How to Profit From the Yuan Revaluation

published 24 May 2006

Regular Fleet Street Letter readers were well prepared for the upward revaluation of the yuan in July; we advised you to examine your portfolio for winners and losers on 27 November, 2004. The move is just the start of a region-wide process of currency appreciation - and plenty of opportunities to profit remain.

Of course, in technical terms, the reform itself was very limited. The currency will be allowed to trade in a narrow daily band of 0.3% against an unspecified basket of currencies. China has a closed capital account, which keeps foreign currency traders out and will make it much easier for the People's Bank of China to exercise control.

Nevertheless, it's important to appreciate the significance of the shift. There has been a concession of principle, a move away from the desire of the Communists for central control and towards acceptance, at least in theory, of market-determined currency valuation. Under the new system, the People's Bank could allow the currency to rise 0.3% each day, which over time would add up to substantial appreciation.

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Washington will soon be demanding further concessions and the threat of punitive import taxes means it has the muscle to get them. Against the euro, the yuan had already appreciated by 10% in 2005 prior to the announcement. Merrill Lynch expects the currency to rise to 7.50 per dollar by the end of the year, an increase of almost 11% from the former peg. Lehman Brothers forecasts a 5% gain. Taking a slightly longer-term view, money managers at Bridgewater Associates forecast that the yuan will be about 25-30% higher in three years and will rise about 60% over the next decade.

Companies that trade in London and have a big proportion of their sales in the region are the obvious ways for investors to play the trend. Standard Chartered, for instance, gets about two-thirds of its revenue from Asia. Banks are a good way to benefit from yuan reform because currency liberalisation will increase the appetite of their customers for more sophisticated financial products, such as futures contracts - Standard Chartered and HSBC Holdings have both appointed new treasury chiefs in China in recent months.

Keep an eye, too, on Royal Bank of Scotland as a potential future beneficiary. Reports have suggested that the bank plans to buy a substantial minority stake in Bank of China, the country's second-largest lender. Foreign banks will get unrestricted access to the country's corporate and consumer markets at the end of next year, and those with a substantial footprint in the country will be best placed to benefit.

Certainly, Chinese banks will need foreign expertise in areas such as technology, internal controls and risk management to help them survive the coming wave of competition. At worst, the number of foreign banks that are keen to get into China will mean that RBS's stake will remain a highly saleable asset.

Natural resources stocks such as BHP Billiton and Rio Tinto, which supply the raw materials for China's industrialisation, are also clear winners. BHP Billiton, which is already in the FSL portfolio, plans to lift sales to China by more than a third this year, after Chinese consumption, accounting for a tenth of sales, helped it achieve record profit in the first half.

A higher yuan simply increases the demand from an economy already growing at a blistering pace - yuan revaluation came a day after the government said the economy grew 9.5% in the second quarter, following on from 9.4% in the first. Be careful, though, as there will also be losers. Clothing retailer Next is an example of a company that sources goods in China and is therefore likely to experience higher costs.

The safest prediction arising from yuan liberalisation is greater purchasing power for Chinese consumers and businesses. A stronger currency means that Chinese tourists, for example, will feel relatively richer when they travel abroad. Businesses in China that purchase materials from other countries will also find that their finances stretch a little further, so increasing profitability. Hotel operator Millennium & Copthorne, which gets 24% of its revenue from Asia, is among companies likely to feel the effect.

Derek Moorhouse is a freelance financial writer, and has been a regular member of the FSL investment team since 2002.