Bulls claim that current weakness in the property market has been largely driven by government tightening.  We would agree, but they also contend that as policy reverses and addresses weakening fundamentals, markets will respond accordingly.  Fed tightening ultimately busted the US housing bubble, but subsequent easing hasn’t had much of an impact.  The oversight in this argument is sentiment.  Once Chinese buyers awaken to the reality that house prices can move in two directions, we believe the genie is out of the bottle.  This article from Caijing suggests the genie might be a little upset about falling prices, as investors storm the offices of property developers after 25% price cuts.  Optimists also point to varying regional dynamics to support the notion that national market is holding up well.  Entirely possible, but California, Florida and the rest of the sunshine states were more than enough to wreak havoc on our banking system.  We doubt the Chinese capital cities (or Australian “regionals” for that matter) will avoid similar repercussions.

While many agree that a property-led hard landing is likely “in the next few years,” few are willing to acknowledge that it could happen sooner rather than later.  We wonder how long a country can go on building ghost towns and empty housing projects, before the bill comes due.  I suppose they need to create demand for all their Expressways of Excess.  Signs of misallocation are everywhere, but the most unsettling is the affect unregulated mining is having on one of the world’s great wonders.  Apparently, part of the Great Wall is now collapsing according to China Daily. Investors are also aware of the issues that the Chinese banks are facing, but point to declining NPLs as “proof” that the banks are well capitalized or that the deterioration will remain manageable.  History is not on their side. Didn’t American banks boast miniscule NPLs prior to the collapse of US housing?  It would seem the street is confusing cause and effect.

Finally, even those willing to admit that the banking system may be insolvent (trust us . . . it is), argue that an insolvent banking system is not an issue for China’s command economy as the problem is ultimately a fiscal issue and will inspire a fiscal solution.  This is perhaps the most misunderstood and ridiculous claim by consensus today. China’s reserves do not make its economy bullet proof by any means.  They simply represent assets on the PBOCs balance sheet for which there are offsetting liabilities.  The dangerous assumption underlying a bullish China thesis today is that these capital inflows will continue.  In an economic slowdown, particularly one driven by a credit freeze, capital flight is a significant risk.  Importantly, we have begun to see this already in the third quarter as outflows were more intense than even those experienced in 2008.  Increasing this risk, is shifting sentiment within China as 60% of the rich are already looking to take their money elsewhere, according to the FT.  Victor Shih has highlighted The Fragile State of China’s FX Reserves repeatedly.  But perhaps the most disturbing development we’ve recently heard, is this quote from a Chinese banker with close ties to powerful political parties: “There is a sense that we are approaching an inevitable breaking point, when the pressures in society will boil over and consume the rulers . . Almost all the elements are in place for an uprising like we saw in 1989. Corruption is worse today than it was then, people feel they can’t get ahead without political connections, the wealth gap is much bigger and growing , and  there has been virtually no political reform at all. The only missing ingredient now is a domestic economic crisis.”

We have written extensively about the link between China and Australia over the past year.  We think now is a good time to revisit these Predictable Surprises we outlined in June 2011, and the potential for an abrupt reversal in Australia’s terms of trade.  On November 2^nd, Governor Stevens explained the following after cutting Australian interest rates: “The terms of trade have now peaked and will decline somewhat in the near term, but they remain very high.”  What he means by “very high” is illustrated below.  The rise in Australia’s terms of trade over the past decade is the biggest in a very long time.  In the five major mining booms in Australia’s history since 1850, the exchange rate has played an important role in each of them.  In the current episode, the only period with a floating rate, it has risen by a large amount.  If the terms of trade has now peaked, as the RBA (and Chinese growth) suggests, the implications for AUD are massive

But don’t take it from us.  This recent interview with Jim Chanos touches on all the main points of our thesis.  Here’s a quick summary of his points along with a link to the video well worth a few moments of your weekend:

