Be careful what you wish for with China’s currency

April 6, 2010

Now that Easter is over and the spiritual affairs of the world are in order, we may look again at temporal matters. And when it comes to temporal matters, a coming trade war with China is a big one. We now read that there is pressure on the administration to declare China a currency manipulator, and there are calls from the Obama administration for China to float its currency.

Now, as you may know, China manages its currency, the yuan or renminbi, in a fairly tight range based on a basket of other currencies including the US dollar. The Chinese government controls all yuan-dollar exchanges. Economists claim that based on purchasing power parity, the yuan is highly undervalued, by a little under half. The result of the currency peg is that China’s currency is kept artificially weak, which boosts its exports. Financial theory predicts that a nation that is a net exporter will see its currency get stronger and stronger until it is no longer economically viable for other countries to buy their goods, at which point the currency will reach an equilibrium, and a currency peg is said to obstruct this process.

(However, these would be the same free-market fundamentalists who almost destroyed Russia after the fall of communism and who gave Greenspan his “flaw.” The likes of Nassim Taleb, noted author and Wall Street critic, know that the real world is more chaotic and complex than economists would have us believe).

However, what would be the effect of letting the yuan float? It stands to reason that if China’s currency is artificially weak, then the US dollar is artificially strong, and as the United States has a global trade deficit, we benefit from that strength. China itself may have a rare trade deficit this March, but that is the deficit in their global trade, and they most definitely do not have a trade deficit with the United States. Well, so what, you say? China trades with the entire world, and if the yuan is devalued then every currency will weaken against China, but not necessarily against each other. But, after Europe the United States is China’s largest trading partner, so the effect should be proportionally greater in our currency. And, with the price of oil at about $87 at the time of this writing, when it had stayed in the $70-80 range for months on end, do we really want the dollar to weaken?

But I can’t see a piece of news without wondering what its effect on my portfolio would be. It reminds me of the fellow in Liar’s Poker whose first reaction to Chernobyl was “buy potatoes,” because if the fallout contaminated the European potato market, US potatoes should sell at a premium. In this case, I don’t say “buy potatoes;” I say “buy American Lorain.”

If you recall, American Lorain is a Chinese food company (by which I mean they’re a food company in China, not that they make Chinese food (although they do)).  When I first recommended the company, it was selling at a P/E ratio of 5.25, and it is still selling at 6.29, which is largely due to appreciation, as their earnings are basically flat as compared to last year. The reason they play a role in this affair is that the bulk of their sales are actually from China and in the yuan. Of course, under the current system of currency controls the United States can’t actually get the money out of there very easily, which could explain the low P/E ratio.

But if it is alleged that the rate should be 3.5 yuan to the dollar instead of just under 7, that means that American Lorain’s income stream should be worth twice as many dollars (they will be weaker dollars, of course, but not 50% weaker as to the rest of the world). So, by holding American Lorain, we hold a company that seems to be fairly priced based on China’s higher risk premium, that has growth potential, and that has a built-in option on China’s liberalizing its currency policy. And if there’s one thing a fructivore likes, it’s free optionality.

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