Why China's RMB will never be a global standard

Premium China Fund's Jonathan Wu argues that notwithstanding the doubts around the US dollar, there is little chance of the 'People's Currency' becoming a global standard, at least in the near-term.

The situation with the Chinese RMB currency is a contentious one as people put forward their views on where to go from here.

Given the quite bleak situation seen in the US and the eurozone, people are putting forward the prediction that China’s RMB will become the next global currency after the US dollar.

Will this be the case? We don’t believe this will be the case in the near term.

To provide some historical context behind the RMB, the cultural term is Ren Min Bi, which literally translates to ‘the people’s currency’.

It was subsequently named the Chinese Yuan, but both names refer to the same set of currency. It was first issued by the Chinese Communist Party’s People’s Bank of China in 1948.

Up until the 1990s, when foreigners went to China they were issued ‘foreigner notes’ as opposed to local currency.

This in itself will be one reason within the short to medium term why people don’t see the Chinese RMB as transparent as the US dollar.

Transparency started to open up in 1997, when the RMB was hard pegged to the US dollar at RMB 8.3 per US$1. This remained in place until 2005.

Over this eight-year period tensions started to rise between the East and the West.

Historically, due to the low cost of labour, China has consistently exported deflation to the world, with cheap labour intensive goods flourishing right across the globe, including Australia.

This increasingly rendered many Western manufacturing capabilities uncompetitive and the US started to push for China to allow its currency to naturally appreciate through market forces.

This situation mirrors what happened when the US started its push for the Japanese central bank to let its currency appreciate and allow it to operate in a free float environment, and we all saw its dire consequences.

In 2005, the People’s Bank of China announced its lift from a hard peg to a dirty float, which allowed a maximum movement in the currency of +/- 0.5 per cent per day.

From July 2005 to the beginning of 2008, when the dirty float was frozen once again due to the global financial crisis, the Chinese RMB appreciated 18 per cent (RMB 8.3 to RMB 6.2).

Which brings us to today.

On 21 June, 2010, the Chinese RMB reinitiated its +/- 0.5 per cent maximum movement per day, and it has steadily been appreciating ever since.

Since 21 June, two large institutional offerings have been created and it reflects the global sentiment as to where the Chinese RMB is heading and its higher level of demand.

The first global RMB fund offered by Haitong Asset Management was launched on 11 August, 2010. This fund focuses solely on bonds and yielding instruments, taking advantage of one catalyst alone: RMB appreciation.

On top of this, in Mid August 2010, TPG, one of the world’s largest private equity firms based in the US, launched its first Chinese private equity fund worth RMB1.5 billion (A$246 million) purely denominated in RMB.

This provides a clear indication that trading houses and private equity firms see a strong future in the RMB.

The other major use of foreign currency is for trade. Even though it is not mentioned in mainstream media, trading between China and Brazil, India, Malaysia, Taiwan and Russia has begun in RMB as opposed to US dollars.

The ability to obtain RMB has been made easier in the last decade, with trade levels increasing in local currency. So at this point in time, all roads seem to lead upwards with respect of the use of the Chinese RMB.

So after discussing the history, what are the consequences of an appreciation of the RMB? First and foremost is the inflation turning point.

An appreciating RMB coupled with other issues such as wage increases will see China export inflation for the first time in modern history.

The negative consequence of this will obviously be the squeeze in margins for manufacturers.

This will be offset in some part by the cheaper cost of inputs (with imports costing less). There has already been a shift in labour intensive goods from China to other countries such as Vietnam and Thailand that provide a more cost competitive option.

This has pushed China to upskill its labour force to manufacture high margin, high quality goods to ensure the survivability of its manufacturing sector.

China managed to adapt throughout the global financial crisis by shifting its manufacturing gross domestic product creation to consumption, which left the economy relatively unscathed, and we continue to believe China's strong internal ‘balance sheet’ and the nimbleness of its economy will see it strongly into the future.

The upskilling of the Chinese labour force and the subsequent rise in wages will ultimately lead to a higher standard of living for the Chinese and an increase in the consumption of luxury goods.

Overall, this will benefit the global economy because there are some goods and services that the Chinese still do not or cannot produce themselves (eg, Australian beef, Italian shoes and handbags, Californian almonds and high quality fresh milk, etc).

This in turn will create more jobs in the western world (to keep up with Chinese demand) and provide some level of global economic stability.

Refocusing on imports, commodities will be a huge positive for China as it continues its intensive infrastructure spending plans.

This will set the Chinese Government spending in good stead in the medium term to long term.

The Asian region as a whole is set to ride an appreciation of their respective currencies in the short to medium term as capital flows look to the strongest economies, those with higher interest rates and long-term growth prospects, of which China is one of the few providing that at this point in time.

So the ultimate question is: how do you capture RMB appreciation in your clients’ portfolios? Some say investing in global companies to gain exposure in Asia is suitable.

But we would like to put forward our viewpoint. If you invest in a European corporate, a US corporate or a South American corporate because they derive a large proportion of their income from Asia, why don’t you invest directly in the region?

Logically, changing the argument slightly, if a foreign company is investing into Australian agriculture due to its long-term growth potential, would you buy the foreign company that is new to Australia or the local Australian company that understands the ins and outs of the industry?

Similarly, would a local corporate in Asia have a better idea of what sells and what doesn’t in the local economy or a foreign multinational?

Automotive is a classic case in point. Renault/Citreon/Honda all are manufactured by Dong Feng Motors, BMW teamed up with Brilliance Automotive, Volkswagen with Shanghai Motors and the list goes on.

This is the key reason why they have succeeded in China to date. You will derive the clear appreciation of RMB by investing in local Asian companies that earn RMB, and then subsequently invest the RMB back into the economy.

We don’t see the RMB as being the next US dollar for a very long time as the perception of the currency is that it has been controlled by the Chinese Government, but as it frees up and is acknowledged as a powerful trading currency, it will form part of the powerhouse currencies for decades to come.

Jonathan Wu is the head of the distribution team at Premium China Funds Management.