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Aside from my newfound love for Twitter (follow me: @elliottng) has been my growing concern about dollar decline relative to RMB. My company has a software development center in Beijing, and I had hoped to scale up marketing operations outsourcing to China as well. But continued dollar decline significantly affects how cost-effective that outsourcing can be. I’m also concerned about the future purchasing power of my personal assets if the dollar continues to slide.Warning: this is a long and boring post unless you care about the RMB-USD exchange rate.My conclusion: RMB will continue to appreciate and potentially face a “one-off maxi-revaluation” to stop speculative inflows.

• Because China is exporting more to Euroland than to US, China must start valuating RMB relative to USD. And since the beginning of 2006, the RMB is down 16% vs. the Euro. So the RMB-USD exchange rate is virtually guaranteed to go down (RMB gets more expensive) because of the dollar’s current exchange rate vs. the Euro.
• Chinese economic policy makers need to sustain growth to minimize unemployment. But they also have to fight inflation. And currency appreciation is one of their few weapons for cooling inflation.
• For my own planning purposes, I am modeling a 5-6% rate of appreciation for the RMB, but even this year to date the RMB has appreciated 4%. So this seems insufficient.
• As appreciation increases, hot money inflows also increase, making the situation worse.
• Therefore it appears that the policy of a “one-off maxi-revaluation” of 15-20% is in the realm of possibility, as crazy as that might sound.

What I’m doing about it: moving some cash savings into RMB-based accountAfter having maxed out my annual USD 50,000 limit for RMB exchange at my friendly Shanghai Huaihai Zhong Lu China Merchant Bank branch, I’ve been struggling to figure out what to do to move USD into RMB. Here’s my plan:

• Open a EverBank World Currency Deposit account. These are CDs that are somehow tied to nondeliverable forward contracts in RMB so the value of the principal behaves like RMB. Minimum opening deposit amount of USD $2,500. No monthly fees, no time deposit requirement. FDIC insured up to USD $100,000. Downside is that the account currently has 0% interest rate on RMB backed deposit. I sent in the paperwork 5 days ago but don’t have confirmation of the account opening yet.
• Continue to research Market Vectors CNY, an Exchange Traded Note that I posted about earlier. But I have not purchased CNY because a IRS election (Section 988) has to be made within 1 day of the trade, and I haven’t figured out what that is about even after talking to my broker and accountant. If I’m eligible for this Section 988 election and the gains can be treated as Capital Gains, then this might be a good option. UPDATE: From SeekingAlpha - Also consider credit risk of ETNs backed by Morgan Stanley.
• Any other options out there? Advice needed.

Here’s a summary of the posts I read that led me to these conclusions:Michael Pettis: China’s monetary trapI found Michael Pettis’ blog via Seeking Alpha, where he is a guest blogger. I read Michael’s March 26 summary of China’s monetary trap leading to his belief that a one-off maxi-revaluation” is what will happen to address this. His argument is as follows:

1. China tied the RMB to the dollar, and then set the exchange rate too low. Dollars would flow in, the People’s Bank of China (PBoC) would need to issue RMB to purchase the dollars, and that RMB would go into domestic investment aand production.
2. One result of this growth is inflation. With more RMB chasing a fixed amount of goods, the price of goods would necessarily rise. Global rises in oil prices further drive inflation. More on China inflation here.
3. To fight inflation, China needs to stop money inflows. But China’s currency controls are not effective enough because of “China- or offshore-based transnational family business networks and China’s size and long borders” according to Michael Pettis.
4. A slow adjustment, as we have seen between July 2005 -July 2007, does not address the issu fast enough. However, a rapid adjustment, from middle of Summer 2007 to present, just encourages “hot money inflows, which will cause the domestic monetary problem to accelerate before it is fixed.”
5. The final option is a “one-off maxi-revaluation that causes hot money inflow to subside or even reverse.” With a much more expensive RMB, exports would be less competitive and this could mean increased unemployment. One way out of that is that productive capacity would be sustained by growing domestic consumption.
6. According to Michael Pettis, this means a 15-20% revaluation of the RMB, the minimum amount to “shock” speculative investors in stopping money inflows into RMB.