• The Chinese were supposed to get involved a year ago, that didn’t happen.  They were supposed to save Greece months ago, but that didn’t happen.  China will do what’s in China’s interest.
• Big misconception regarding Chinese reserves.  FX reserves have liabilities against them. They arise when exporters earn income in other currencies and turn them in for RMB. Like any central bank liability, there are RMB liabilities against their dollar reserves.
• China is on a bigger and faster treadmill to hell than ever.
• Chinese are beginning to realize that property prices can go down.  Numerous reports of investors thrashing property development offices.
• Take Chinese bank profits with a grain of salt.  American banks recorded record profits prior to 2007. It’s all about credit.
• In the last two banking crisis in 1999 and 2004, Chinese banks had 40% non performing loans without recession.
• Real estate transactions are down 60% year over year.  The property slow down has started.
• Chanos is short Ag Bank of China.  They are holding onto restructuring receivables from previous bailouts at 100 cents on the dollar.  Those receivables account for more than 100% of their tangible book value.  They are probably worth 10 or 20 cents on the dollar.
• Most China observers weren’t talking about any “landing” three months ago.  The fact that they are not admitting that the plane is not staying aloft says something in itself.
• Chinese consumers are shrinking as a percent of the economy. Fixed asset investment is driving everything – up 24% versus 9% economic growth in the year.
• The inherent problem China has it two governments. Central government is hitting the breaks, but local governments who are in bed with developers have every incentive to keep building.
• There were 30-40% rallies in credit-sensitive sectors for three years in the west.  Chanos didn’t cover his shorts until things stopped deteriorating in 2008. We are not anywhere close to that in China as things have just begun to unravel.  The property slow down started in the third quarter of this year. The fundamentals have just started to deteriorate.
• No numbers of visas in your passport will substitute for lack of judgement.  Plenty of people who lived in Miami all of their lives lost everything.

Easy Money (Nov-11)

Shortly after seeing Cullen’s piece, we came across this article in the FT from another friend and one of the top financial historians, Ed Chancellor – China’s bad debts a cause for concern.  As always, Ed is a must read and a wealth of knowledge.  After reading Ed’s piece, we tracked down the CSFB research he referenced and found it rather interesting that even their “hard landing” scenario assumes 7% real growth and a “sharp” rise in NPLs to 5-10%.  Their base case is for a gradual rise in NPLs toward 2.5% through 2013.  Remember, this should be measured relative to the 40% NPLS taken by Chinese banks just last decade, when loan growth wasn’t anywhere near levels seen during the past two years.  And furthermore, when have you ever seen a “gradual” rise in NPLs?  Cullen’s response – “kind of like “gradually” trying to let a fart out at a party. Not likely.

A few months ago, at CFA North Carolina’s Annual Forecast Dinner, Ed offered up the following Characteristics of Great Manias:

1. Uncritically assumed growth story
2. Overconfidence in authorities and moral hazard
3. Easy money and credit expansion
4. Investment boom and the misallocation of capital
5. Agency issues: Don’t trust your broker
6. Madness of crowds: Don’t trust your feelings
7. Frauds: Galbraith’s bezzle
8. Ponzi finance: Minsky’s financial instability hypothesis
9. Luxury: Conspicuous consumption
10. Bubble valuations: It’s all in the numbers

Cullen touched on many of these characteristics in his Unhedged Commentary, but perhaps our favorite example of Conspicuous Consumption is this Million-Pound Mutt, first highlighted in Ed’s presentation.  I give you – the world’s most expensive dog!!

On a closing note, one of the best minds on China, Michael Pettis of Peking University’s Guanghua School of Management, providing the following concise analysis of “the problem” in a recent note:

“It should have been clear for many years that China’s investment-driven growth model was leading to unsustainable increases in debt . . . But dangerously high levels of municipal debt are only a manifestation of the underlying problem, not the problem itself. Even if the financial authorities intervene, unless they change the economy’s underlying dependence on accelerating investment, it won’t matter. They will simply force the debt problem elsewhere.

