While a floating Yuan may lead to greater American Exports to China, it will also mean a rising middle class in China, and a self sustaining Chinese Economy, less reliant on Exports to the U.S.   As the Balance of Trade, between the U.S. and China – possibly narrows – The Chinese may feel less of need to buy U.S. Debt (something they have already been divesting).   The Flip Side is that American manufacturing may see resurgence, as labor markets in the U.S. and China come closer parity, and China become a First World Power.

 

J.M. HAMILTON

 

Yuan Options Most Expensive as China Pledges No Rise (Update1)

 

By Ye Xie

 

March 5 (Bloomberg) -- Options traders are more bullish on the yuan than any other currency as they bet that growing exports and accelerating inflation will overcome China’s vows to maintain a 20-month dollar peg.

The premium charged for the right to buy yuan in three months over contracts to sell has more than tripled this year to the most among 44 currency options tracked by Bloomberg. The 2 percentage point difference is the most since China last ended a fixed-exchange rate in July 2005, so-called risk-reversal rates show. Expectations for price swings also have tripled in the fastest implied volatility rise among the currencies.

Premier Wen Jiabao today told lawmakers at an annual meeting the government will promote the yuan’s usage abroad and aims to manage inflation expectations, a goal that may be aided by a stronger currency. While President Barack Obama has urged China to let the yuan climb to aid U.S. manufacturers, Chinese exporters say a gain of more than 2 percent may wipe out profits.

“It’s the optimal timing to bet on yuan appreciation,” said Richard Benson, who oversees $14 billion as an executive director at Millennium Global Investments in London. “They have a number of tools in their armory to tighten monetary policy, and the currency is the bluntest one. It is highly likely the yuan will rise at least 3 percent this year.”

Flat Yuan

The People’s Bank of China has held the currency almost unchanged at about 6.8 per dollar since July 2008 as it protected exporters from the global financial crisis, which left 20 million Chinese migrant laborers unemployed. Policy makers had allowed the yuan to strengthen 21 percent in the previous three years.

Traders are betting it will gain 0.8 percent by June, three-month non-deliverable forwards show. The yuan will rise 4.2 percent to 6.55 by the end of 2010, according to the median estimate in a Bloomberg survey of 20 analysts. The consensus was 2.2 percent weaker at 6.7 in September.

Jim O’Neill, the chief Goldman Sachs Group Inc. economist who coined the term BRICs for Brazil, Russia, India and China in 2001, said last month that “something is brewing” and predicted policy makers will allow a one-time 5 percent gain.

Chinese Commerce Minister Chen Deming told reporters in Beijing on March 3 that the yuan will be held steady. Yao Jian, spokesman for the ministry, said on Feb. 25 the policy was necessary because China’s foreign trade hasn’t recovered to pre- crisis levels.

Weakening Euro

The dollar peg has pushed the currency 8.9 percent higher against the weakening euro in the past three months, increasing the price of China’s imports in Europe, its largest trading partner, said Warren Hyland, who helps Schroder Investment Management Ltd. oversee $200 billion in assets from London.

Exporters also are being hit by rising wages. China’s Jiangsu province, the third largest export region, increased minimum wages by about 13 percent in February to ease a labor shortage. Shanghai, the No. 2 exporter, will do likewise on April 1.

“They may find this is still a fragile environment to drop the peg,” said Hyland, who abandoned a wager on the currency’s appreciation earlier this year. “At this juncture, betting on the yuan’s gain is probably a poor bet.”

The central bank is reducing its focus on protecting growth to contain inflation. Regulators have ordered banks to set aside more cash as reserves and to curb lending after the economy grew 10.7 percent in the fourth quarter, the most in two years. Housing prices climbed at the fastest pace in 21 months.

$1 Million

Anti-inflation efforts are being undermined as central bank sales of yuan for dollars to maintain the peg flood the economy with cash. China’s accumulation of foreign reserves grew by $1 million per minute in the second half of 2009 to $2.4 trillion, a sum approaching the size of the U.K. economy, central bank data show. Money supply, as measured by M1, rose a record 39 percent in January, triple the average rate in 2005, according to the data.

Consumer prices probably climbed 2.5 percent in February from a year earlier, up from 1.5 percent in January in the biggest increase since October 2008, according to the median estimate from 23 economists. The inflation rate was 1.8 percent in July 2005, when the government loosened its grip on the currency by letting it appreciate 2.1 percent in one day after maintaining a peg of about 8.3 for a decade. China’s statistics bureau will issue its next inflation report on March 11.

Fighting Inflation

“Additional tools will be needed to fight inflation, and one of them is to allow the currency to appreciate,” said Guillermo Osses, who helps oversee $50 billion in emerging- market assets at Pacific Investment Management Company LLC, manager of the world’s biggest bond fund. “The currency has room to appreciate much more than 5 percent in the medium to long run.”

A fixed-exchange rate adds inflation pressure because the Chinese central bank can’t raise interest rates without luring more speculators at a time when the U.S. Federal Reserve’s target rate is near zero. China’s benchmark deposit rate is 2.25 percent.

“An earlier appreciation would give more freedom for policy makers as hot money inflows increase and foreign pressure rises,” said Zhang Ming, deputy chief of the International Finance Research Office of the Chinese Academy of Social Sciences, the government’s economic adviser.

Overseas shipments have rebounded from the global recession, rising 21 percent in January from a year earlier, the fastest pace in 16 months. Fifteen U.S. senators called for stiffer tariffs on China’s imports last week, accusing the country of artificially keeping the yuan cheap.

‘Manipulator’

Under the Omnibus Trade and Competitiveness Act of 1988, the Obama administration must decide by April whether to declare China a “currency manipulator,” a designation the U.S. hasn’t invoked since 1994. China held $895 billion of Treasuries on Dec. 31, the leading overseas investor in such debt.

The Chinese government is surveying manufacturers to gauge the effect appreciation would have, according to a Feb. 26 report in the 21st Century Business Herald, a Guangzhou newspaper.

Ten companies surveyed by Bloomberg News at the East China Fair trade show on March 1 said they could withstand appreciation of between about 1 percent and 5 percent. The median response was 2.3 percent. Exports accounted for a quarter of China’s gross domestic product last year, down from a third in 2008.

Increased Swings

Traders are increasing bets on the currency. Three-month implied volatility on yuan options show traders expect swings of 3.27 percent, a one-year high, up from 1.07 percent on Jan. 1. Implied volatility has risen for six of 44 other currencies, including the Chilean peso and the Israeli Shekel, Bloomberg data show. The premium on three-month contracts to buy the yuan over options for sales has risen to 2.03 percentage points, from 0.58 point at the start of 2010 and the most since July 2005.

“Implied volatility has gone through the roof,” said Bernard Yeung, the head of currencies for Asia at National Australia Bank Ltd. in Hong Kong. “Everyone is banking on a one-off revaluation or a big jump” by May, he said.

A stronger yuan increases the purchasing power of Chinese residents and reduces the country’s reliance on exports, said Karthik Sankaran, a money manager and principal in New York at Covepoint Capital Advisors, an emerging-market hedge fund.

Chinese President Hu Jintao urged “no delay” on Feb. 3 in efforts to reduce dependence on exports and to boost service industries and domestic consumption.

“It seems the Chinese leadership has agreed that the development path will be more focused on consumption and less on exports,” Sankaran said. “The export market won’t be the same in the next couple of years as the U.S. consumers retrench. The yuan policy is one of the ingredients to rebalance the economy.”

To contact the reporter on this story: Ye Xie in New York at yxie6@bloomberg.netJudy Chen in Shanghai at Xchen45@bloomberg.net.