RGE Monitor: China’s currency is not really appreciatingVia Google search, I found Brad Setser’s blog about global economics (about, bio). He reports on a Standard Chartered Bank FX alert with a chart titled “China’s currency is not really appreciating”. So he posts on this topic:RMB appreciation has been against the dollar. But this is offset by the the dollar’s depreciation against other currency:

From the beginning of 2006, the RMB is up 12.2% against the dollar but down 16.0% against the euro. And Europe, not the US, is China’s largest export market — and the main source of Chinese export growth. The US was the world’s consumer of last resort through 2005. More recently, though, it has been Europe. The Standard Chartered team writes:“Last year we calculate, the US only bought 22% of China’s goods — and only provided 13% of the increase in exports. Europe in contrast, bought 27% [of China’s exports] and was responsible for 31% of the growth.”The Standard Chartered team now expects the RMB to appreciate by 15% v the dollar in 2008, making up for some of its past depreciation against the euro.They concede that there forecast is ahead of the policy consensus in China. They expect, though, that the new Chinese economic policy team will be pulled in their direction by ongoing dollar weakness, low US rates, inflationary pressure and the risk of even larger hot money flows.I personally would be surprised by a 15% move. Not because such a move doesn’t make economic sense. But rather because, as the Standard Chartered team notes, “the default mode in Beijing has been caution.” Right now though a faster than expected pace of RMB appreciation against the dollar cannot be entirely ruled out. China presumably doesn’t want all of the necessary real appreciation of the RMB to come from higher inflation. $50b or so in monthly reserve growth likely has caught the authorities attention. As has the possibility that the US may not be through cutting rates.   

What’s interesting is the point that “real appreciation” of the RMB may happen, even if policy makers decide that a “nominal appreciation” is not in their best interest. In other words, if the RMB continues to be undervalued, the price of real products will just inflate to the market-driven level. If the Chinese government intends to fight inflation, currency appreciation is a necessary weapon to do so.RGE Monitor: What can not go on forever seems to be going on forever: China’s amazing January reserve growthSetser’s March 5 blog post also frames the magnitude of what is going on:

• China’s reserves increased in January by $61.6 billion
• Saudi Arabia’s reserves increased in january by $18 billion
• Other emerging Asian countries increased their reserves by about $30 billion
• The US current account deficit is about $62.5 billion per month. Setser comment: “It kind of makes you wonder why the US goes through the motions of selling Treasury and Agency bonds on the open market rather than doing direct placements with a few big central banks.”

RMB appreciation seems to be a necessary outcome of runaway growth in Chinese foreign reserves.Jeff Frankel’s WeblogSetser linked to Jeff Frankel, a professor at Harvard’s Kennedy School of Government (Jeff’s blog, bio). Some recent posts that are relevant to the topic of dollar depreciation (and thus RMB appreciation):The Euro Could Surpass the Dollar Within 10 years. According to Frankel, central bank reserves will shift away from USD and toward Euros by as early as 2015:In fact, the Wall Street Journal reports that shops in Washington and New York are starting to accept foreign currency already!Geopolitical implications if the US $ loses its role as top international currency. The consequences of this change are as follows:

• The US loses the “‘exorbitant privilege’ of being able to finalce our international deficits easily”
• US allies no longer are willing to pay a financial price to support American global leadership: “Unfortunately, since 2001, during the same period that the US twin deficits have re-emerged, we have also lost popular sympathy and political support in much of the rest of the world. Now the hegemon has lost its claim to legitimacy in the eyes of many. In sharp contrast to international attitudes at the dawn of the century, opinion surveys report that the U.S. is now viewed unfavorably in most countries. Next time the US asks other central banks to bail out the dollar, will they be as willing to do so as Europe was in the 1960s, or as Japan was in the late 1980s after the Louvre Agreement? I fear not”

However, what doesn’t make sense in this picture is the swarms of European tourists coming to the US to buy products. Seems to me that the Euro is overvalued from a purchasing price parity basis.UPDATE 4/1:  Read SeekingAlpha post on the risks around maintaining the USD’s Reserve Currency Status.  Quoting Stephen Jen of Morgan Stanley’s Global Economic Forum: In the long run, the most likely contender to the USD as the dominant international reserve currency, in our opinion, is likely to be an Asian currency centred on the Chinese RMB.  But this risk may be several decades away, we suspect.”