“In all previous cases of countries following similar growth models, the dangerous combination of repressed pricing signals, distorted investment incentives, and excessive reliance on accelerating investment to generate growth has always eventually pushed growth past the point where it is sustainable, leading always to capital misallocation and waste. At this point – which China may have reached a decade ago – debt begins to rise unsustainably.

“China’s problem now is that the authorities can continue to get rapid growth only at the expense of ever-riskier increases in debt. Eventually either they will choose sharply to curtail investment, or excessive debt will force them to do so. Either way we should expect many years of growth well below even the most pessimistic current forecasts. But not yet. High, investment-driven growth is likely to continue for at least another two years.

“I want to stress this point. Right now everyone is worried about municipal debt levels and wondering if Beijing’s plans to resolve the problem will work or not to clean up the municipalities. But this is the wrong focus. The problem is not whether or not the municipalities will be able to repay. Repayment simply means shifting the debt servicing to another entity, and we should be worrying not about the debt-servicing ability of specific borrowers but rather about the whole system.

“The problem, as I see it, is that the system has reached the point at which unsustainable increases in debt are necessary to sustain growth.”

“Thinking about fundamental risk also reduces the “black swan” element of investing. Nassim Taleb defines a black swan as a highly improbable event with three principle characteristics: 1) it is unpredictable; 2) it has a massive impact; and 3) ex post explanations are concocted that make the event appear less random and more predictable than it was.

“It should be noted that some black swans are a matter of perspective. Rather than genuine black swans, most financial implosions are the result of “predictable surprises” . . . Like black swans, predictable surprises have three characteristics: 1) at least some people are aware of the problem; 2) the problem gets worse over time; and 3) eventually the problem explodes into a crisis, much to the shock of most.

“The nature of predictable surprises is that while uncertainty surrounds the details of the impending disaster, there is little uncertainty that a large disaster awaits.”

China’s debt-fueled speculative bubble is likely to be yet another victim in a long list of predictable surprises.  As we discussed in a Cautionary Fable last year, forecasting the timing of such trend changes is always a challenging (and frustrating) exercise.  But just because the timing is questionable doesn’t mean the risks should be ignored.  More often than not, investors are rightly focused on the odds that circumstances turn negative.  But every so often, it is much more important to consider the consequences of these low probability events.  With so many believers in today’s Chinese growth miracle and China’s path to world dominance so obviously clear, risks to the downside are not immaterial, yet insurance to hedge against such a risk is almost free.

Consider that China’s local government debt load has increased by 36 times in nominal terms and five times relative to GDP since 1997.  In just the last three years, total liabilities of local governments have mushroomed from 17% to 27% of GDP based upon the State Council’s Audit Report. With more than 80% of those borrowings going to infrastructure, it’s difficult to imagine that the return on investment for each additional project has not declined.  Aggravating this debt load, about one quarter of it is promised with land sale revenue, making today’s real estate bubble even more detrimental to the command economy.  Defaults are already happening, even with economic growth rates hovering near 10%.  According to Reuters, China’s regulators plan to shift 2-3 TRILLION yuan off local government balance sheets – a massive bailout that is multiples of TARP relative to China’s GDP.  With monetary conditions in China now tighter than the 2007-2008 peak and a global economy much more fragile today, we wonder how fast this number will increase once slowing credit actually stalls economic growth.  Consider that in 1999, after borrowing and binging through the 80s and 90s, the NPL ratio of the Big 4 Banks was a massive 39% or roughly 20% of China’s GDP from 1988 to 1993.  For China, this was a huge sum of money, equivalent to 25% of foreign reserves at the time.  Contrast that with the banks current “reported” NPLs near 1% . . . and consider that Fitch reports bad loans could rise to 15% to 30% of assets.

