that it will be the financial capital of China for the foreseeable future.
The indirect currency game
China’s move last week will also increase pressures for a number of other undervalued Asian currencies to appreciate. To compete with China’s export machine, many Asian countries have resisted letting their currencies rise, but now they have some room to maneuver. The Malaysian ringgit was released from its peg to the dollar last week and rose 0.7% on the first day. While the appreciation of the currency will slightly reduce the growth of exports, it will also reduce the cost of the increase in energy import costs and analysts expect the economy to grow 5.5% this year. The easiest way to invest in Malaysia is through Malaysia iShare (EWM) which tracks a basket of leading companies listed on its exchange. Another attraction – the annual fee for Malaysia iShare is only 70 basis points.
The game for the informed
Malaysia is often overlooked by investors even though it has progressed quietly but remarkably from a relatively poor producer of raw materials to a vibrant and widely diversified middle-income country.
Malaysia, located along the strategically important Strait of Malacca, should be on every investor’s radar screen for the following reasons:
It has little external debt and healthy foreign exchange reserves. In area, it is slightly larger than New Mexico.
Another smart indirect play by China would be to invest in Canada iShare (EWC). The Chinese are on a buying spree investing in Canadian energy companies and recently shelled out $2 billion to build a thousand-mile pipeline from Alberta’s tar sands to a West Coast port and onward to Beijing and Shanghai. The Canada iShare tracks the MSCI Canada index which has a 40% exposure to the Canadian energy and materials sector.
And what about Starbucks (SBUX) as a China play? Starbucks has about 9,000 stores worldwide and in the first quarter of 2005 its sales increased by 27% and revenues exceeded $100 million. It entered the Chinese market in 1999 and has about 300 stores that have performed beyond 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 young people aware of affluent status, Starbucks expects that before long China will be its second most important market. During my recent trip to China, I visited ten Starbucks stores and all of them were bustling with lots of young Chinese enjoying not only the coffee products but also the higher margin specialty drinks. Do you think the Chinese will still prefer tea? Japan shows that when income levels reach certain tipping points, consumer preferences change from tea to coffee. Starbucks still looks expensive, but many great companies still are. Starbucks investors made 43 times their investment in their 1992 IPO and revenue rose 27% in July.
China represents a huge opportunity for long-term investors, but an indirect approach may be the smartest strategy.
Next week: Find out who the next big Asian Bull Market is in the 21st century – hint “It’s not China!
Carl Delfeld is head of global consulting firm Chartwell Partners and publisher of the Chartwell Advisory and Asia Investor Intelligence newsletters. He has served on the executive board of the Asian Development Bank and is the author of The New Global Investor (iUniverse: 2005). For more information go to http://www.chartwelladvisor.com or call 877-221-1496
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