The Reluctant Rise of the Yuan


To many Wall Street insiders, it was no surprise that Bridgewater Associates' Ray Dalio operated the most profitable hedge fund in 2011. In an otherwise dismal year -- just 21 of the top 100 hedge funds returned more than 10% last year -- Dalio's Pure Alpha II fund returned 23.5% through the end of October alone.

Insiders weren't surprised because Bridgewater operates "macro funds," betting on the relative direction of global markets and international events. And 2011 had plenty to offer given the ongoing growth in Asia, the near collapse of the European Union, and the continued economic malaise here at home.

The good news for those of you using a similarly successful approach is that the global economy's tectonic plates have only just begun to shift. In fact, as I discuss below, the reluctant emergence of China's yuan onto the reserve currency stage offers perhaps the best opportunity for macro-oriented investors to get rich over the foreseeable future.

Why currencies rise reluctantly
Although it may sound counterintuitive, there are many reasons that a rising power like China would prefer its currency operate in obscurity, beyond the prying eyes of the world's central bankers. A recent paper by an economist at the Council on Foreign Relations, for example, argued that all three major currencies that attained international reserve status in the 20th century -- the dollar, yen, and mark -- did so reluctantly and without widespread domestic support.

The primary reason for this reluctance concerns competitiveness. The modern model of economic growth can be traced to the phenomenal ascent of the "Asian dragons": Hong Kong, Singapore, South Korea, and Taiwan. These nations and territories pursued export-led growth models predicated on weak currencies. In other words, like China today, their central banks kept their currencies artificially cheap, thereby boosting the competitiveness of their exports abroad.

The second reason concerns control of the financial system. The countries that attained reserve currency status last century emerged as trading powerhouses with tightly regulated financial systems. Here in the United States, for example, Regulation Q of the Banking Act of 1933 (better known as the Glass-Steagall Act) prohibited the paying of interest on commercial checking accounts and capped the interest rate on savings accounts. By regulating the system in this way, as China does now, a country can bolster the supply of cheap credit and thereby further fuel its economy.

Looking at China's recent success, it's hard to argue with the wisdom of its approach. It went from being a desperately poor country mired in social upheaval to being the world's most prolific exporter, largest sovereign creditor, and second largest economy. And it accomplished these feats in a mere three decades, in large part, on the back of an artificially cheap yuan and a highly regulated financial system.

The internationalization of the yuan
While I believe China's decision to internationalize the yuan was nevertheless inevitable, the financial crisis of 2008 served as the final catalyst. As discussed above, China's economic model had relied on boosting exports by keeping its exchange rate undervalued. This required China's central bank to purchase large quantities of American dollars, effectively reinforcing the dollar's status as the world's primary reserve currency. In the aftermath of 2008, however, these holdings turned into an enormous and unanticipated liability. The Chinese refer to this as the "dollar trap."

At the time of the collapse, China held nearly $1.5 trillion worth of U.S. financial assets. These assets included about 7% of all the bonds issued by government-backed lenders such as Fannie Mae and Freddie Mac, and approximately $1.1 trillion of U.S. Treasury securities. And it's the latter that keeps China up at night, as the Federal Reserve seems intent on driving down both their yields and, if you read between the lines, the dollar's exchange rate vis-a-vis the yuan. At about this time last year, for example, Fed Chairman Ben Bernanke blamed China for contributing to a "pattern of global spending that is unbalanced and unsustainable," and went on to add that countries like it "will need to allow their exchange rates to better reflect market fundamentals and increase their efforts to substitute domestic demand for exports."

Suffice it to say, the Chinese leadership got the point -- though perhaps not the point Bernanke was trying to convey. During the G-20 summit in November 2008, Chinese President Hu Jintao called for a "new international financial order that is fair, just, inclusive, and orderly." In other words, not one that's dominated by the American dollar. This call was seconded in 2009 by Zhou Xiaochuan, the governor of the People's Bank of China, who called for greater use of special drawing rights, or SDRs, the quasi-currency issued by the International Monetary Fund.

More important, China has since taken a number of concrete steps toward an international currency. It's begun encouraging the use of the yuan in international trade, swap arrangements between central banks, and bank deposits and bond issuances in Hong Kong. During the first six months of 2011, for instance, trade transactions settled in yuan totaled around $146 billion, a 13-fold increase over the same period last year. And by mid-2011, yuan deposits in Hong Kong equaled $85 billion, a tenfold jump since Hu's speech in 2008. In addition, the yuan is already accepted as a form of payment in Mongolia, Pakistan, Thailand, and Vietnam. While I could go on, I think you get the point.

Exploiting these dynamics
I believe it's a foregone conclusion that the yuan will attain reserve currency status and eventually compete with the dollar for global pre-eminence. The only question is when.

For this reason, I think it's important for investors to start thinking about how to prepare for the yuan's rise before the rest of the market catches on. My recommendation is to consider American companies with significant exposure to the Chinese market, as the latter's consumers will gain purchasing power as the exchange rates adjust. The four that come to mind immediately are Starbucks (NAS: SBUX) , Yum! Brands (NYS: YUM) , McDonald's (NYS: MCD) , and Caterpillar (NYS: CAT) , all of which are aggressively expanding their already extensive operations on the Chinese mainland.

And along these same lines, you can't go wrong with any of the cash cows identified in a free report we recently released. The report identifies three companies that are so successful and well-diversified that few macro events could knock them off their profitable path going forward. To access this timely report before the rest of the market catches on, click here now -- it's free.

At the time thisarticle was published Foolish contributing writer John Maxfield does not own shares in any of the companies mentioned above. The Motley Fool owns shares of Yum! Brands and Starbucks. Motley Fool newsletter services have recommended buying shares of Yum! Brands and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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