Significant Changes for the Chinese Yuan and Japanese Yen are in the Winds

By: Christopher_Laird

With Paulson going to China again, it is time to look at what changes may come for the China manufacturing boom and financial/stock boom if China revalues the Yuan/RMB. Last week, China made some small moves to reign in liquidity, raising interest rates, increasing reserve requirements, and allowing the Yuan/RMB to trade is a wider band. 

These moves are seen as a bit of dressing – in anticipation of Paulson's visit. Clearly, a major topic of that meeting will be to address increasing pressures for US trade sanctions with China. China, on the other hand, has serious problems with their bubbles – notably the stock bubbles – and has already been trying to modestly tighten liquidity for its markets.

So there are two major issues China is dealing with – an out of control stock bubble, and also relatively serious impending US trade sanctions by a now Democratic controlled US congress.

Trade and currency backdrop

The solutions (or at least an attempt at one) to both of these China dilemmas – trade frictions and a China stock and finance bubble – would seem to work together. If China allowed the Yuan/RMB to strengthen – more than a couple of percent – then their manufacturing/export sectors would see some cooling in stock prices – ostensibly.

And, if China allows the Yuan/RMB to strengthen in a meaningful way, trade frictions with the US would cool for a time. The last time China did a significant move to let the Yuan float more freely, about a year and a half ago, they took the wind out of the sails of the US trade protectionist's sails for a good period of time. 

This time, with new trade pressures, and the fact that China has already voiced serious concerns about their finance/stock bubbles – it is quite possible that some meaningful results toward strengthening the Yuan/RMB will come after the next meeting with Paulson.

What would a stronger Yuan/RMB do to China?

Now, if that is the case, the question arises – what would such a move – to allow the Yuan to strengthen – do to the Chinese and world financial markets?

Well, for one thing, a stronger Yuan would cause some significant pressures on China's manufacturing boom. People talk incessantly about the success of their manufacturing sector, but don't often focus on the fact that the vast majority of Chinese businesses are very unprofitable, and are held up by rolled over bad loans. Also, even the profitable manufacturing businesses are facing cutthroat competition between each other. In spite of the fact that China has an exploding manufacturing boom, profit margins are extremely slim.

Just because China's Yuan is way undervalued, that does not mean they can easily raise it without serious pain. If their economy is now dependent on that level, of the Yuan being so cheap, then any serious rise in its value could significantly hurt Chinese export profits – regardless of whether people think their exchange rate is ‘fair' or not. China is very very sensitive to any action that might hurt their employment growth, far more than many people might think.

The point is, there is not a great deal of room for China to play with in letting the Yuan/RMB strengthen. Any meaningful strengthening of the Yuan/RMB would cause rather significant pressures on the entire manufacturing sector in China, and also would likely put a real damper on their stock markets. China is well aware of how sensitive their markets are to any strengthening of their currency….This is the real reason they are very resistant to letting the Yuan rise.

The problem for China is that they cannot simply ignore rising US trade pressures either. Congress' proposed trade tariffs of 27% have been on the table for several years, and at the very least, the US congress is on the verge of some meaningful trade sanctions on China. China cannot just ignore the situation.

Hard to keep ignoring US pleas

The fact of the matter is that China does indeed massively subsidize their manufacturing industry with a highly undervalued Yuan/RMB that is said to be at least 40% undervalued.

With the US having lost several million manufacturing jobs to China and elsewhere, the US congress cannot afford to ignore the situation any longer. So, we are likely going to see some significant changes – with either the Yuan, or else some nasty trade frictions emerging this year with China. 

Japan is also on the list of concerns with the US congress, with the US auto industry bewailing the highly undervalued Yen (rightfully so). They estimate that the Japanese have at least a $2000 cost advantage per vehicle due to the undervalued Yen alone. The EU has also been complaining very loudly about the very cheap Yen.

Some significant changes for the Yuan and the Yen are in the winds.

Yen and RMB

Another interesting point is that the Yen is often seen as a surrogate for the Yuan. China is one of Japan's top trade partners and is a rapidly growing export market for Japan. IF the Yuan (the Yuan/RMB -but I get tired of writing it that way all the time) were to strengthen more than a couple of percent, then the Yen will have room to strengthen as well. In fact, with the EU and now the US really making a lot of noise about the overly weak Yen, I expect the Yen to follow the Yuan up, if it should rise more than a few percent in 07.

This now leads to the dicey Yen carry trade situation. If the Yen indeed does strengthen in any significant way vs the Euro and the USD and other currencies – then the already massive Yen carry trade wants to unwind. Needless to say, any indication of that causes huge global market sell offs – as happened when, after the Feb 27 Asian market sell off this year, the Yen carry trade continued to unwind and put more liquidation pressures on most financial markets for two weeks.

Probable outcome of a Yuan rise

In any case, if the Yuan rises much at all this year, the Chinese stock and financial markets will not like that one bit. With all the bubble excess now in the Shanghai market for example, we could see a very bad reaction to any strengthening of the Yuan that would affect China export profits – since the Shanghai stock market is so ridiculously over valued on a PE basis.

Any major developments in the Shanghai market seem to have a very exaggerated effect of the Asian markets – and so on, as we saw in Feb of this year (the crashes). Also, any China negative economic news immediately hits commodities hard.

Now, furthermore, commodities have been heavily infected with speculative froth, and as I mentioned a week or two ago, copper was due for a fall, and, the USD has apparently bottomed for now and is turning up. The prospects of the USD strengthening vs the Euro remain – the EU is not too happy about the strength of the Euro – and wants to halt its rise. Weak base metals, and a now turning USD from falling to rising, has hit gold. 

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By Christopher Laird
PrudentSquirrel.com

Chris Laird has been an Oracle systems engineer, database administrator, and math teacher. He has a BS in mathematics from UCLA and is a certified Oracle database administrator. He has been an avid follower of financial news since childhood. His father is Jere Laird, former business editor of KNX news AM 1070, Los Angeles (ret). He has grown up immersed in financial news. His Grandmother was Alice Widener, publisher of USA magazine in the 60's to 80's, a newsletter that covered many of the topics you find today at the preeminent gold sites. Chris is the publisher of the Prudent Squirrel newsletter, an economic and gold commentary.

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