Consequently, we think a small investment today can serve as an effective hedge on a much larger portfolio, in case the global economy’s locomotive hits a speed bump along the way.  That being said, we are much more comfortable taking larger positions when we can say with confidence, “This is going to happen.”  I’m not sure I can say that with confidence about a yuan devaluation, but I can say that the odds are currently much higher than what Mr. Market is offering today. Aussie housing is one of those “near certainties,” with or without a Chinese hard landing.  And it appears that the risk in the Australian property market has elevated sharply over the past year.  Part of this may be attributable to the slow-down in China.  Part of it may be attributable to the Australian banks’ reliance on European financing. Or it may simply be bursting under its own weight, with a little help from the RBA and higher rates. Whatever the cause, the evidence is right in front of anyone who cares to look.

Gold Coast beachfront values have plunged by as much as 50 percent since the peak of the boom in 2008, states The Australian Newspaper Online. We are beginning to see signs of the “blame game” emerging even as we are very early into the expected decline in property prices – check out the collapse of Ray White Broadbeach. Despite claims of a “housing shortage” which is typical of just about every housing bubble, Real Estate Institute of WA president Alan Bourke said that there were now thousands more properties on the market than needed to meet demand. Meanwhile, real estate agents are cutting their sales commissions to compete for fewer buyers – some below one percent. Major banks have warned that loan arrears have increased, real estate data shows house prices in affluent suburbs have fallen more than the overall market and new loans have dropped sharply. High-income earners are also experiencing mortgage problems but nobody is talking about it – they are financially overstretched and quietly making lifestyle changes, deleveraging and selling investments to reduce loans and other debt, and avoiding unwanted public attention they would have if they had to foreclose on their mortgage.

Coming back to China, the 1880s – 1890s boom provides an interesting parallel.    In 1890, more than half of Australia’s exports went to Britain, with wool making up the majority.  This concentration of exports was a critical vulnerability then, as it is now.  Today, Australia’s exports are again dominated by commodities (iron ore) and its future is almost entirely tied to its largest customer, China.  That said, the magnitude of the housing boom in the 1880s is dwarfed by what we’ve seen in the past two decades – where prices have more than doubled in real terms versus a gain of a third the first time around.

Then, the withdrawal of foreign capital served as a catalyst for recession, credit crunch and price declines.  Today, Australian banks find themselves in an eerily similar position – almost entirely reliant on foreign funding (chart below from RBA), which Moody’s recently cited as they downgraded the major banks.  “With the domestic economy increasingly biased to the commodity sector, terms of trade that are exceptionally favorable by historical standards, and high asset prices, there is a potential for confidence shocks to impact the bank’s access to funding.”  We believe slowing Chinese demand will be a catalyst for an abrupt reversal in Australia’s terms of trade, likely followed by a collapsing currency, vanishing foreign capital and significant stress on the banking system.  Aussie bank CDS look very cheap relative to global peers.  The sovereign looks even cheaper when one considers the potential cost of a bank bail-out.

Disclosure: At the time of publication, the author was short the Chinese Yuan, Australian Dollar, various Australian financials and long Australian interest rates via traditional and derivative investment vehicles, although positions may change at any time.

The following is an excerpt from a report issued by Simon Hunt included in John’s letter:

The scale of speculation in real estate is enormous. There is a total of 64.5 million apartments and houses lying purchased but vacant in urban China, about five times the surplus in the USA, according to an economist from the Chinese Academy of Social Sciences.

A report written by the National Bureau of Economic Research in July this year provides interesting data on China’s housing market. Real housing prices have risen by 140% since the first quarter of 2007. In the first quarter of this year, house prices rose by a record 41%, since when it appears that prices have stabilised but not fallen. Price increases have not been driven by any shortage in housing.

In Beijing, there has been an almost eight-fold increase in land values since 2003, but since the end of 2007 land prices have nearly tripled. The impact of rising land prices on home and apartment prices has been equally great. From 2003 to 2007, the ratio of land-to-house values hovered between 30% and 40%, but since then it has doubled to just over 60%. The report also found that when a central government state-owned enterprise (SOE) was a winning bidder for land, prices rose by about 27% more than if they had not been involved, thus showing the influence that SOEs bring to bear on land values, an influence that grew in 2009 when they became more active. A separate report shows that so far this year 82% of Beijing’s land auctions have been won by SOEs.

