China's Plan For Yuan Appreciation Likely to Boost Inflation in U.S. & Lift Chinese Consumer Stocks

China's plan to let the yuan appreciate against the U.S. dollar is likely to hit U.S. shoppers in the pocketbook, while also making the stocks of companies with goods aimed at Chinese consumers more attractive.
But because of wage pressures, the effects of China's move to introduce more flexibility to its currency policy won't fundamentally change its inflation problems, according to Money Morning Contributing Editor Martin Hutchinson.

"With workers in China demanding huge wage increases to keep up with prices, there's really no economic case for letting the yuan appreciate," Hutchinson said in an interview yesterday (Monday).
But a rising yuan and wage increases in China may gradually spell bad news for U.S. consumers.

"Eventually, the guy shopping at WalMart Stores Inc. (NYSE: WMT) won't like it when he sees prices go up 15% or more…prices of Chinese goods – everything from video games to sweatshirts – are likely to rise in dollar terms," Hutchinson said.

Confidence in Global Economy

The People's Bank of China (PBOC) formally announced its intentions to gradually let its currency appreciate late Saturday in Beijing, while signaling that the revaluation represented the central bank's increased confidence in the state of the Chinese and global economy.

But the PBOC's initial statement Saturday indicated that any large move in the yuan would be unnecessary, given that China's once-large trade surplus with the rest of the world has faded.

"The recovery and upturn of the Chinese economy has become more solid with the enhanced economic stability," according to the PBOC. "Management and adjustments of the exchange rate must be carried out gradually to give companies time to adjust their structure and gradually absorb the impacts of yuan exchange rate fluctuations."

And the central bank underlined the gradual nature of the move yesterday (Monday) when it set the central parity rate – the level marking the middle of the yuan's trading band – at the same value it traded at on Friday.

The People's Bank set its daily yuan reference rate unchanged from Friday at 6.8275. The currency is allowed to fluctuate up to 0.5% from the official rate.

"It will be a very gradual appreciation but it could be front-loaded," Nizam Idris, a Singapore-based currency strategist at UBS AG (NYSE: UBS), the world's second-largest foreign- exchange trader, told Bloomberg News. "The yuan will appreciate about 4% this year and 5% next year."
Many of China's trading partners have objected to the de-facto peg to the dollar, saying that it keeps the yuan artificially weak and thus gives Chinese exports an unfair advantage. A weaker yuan makes Chinese goods less expensive overseas.

By signaling it would let its currency appreciate against the dollar, the Chinese government -which has accumulated $2.4 trillion in reserves largely by posting huge trade surpluses – boosted the hopes of U.S. manufacturers and other exporters.

"We welcome China's decision to increase the flexibility of its exchange rate," U.S. Treasury Secretary Timothy F. Geithner said Saturday. "Vigorous implementation would make a positive contribution to strong and balanced global growth."

In response, U.S. stocks rallied early yesterday, before fading in the afternoon on a falling euro.

"China's move toward currency flexibility will be taken as a vote of confidence in the global recovery and in the stability of international financial markets, which is a boost for market confidence," Lena Komileva, the head of G-7 market economics at Tullett Prebon, told MarketWatch.

Artificial Peg Keeps Exports Growing

Chinese authorities have prevented the currency from strengthening against the dollar since July 2008 to help its exporters cope with the global financial crisis. The currency appreciated 21% in the three years after a managed float against a basket of currencies was introduced in 2005.

Gains this time around may be more moderate since the yuan has already strengthened 16% against the euro this year – eroding earnings for Chinese exporters in the European Union, the Asian giant's largest market
The country's exports have recently been rebounding, surpassing imports by $19.5 billion in May. That's up from a $1.68 billion surplus in April and a deficit of $7.24 billion in March. Overseas sales jumped 48.5% in May from a year earlier, Bloomberg News reported.

The World Bank said last week that a stronger currency would help China cool inflation, which accelerated to a 19-month high of 3.1% in May, higher than the government's full- year target of 3%. A cheaper yuan also makes imported consumer goods pricier for those living in the world's most populated country.

Net Effect on Commodities Likely Neutral

The currency move sparked a surge in commodity markets, which have been spooked recently by the prospect of slowing Chinese demand growth for raw materials.
Copper jumped almost 5% in early trading on the London Metal Exchange, while oil gained $1.50 a barrel to hit its highest level in a month. Gold hit a new high of $1,264.90 an ounce, while platinum rose above $1,600 an ounce for the first time in a month and palladium gained 1.8% to $496 an ounce.

A more valuable renminbi (the official name for the yuan) would boost Chinese purchasing power for such commodities as iron ore, copper, and oil. China is a net importer of commodities.
But the net effect of a currency appreciation may be more or less neutral in some commodity markets, analysts said.
Iron ore, for instance, is imported into China to be processed into steel – most of which is then exported. While a currency appreciation would boost purchasing power of Chinese steelmakers, it would make exports of steel more expensive.

Melinda Moore, commodities analyst at Credit Suisse Group AG (NYSE ADR: CS), told The Financial Times the impact of the decision would be "fairly muted".

"They'll buy what they want to buy: the most important driver is economic growth," she said.

Winners and Losers

If the Chinese government is serious about letting the yuan appreciate against the dollar, companies that sell a large share of their products in China – not Chinese exporters – would stand the most to gain from a stronger yuan.

And specifically, companies that focus largely on Chinese consumers are likely to be the biggest winners of all, Money Morning's Hutchinson says.

"Rising wages have put more money in the pockets of Chinese consumers," he said. "Also, many products are priced in American dollars, which is going to make it more affordable for them."

Chinese domestic consumption "should be the biggest beneficiary of these structural changes," analysts at Deutsche Bank AG (NYSE: DB) told MarketWatch, identifying instant noodles, dairy, tobacco and alcohol shares as "key winners."

A few companies focused on the Chinese market, including Beijing-based computer maker Lenovo Group Ltd. (OTC ADR: LNVGY), and airlines such as China Eastern Airlines Corp. Ltd (NYSE ADR: CEA), are likely to benefit from lower import costs and stronger consumer purchasing power.

Because a large portion of the debt held by China's air carriers is denominated in U.S. dollars, any dollar weakness would give them significant foreign-currency translation gains, the Deutsche Bank analysts said.
"Also worth noting is the Macau gaming sector," Macquarie Group Ltd. (PINK ADR: MQBKY) analysts told MarketWatch. "This sector generates the bulk of its revenue outside China, but their key market is mainland Chinese visitors," and a stronger yuan could translate to higher spending in the casinos, whose costs are mostly incurred in U.S. dollars.

Wynn Resorts Ltd. (Nasdaq: WYNN) and Las Vegas Sands Corp. (NYSE: LVS) are two companies with large casino operations on the island, where revenue is projected to rise more than 30% in the second half this year.

News & Related Story Links:

• Bloomberg:
  Yuan Strengthens Most Since 2005 After China Signals End to Peg
• Money Morning:
  China's Inflation Higher Than Target Rate, Could Be a Sign It's Time to Tame Rapid Growth
• MarketWatch:
  U.S. stocks rise as Wall Street cheers China currency move
• Financial Times:
  Commodities lifted by Beijing currency move
• MarketWatch:
  China's yuan move good for some, bad for others
• Bloomberg:
  Macau Gaming Growth Will Exceed 30%, Adelson Says.
• Money Morning Archives:
  Chinese Yuan Category
• People's Bank of China:
  Official Web Site.