Newsletter June 2005

Yuan Appreciation: When and How?   Pressure for a stronger yuan is mounting. Last week Treasury secretary John W. Snow named a special envoy to engage China on exchange-rate issues, signaling a deepening commitment across the Bush administration to draw a harder line with Beijing. The administration began raising pressure on Beijing amid sharp criticism in Congress that Chinese companies get an unfair advantage in the market from Beijing’s currency-management practices, The result is well known, the trade deficit with China has been soaring to $155 billion last year. And if we think the U.S. has been hard hit, take a look at Europe. Even though European industries export substantially more to China than the U.S. does, Europe’s heartland, the euro zone, is suffering from the currency’s 45% appreciation in the past three years against the dollar and the dollar-pegged yuan, “In the past two years, Asian competitors have gained a price advantage of 40% thanks to the exchange rate”, says a Bavarian machine maker. The Chinese juggernaut has been hitting Japan and other East Asian nations head on for more than a decade. Japan’s GDP has been contracting as they supplied much of massive investment underpinning China’s booming economy. Unemployment, virtually unknown in Japan since the 1950s, is around 5% as we speak.  Though the Chinese will not directly admit, but the  stable connection to the dollar has brought in hundreds of billions in foreign investment, which has been put to good use by an industrious Chinese population. The question is obvious; how long can it go. However engaging China is a delicate issue. The Bush administration is caught in a complex balancing-act: bashing Beijing enough to appease critics in Congress and stir action—without provoking trans-Pacific backlash. As Treasury secretary John W. Snow put it in diplomatic language: “Beijing badly needs a more flexible renminbi regime. So does the world economy.” According to Mr. Snow, “A stronger yuan is in China’s long-term interest as well. Keeping the currency pegged to the dollar unleashes inflationary pressures and contributes to misallocation of resources.” He well may be all right. But will the Chinese listen? There is growing concern than Beijing’s global ambitions could bump up against U.S. interests. Beijing’s influence has grown with free-trade agreements it has signed with a number of East Asian countries. And watchful observers are unnerved by state-owned Chinese petrochemical companies’ efforts to secure oil supply from Canada and Africa. China also has been successful to gather support by engaging some foreign governments that were facing international isolation because of alleged human-rights abuses. And lastly, China and India declaring strategic partnership is something the administration should not miss. However the situation is not as bad, yet. The U.S. still has the upper hand given its technological and military superiority. The Chinese still need direct foreign investment and know-how. And they know it. This is why they are reluctant to introduce a full float with fully liberalized capital markets. Foreign and Chinese economist are deeply divided over whether China will allow an appreciation of the yuan, also known an renminbi, any time soon. But eventually they will have to yield. “What we are calling for is an intermediate step that reflect underlying market conditions and allow for a smooth transition –when appropriate– to a full float.” said Mr. Snow. No one knows what exchange rate exchange rate the peg will move to, but it will mean that the yuan strengthens– and along with that will come a strengthening of most other currencies in the region.  And institutions are preparing for it. The Hong-Kong Monetary Authority said lately that it will introduce a ceiling on the local currency’s exchange are to the U.S. dollar, a move that is aimed both at discouraging use of the Hong Kong dollar as a proxy for speculating on the yuan as well as giving the body room to raise interest rates. With in effect last week, the quasicentral bank will guarantee to sell Hong Kong dollar to commercial banks at HK$7.75 to the U.S. dollar. Now, if the appreciation takes place, who will benefit? First, a stronger yuan benefits foreign companies that sell in Asia.  That’s because their Asian revenue will be worth more when converted into dollars, euros and other European currencies.  Second, sectors that derive a lot of revenues from Asia include semiconductors, technology, consumer durables and apparel, and Hong Kong banks, says Ronan Carr, a European equity strategist at Morgan Stanley. Likely losers will be companies that use dollars to buy goods from Asia for importing, because they get much more bang for their buck than they would if the yuan and other currencies were much stronger. Sectors hurt will be retailers such as Target, Wal-Mart and cell phone makers like Motorola and Nokia whose substantial costs are coming from China, so they could suffer, too.     China is Preparing Financial Institutions   China’s emerging as a global player poses both opportunities and danger for its leading elite.  