Price-to-rent values in Beijing and seven other large markets across the country have increased from 30% to 70% since the start of 2007.

In summary, against a background of cheap money and plenty of credit, house prices across the country have become unaffordable to most first-time buyers. In Beijing, for instance, average house prices have been between 14 and 15 times incomes for the past three years, but rose to 18.5 times in the first quarter of this year.

The evidence appears to be stacking up against the few remaining property bubbles around the globe.  As we’ve stated previously, an economic hiccup in China is not a prerequisite for a bursting Australian property market, as bubbles of this magnitude often collapse under their own weight.  But we certainly don’t mind having multiple potential catalysts when evaluating the risk/reward of investment themes.  In this case, our Chinese Pin appears to be pointed directly at the Land of Oz.  The potential consequences are alarming . . . even to Jack Burton!!

The gap between Western and Eastern economic performance eventually became a political issue. The Democrats recaptured the White House under the leadership of a young, energetic new president who pledged to “get the country moving again”–a pledge that, to him and his closest advisers, meant accelerating America’s economic growth to meet the Eastern challenge.

The time, of course, was the early 1960s. The dynamic young president was John F. Kennedy. The technological feats that so alarmed the West were the launch of Sputnik and the early Soviet lead in space. And the rapidly growing Eastern economies were those of the Soviet Union and its satellite nations.

While the growth of communist economics was the subject of innumerable alarmist books and polemical articles in the 1950s, Some economists who looked seriously at the roots of that growth were putting together a picture that differed substantially from most popular assumptions. Communist growth rates were certainly impressive, but not magical. The rapid growth in output could be fully explained by rapid growth in inputs: expansion of employment, increases in education levels, and, above all, massive investment in physical capital. Once those inputs were taken into account, the growth in output was unsurprising–or, to put it differently, the big surprise about Soviet growth was that when closely examined it posed no mystery.

The source of the cautionary fable outlined above is Paul Krugman’s 1994 essay titled The Myth of Asia’s Miracle. While we applaud Morgan Stanley’s Stephen Roach for his plea to take a baseball bat to Krugman for “giving Washington very, very bad advice,” we can’t help but think that the Nobel Laureate got this one right.  A few short years following the publication of this essay, the Asian Crisis proved that trees don’t grow to the sky.

Consequently, it is important for investors (and politicians) to understand that the concerns surrounding the rise of China today are not new.  In fact, they are quite similar to past threats faced by our great nation – the Soviet Union in the 60s, Japanese Superiority of the 80s, and the Asian Tigers in the 90s.  The lessons learned, from an investment perspective, are no different than the countless experiences of bubbles past – if something can’t go on forever, it won’t.  If it seems too good to be true, it probably is.  More often than not, investors are rightly focused on the odds that circumstances turn negative.  But every so often, it is much more important to consider the consequences of these low probability events.  With so many believers in today’s Chinese growth miracle and China’s path to world dominance so obviously clear, risks to the downside are not immaterial.

There is no such thing as a bad investment; only a bad price.  We were constructive on Chinese equity markets early last year, as we discussed in the First Quarter 2009 Broyhill Letter.  We still believe that Blowing Bubbles in emerging markets may well develop into the next Financial Mania.  But after triple digit percentage increases from the panic lows reached one year ago, investor fear has been quickly replaced with greed.  And greed has an unfortunate habit of making investors blind to risks.  We’d encourage China bulls to consider the following:

• Chinese leading economic indicators are stalling and topping out, whereas they were recovering from depressed levels last year.

• Chinese Fixed Asset Investment as a per cent of GDP is massive and unprecedented in history.  See Krugman’s essay for implications.

• Chinese Real Estate is a bubble.  Period.  A recent NYT article notes that apartment prices in Shanghai have reached up to $200K where most residents earn less than $5K annually.

