Chinas Inscrutable Currency Strategy

Purpose: Expose Opportunities for Smart Investors

The move by China's central bank to drop the yuan's rigid peg to the dollar on the day of my return after a three-week trip to Asia left a host of questions unanswered. The basket of currencies that will allegedly determine the value of the yuan going forward was not disclosed. What sort of band the currency will be allowed to fluctuate within is not at all clear. The 2% revaluation in the currency on Thursday followed by a slight strengthening on Friday week may actually encourage further short-term speculation since most economists believe the yuan is undervalued by roughly 10% to 20%. With $1 trillion of trade transactions each year and hot money capital inflows equivalent to 5% of its GDP, the uncertainty concerning the Chinese currency is high.

Not In the Mainland
In the near term, this uncertainty gives investors an opportunity to benefit not just from the expected strengthening of the Chinese currency but the overall rise of Asian currencies against the dollar. In early 2005, I advised clients that the Euro's rise against the dollar was over and that Asian currencies would be the next area to appreciate versus the dollar. It may turn out that many of your best China investment options don't involve investing in mainland Chinese companies at all.

Direct Currency Approach
The cleanest direct currency play on the expected rise in the yuan (also referred to as the 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 world currency accounts as well as FDIC backed three and six month CD's which offer attractive rates.

Direct iShare Approach
Another direct equity China play is through the China iShare (FXI) that tracks the FTSE/Xianhua China 25 index that is comprised of 25 of the largest and most liquid China names. FTSE is a UK based index company and Xianhua is a China based media company.

All of the 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 cap of $550 billion.

To put this in perspective, the average market capitalization for a company in the S&P Global 100 Index is $70 billion. Again, that's for one company. The China iShare provides good exposure to three key sectors of China: energy (20%), telcom (19%) and industrial (18%). This concentration can be viewed as a plus or a minus depending on your perspective. For example, some smart investors are placing a bigger bet on China's consumer markets. The top five companies represent 40% of the index. The annual operating expenses of the China iShare are only 0.74% compared to 2% plus for other alternatives out there 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.

Indirect Approach
The best way to invest in China may be through more indirect vehicles that benefit from Chinese growth and its currency moves. One example of an indirect investment in China is through the Hong Kong iShare (EWH). It has sizable allocations to Hong Kong real estate (33%), utilities (17%) and banking (16%). Having just returned from a trip to Hong Kong, it seems clear to me that real estate markets have a way to go before becoming too pricey. Supply is inflexible and even if prices rise as expected 30% during the next 18 months, price levels will still be about 50% below where they were in 1997. Being the last Asian currency pegged to the dollar should encourage capital inflows. Furthermore, 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 Play
China's move last week will also increase pressures for a number of other undervalued Asian currencies to appreciate. To compete with the China export machine, many Asian countries have resisted letting their currencies rise but now they have a bit of room to maneuver. The Malaysian ringgit was released from its peg to the dollar last week and it rose 0.7% the first day. While currency appreciation will somewhat dampen export growth it will also reduce 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 exchange. Another attraction - the annual fee for the Malaysia iShare is only 70 basis points.

The Play for the Informed
Malaysia is oftentimes overlooked by investors even though it has progressed quietly but remarkably from a relatively poor producer of raw materials to a bustling and broadly diversified middle income country.

Malaysia, positioned along the strategically important Straits of Malacca , should be on every investors 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.