Remember, China is still a fragile economic and political system. The Chinese Communist Party has been unwilling, or unable, to reform the banking system because it is the party’s means of bestowing political favors and thereby retaining support. Because the banking system is so weak, China is making only small progress in removing controls on cross-boarder capital movements for fear of subjecting banks to fatal foreign competition. Thus China piles up billions of U.S. dollar securities, sterilizing the inflationary pressures on the yuan by issuing bonds to Chinese banks. Until China frees up the capital account, it is in no position to float the yuan. And while there structural imbalances occur, China’s central bank issued rules to allow trading of “bond forwards” on the interbank market, another step in developing the country’s rapidly growing debt market.  The rules will take effect June 15. On the same time, China is trying to bring stock trading more in line with market principles by starting the process of converting large chunks of non-tradable shares into tradable ones. The 1,400 companies listed on stock markets in Shanghai and Shenzen won approval in late April to begin making all their shares tradable. The sweeping policy change could pave the way for a wholesale restructuring of how China’s markets operate.   Review of March 2005 Newsletter Recommendation   Reading the latest news about the green vs euro, I must recall our March issue when we were among those few who predicted a solid dollar rebound on stronger economic data.   “The euro lifted to a two-month high versus the dollar on March 8th weakened by higher oil prices, a sell-off in Treasury bonds and nervousness over upcoming U.S. trade figures… if domestic economic activity picks up, interest rates have to go up to keep inflation under control. Higher rates will increase overseas demand for the dollar driving its price higher… time is here to short those EZU positions...” March 2005 issue   And our arguments came true.  After a long stint as the 98-pound weakling of major currencies, the dollar has put on some muscle in recent months, forcing currency traders to revamp their outlooks and giving a break to Americans traveling abroad. The U.S. currency jumped to its highest level against the euro in nearly seven months. The euro has fallen about 7% this year against the dollar.     Re: Who will fix the broken wings?   In our Newsletter in April, we highlighted the airlines sector to watch closely. We did not point out a single airliner but suggested building entry points into the industry in general. The timeline for stock price recovery we gave was about a year. And we are happy to see that factors, that’s been keeping the industry under pressure, are easing. First of all, passenger traffic is picking up. From various estimates we conclude that 715 million passengers are expected to fly this year, the most since the September 11 attacks in 2001 and up from 688 million in 2004. “This is shaping up to be the busiest summer travel season in six years” said Kenneth Mead, inspector general for the Department of Transportation for the Wall Street Journal. This increased traffic is attributed to a continued drop in airfares. However things are changing. As airline industry consolidation is kicking in, like the proposed merger of U.S. Air and America West Holdings, price war will pushed to the side and travel fares will likely increase. According to the Wall Street Journal, “...airlines are pushing through their seventh fare increase since February 24, a sign of carriers’ growing pricing power in a struggling U.S. market.” The latest round of increases include AMR Corp., Southwest Airlines, and Delta  Air Lines. Other important measures of financial strength are improving accordingly. Revenue for airlines was up 5% in the first quarter, and passenger traffic rose 8.5%.Planes were fuller-the ten largest airlines sold about three-quarter of their seats, a very healthy percentage in a slow season. At the same time, airlines have aggressively reduced nonfuel costs. And now we arrived to the major obstacle, the fuel cost. We don’t expect any significant improvement on this department, however the negative sentiment sent below from the Chicago futures trading desks is over. Price seems to be stabilizing in the $50/barrel range. And if so,  Wall Street analysts can relax and gradually adopt share prices to a much less volatile market environment. In the meantime, travelers will enjoy a heck of the summer. There is an element of serendipity at this moment. Fares are low, flights are ubiquitous, and travel is safe, even with the massive cost-cutting. As bad as things are for the airliners, there still are a lot of hedge funds, private-equity groups and suppliers willing to pump in more money. That keeps loss-plagued planes flying, forcing everyone to price below cost. Airline investors are subsidizing your ticket. Have a great summer! To access latest Newsletter and other research content, please register!