Can the Chinese economy and risk assets continue their relentless march higher?  Sure.  Forecasting the timing of such trend changes is always a challenging (and frustrating) exercise.  But just because the timing is questionable, doesn’t mean the risks should be ignored.  GMOs Edward Chancellor outlines many of China’s Red Flags in a recent white paper.  I’d hope we’ve learned at least that much from our own domestic housing bubble which defied gravity for longer than most anyone expected.  We wonder how industrial commodity prices would fair if the Chinese decided that 30 billion square feet of office space is probably enough for now . . .

Disclosure: At the time of publication, the author was short iShares FTSE/XINHUA China 25, although positions may change at any time.

As a follow up to our initial post – A Brazilian – we came across this brief piece from the good folks at PIMCO this week, echoing our constructive view on the Brazilian economy.  Brigitte Posch, EVP and a member of PIMCOs Emerging Markets Team, makes the following observations:

Brazilian local interest rates are attractive on both a nominal and a real basis, as they are still considerably higher than those in comparably rated countries. Because of this as well as the strength of the country’s macroeconomic policies, we expect Brazilian local rates to continue to trend lower and converge with interest rates in the developed world. For now, however, the disconnect between Brazilian rates and rates in other investment grade countries makes Brazil one of the world’s most attractive markets for yields.

With rates in Asian economies generally much lower and emerging market (EM) Europe facing fiscal constraints that are affecting policy, Brazil is the rare case of a solid and improving EM credit with credible monetary policy and the offer of outsized local yields on both an absolute and relative basis.

Proactive public policies and strong support for expansion of infrastructure studies and projects are at the core of Brazil’s plans to boost growth. In the past year, the Brazilian government has placed particular emphasis on public works as a means to offset the effects of the global economic recession.

Another happy development: Brazil recently won the right to host the World Cup of 2014 and the Summer Olympics in 2016, an event that should brings billions in fresh investment.

PIMCO Viewpoints – Posch on Brazil Feb 2010 US

We adamantly agree – particularly in light of the sovereign investment alternatives in the developed world today – and continue to hold a core position in long term Brazilian government debt.  Cyclical corrections in the Brazilian Real, likely brought on by investor risk aversion, should be viewed as long-term buying opportunities. 

“OH NO!” the President exclaims. “That’s terrible!”

His staff sits stunned at this display of emotion, nervously watching as the President sits, head in hands.

Finally, the President looks up and asks, “How many is a brazillion?”

According to David Rosenberg at Gluskin Sheff, Brazil may well boast the most attractive fundamentals on the planet on a risk-return basis. Here are his seven reasons why:

 • It is just about the only investment grade country where inflation is slowing, the central bank has been easing, and where you can pick up a yield of over 12% for 10-year paper.

 • Its most recent change was a credit upgrade last September (Moody’s) and overall the rating agencies are generally favourable over the outlook.  

• The inflation rate is 4%, slowing down and at the low end of the range of the past decade.

 • The current account is in very small deficit, at just over 1% of GDP. 

• The debt ratios are very well contained – 12 % gross external debt and 43% government debt as a share to GDP (the US comparables are 95% and 62% respectively).

• The real is on an appreciating track (+27% in the past year) and that is because Brazil’s terms-of-trade (export price to import price ratio) is flirting near a 12-year high.

• Given that real short-term rates are around 4.5% and the consensus view is 5% real growth this year, there would be little reason to be bearish on the currency outside of a currency setback (and FX reserves at $240 billion are up 15% in the past year and 30% in the past two years.

The biggest risk is if there is a global relapse that drags Asia into the vortex and impair the commodity complex as this would undoubtedly reverse the impressive gains made in the currency — after all, it’s not coffee that is Brazil’s primary export but iron ore; and it is not the USA but China that is the country’s largest customer.

