Strong Yuan in China's Interest

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China, in our assessment, will not allow the yuan to appreciate at the request of U.S. policymakers, but rather when China deems it to be in its own national interest.

The U.S. has pressured China for some time to allow its currency, the yuan, to appreciate. China, in our assessment, will not allow the yuan to appreciate at the request of U.S. policymakers, but rather when China deems it to be in its own national interest. Indeed, we believe this time has come.

Domestic Demand

Much is said about encouraging domestic demand in China to achieve a less export dependent economy. The U.S. and China, however, have a different understanding of what stimulating domestic demand means; we propose a third strategy:
  • It appears to us that U.S. policymakers would want the Chinese government to hand out credit cards to boost domestic demand. If the Chinese only spend more, they could buy more U.S. made goods. This has to be taken with a grain of salt; while the Chinese love American brands, most of them are made in China or elsewhere in Asia. Those items China would like to buy, say commodity producers or nuclear technology, the U.S. is far more reluctant to export. Further, the Chinese reject this approach because they don't want to promote a U.S. style, debt driven consumer boom.
  • The Chinese, in contrast, like to build consumer spending the old-fashioned way. By raising the standard of living, consumers may be able to afford more and thus spend more. So far, so good. But to boost growth, China almost exclusively seems to focus on infrastructure building, along the lines of: if you build a highway prosperity will come. That approach has been very effective in executing a stimulus plan that actually works; however, we believe infrastructure spending alone is insufficient in fostering a more balanced economy.
  • We believe China needs a Ronald Reagan. We are not entirely kidding: Ronald Reagan gave the U.S. a vision, unleashing a major entrepreneurial boom. China is a world leader in marketing (a nicer term than propaganda). Most Chinese believe their fate depends on exports to the U.S., though few Chinese know that more is exported to Europe than the U.S.
  • In our assessment, China could easily unleash a major domestic boom by giving its citizens a vision of the future that encourages entrepreneurship. If the term entrepreneurship is unfitting to the Communist Party, let's call it a patriotic "invest in China" program. The point is that it does not take a debt driven boom to promote a domestically driven economic boom; there is sufficient untapped potential to drive domestic investment and ultimately demand. A strong currency encourages domestic demand.
Inflation

China's inflation has reached a 16-month high. The government is struggling to cool what may be runaway loan growth, increasing wage pressures and property prices that are rising at an alarming pace. One of the ways to bet on a stronger yuan is to buy real estate; such "hot money," or speculative funds, would go away if the exchange rate reflected market forces.

If the yuan is not allowed to appreciate as a valve to contain inflation, the government has to restrict loan growth at banks and try to tame inflation using regulation. These tools are inefficient and, in our assessment, may ultimately fail to contain inflation.

It has become almost a ritual that loan growth explodes early each year, as borrowers fear the government may step in to restrict lending later in the year. It would be far more efficient to work with market forces, i.e. a stronger yuan, than to regulate economic growth. An economy driven by regulation encourages abuse. People will find ways around the rules, causing further distortions and, depending on the scale, they will turn to further regulations and even scandals. Allowing the yuan to appreciate and ultimately float would free up forces to focus on building competitive businesses.

Australia's central bank just issued a report on the importance of flexibility; the analysis credits the floating exchange rate—and it has been a volatile ride for the Australian dollar—to keep inflationary pressures low.

Value Chain Argument

China may be concerned that an appreciating yuan could be too effective in slowing economic growth. After all, many businesses may only be staying alive because their exports are subsidized through an artificially cheap exchange rate. Also, China is concerned about Japan's experience of having a soaring yen cripple its economy. However, this fear must not be the only guide. China's economy has long embarked on a course to be ready for a stronger yuan. In particular, China's low-end industries have gradually moved to lower cost countries in Asia. It is the low-end, low-margin industries, such as the toy industry, that are most price sensitive. Indeed, we fear that countries like Vietnam or the Philippines may engage in competitive devaluation of their currencies should U.S. consumer spending not rebound as we fear.

China, however, is rapidly moving towards what we call the higher end of the value chain. Europe has long ago learned that it can't compete on price, but has to compete on value-added goods and services. Those in the U.S. calling for a weaker dollar should be reminded that it is unlikely we will export sneakers to Vietnam: it's simply not possible to depreciate yourself into prosperity.

In the spring of 2008, when import prices in the U.S. rose at a rate of over 20% year over year, it wasn't only commodity prices that soared: Chinese exporters raised their prices and there was little the U.S. could do about it. Although China and other exporters to the U.S. will always attempt to absorb a higher cost of doing business, such as what a stronger yuan would pose, there comes a point when that is no longer possible. Just as with the experience in the spring of 2008, we believe China has far more pricing power than it recognizes.

Further, a stronger yuan will promote further investment into value added goods and services.

Commodity Prices

Needless to say, a stronger yuan would allow China to lower the cost of its imports, particularly commodities. While inflationary pressures may convince China to allow its currency to appreciate, it is access to commodities that will be China's primary concern over the coming decades. A stronger yuan is in China's interest to satisfy its appetite for resources.

China Is Ready

Ask any businessperson in Asia, and they likely love a fixed exchange rate as it is easier to run the business. Businesses have to get used to floating exchange rates. As a result, we don't expect the Chinese government to rush into a floating exchange rate; however, the sooner China begins on that path, the healthier it is for China's long-term growth.

Importantly, China has laid the foundation to allow for a stronger yuan. Its currency watchdog, China's State Administration of Foreign Exchange (SAFE), has been preparing China. Some of the more recent developments include the use of the yuan in international agreements; also, yuan denominated debt is being issued in Hong Kong.

In our assessment, China currently has an opportunity to move to a stronger yuan out of a position of strength. If China does not move, who knows in what position China will be when the next financial crisis hits.

Role of the U.S.

Policymakers in the U.S. should focus on communicating the benefits of a strong currency to China. The U.S. would be more credible in such a debate, if it pursued a strong dollar policy itself. These days, to qualify for the position of U.S. Treasury Secretary, a key credential is to be able to keep a straight face while uttering the words, "a strong U.S. dollar is in the interest of the United States." It would be helpful if more effort were spent encouraging Congress and the Federal Reserve (Fed) to pursue policies to support a strong dollar.

We have a stake in this debate as we manage the Merk Asian Currency Fund, a mutual fund that invests in a basket of currencies, including the Chinese yuan. To be informed as we discuss other currencies, from the Swiss franc to the yen to the Australian dollar, subscribe to our newsletter at www.merkfunds.com/newsletter. We also manage the Merk Absolute Return Currency Fund and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com.

Axel Merk

Manager of the Merk Hard, Asian and Absolute Return Currency Funds, www.merkfunds.com.

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies. Axel Merk wrote the book on Sustainable Wealth; order your copy today.

The Merk Absolute Return Currency Fund seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.

The Merk Asian Currency Fund seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Hard Currency Fund seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds' website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Funds primarily invest in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds own and the price of the Funds' shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds' portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds' prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.

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