Disclosure:  At the time of publication, the author was long iShares MSCI Brazil Index, although positions may change at any time.

http://www.ft.com/cms/s/0/36c5b6f4-e128-11de-af7a-00144feab49a.html?nclick_check=1

In just the past few weeks President Hu Jintao has politely ignored requests from President Barack Obama, the president of the ECB and the managing director of the IMF to adjust its currency.  While most of the developed world harps on China for alleged currency manipulation, we believe it is entirely possible (if not likely) that the Chinese have already begun a multi-year process that will accelerate toward the free float of the yuan in the intermediate term.  (We also believe this would occur much quicker if foreign policy makers quit their nagging.)  Perhaps it is because the existing peg has served China so well (through turbo-charged exports) that those of us in the developed world find it so difficult to envision China abandoning it? 

However, the next phase of the Chinese Growth Miracle cannot be achieved using the same old tricks.  For China, the peg (and accompanying dollar depreciation) translates into rising prices for energy, food and a number of other essentials.  As we’ve discussed previously, China cannot readily combat this inflation through traditional measures of monetary policy since the existing peg effectively cedes control of monetary policy to Ben Bernanke & Co.  To make matters worse, as Helicopter Ben pursues an ongoing easy-money, debauch-the-dollar policy in the wake of recurring financial catastrophes, China faces even greater inflationary risks.  Monetary and fiscal stimulus pumped into the government-controlled Chinese economy on a scale that dwarfs even our own unprecedented stimulus efforts, assures the return of uncomfortable inflation as we turn the calendar.  (A number of economic variables we monitor already point to double digit increases in Chinese CPI next year.)

A stronger yuan would help rebalance China’s economy, making it less dependent on exports and putting future growth on a more sustainable path.  But Chinese policymakers understand that there is no free lunch in capital markets.  While concerns of an export sector collapse are overblown, the dollar price of Chinese goods would certainly increase.  And the largest losses would undoubtedly come in China’s vast dollar-denominated bond portfolio.  But importantly, reductions in the yuan price of oil and other imports would more than offset these losses.  Hence, an accelerated depegging would alleviate many of China’s inflation problems, as oil and other commodities would decline in yuan terms, relieving pressure on Chinese consumers and improving the cost structure of Chinese manufactures.

There is no way to know precisely how undervalued the yuan is, but most indications point to a free float at levels much stronger than today’s consensus expectations.  Twelve month yuan non-deliverable forwards currently suggest that traders expect the yuan to strengthen 3% in a year, while the Economist’s Big Mac Index (burgers are much better forecasters than traders) points to a near 50% undervaluation.

Source: The Economist

We don’t believe that today’s expectations accurately reflect the yuan’s true trajectory.  To effectively dampen China’s underlying inflationary pressures, exchange rates would have to rise substantially more than levels implied by the market today.  A 50-100% revaluation is even plausible if trends in commodity prices persist, and as history suggests, China overshoots in policy accommodations.  If such a move seems extreme in light of forecasts made by mainstream blue chip economists, consider that in 1976-1978 and again in 1985-1987, Japan (then the fast-growing, pre-eminent Asian exporter) allowed the yen to double to endure a diving dollar and rising import prices.

China allowed its currency to appreciate 21% in the three years after they replaced a pure dollar peg with a basket of currencies in July 2005, but has kept its currency pegged at about 6.83 per dollar since July 2008 to help sustain exports.  As PIMCO has suggested, “A market-based currency would shift the focus of China’s growth to domestic demand from exports, more efficiently allocate resources and reduce the risk of asset bubbles.”

The introduction and tremendous growth of Exchange Traded Funds (ETFs) provides a cost-efficient opportunity for individual investors to gain exposure to the Chinese yuan through an ETF.  The Wisdom Tree Dreyfus Chinese Yuan Fund (CYB) seeks to achieve total returns reflective of money market rates in China as well as changes in the value of the Chinese yuan relative to the U.S. dollar.

WisdomTree: Case for the Chinese Yuan

Disclosure: At the time of publication, the author was long WisdomTree China Yuan Fund, although positions may change at any time.