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Warning: long post about my recent obsession (no, not the other one) with RMB appreciation. My other posts here and here.

Today, I exchanged USD to RMB at the rate of 6.9835. A milestone. It seems like just yesterday that I was calculating the rate at 8:1. (4/12 Update: on 4/3 I also made a deposit into my new FDIC insured RMB Everbank account and the rate was 6.9544.  According to Xinhua the People’s Bank of China (PBOC) set the central parity rate at 6.992.)

Here’s some more links on the subject of RMB appreciation and why it will likely continue. Here’s my quick summary:

• Foreign direct investment and hot money continues to flow in. This more than offsets the reduced trade surplus that results in an appreciated RMB. Therefore, China’s “monetary trap” will continue with the likelihood of a one-off maxi revaluation more likely.
• With a higher RMB, importers are winners, exporters are losers. In general, Chinese people should feel more wealthy, with international travel, foreign real estate, and study abroad less expensive in RMB terms.
• With a 15.6% increase in value since the peg was dropped in July 2005, China’s economy has miraculously offset that increase by generating over 20% productivity growth rate, and overall profit margins increasing from 3% to 6.5%, according to JP Morgan.
• RMB appreciation is a key weapon against inflation. But it is not the only tool. And even with the accelerating appreciation we’ve seen, it appears that inflation has not cooled and now is 13% annualized based on Q1 data.
• In fact, the RMB hasn’t really even appreciated against a trade-weighted basket of currencies. It has only appreciated because the US dollar has depreciated. So expect accelerating appreciation and increasing likelihood of a shocking one-time revaluation.

Michael Pettis: Money Keeps Pouring In

Pettis notes that Foreign Direct Investment (FDI) has increased substantially:

According to the numbers released today, FDI for the first quarter was $27.4 billion – nearly 73% more than the $15.9 billion recorded last year over the same period. So although the trade surplus declined by $4.7 billion, it was more than matched by the $11.5 billion increase in FDI

His argument is simple: even if RMB appreciation cools the trade surplus as one would expect, RMB appreciation is causing more FDI and “hot money inflows” to take the place. This further increases government USD reserves, and further accelerates what he calls “the monetary trap” that will lead inevitably to a large, maxi-revaluation of 15-20% to dramatically change investor expectations:

We are now caught in the most mechanical and frustrating part of the monetary trap in which China has been caught during the past five years. The trade surplus was the original driver of China’s out-of-control money growth, but by now the growth seems to have taken a life of its own as money piles into the country seeking to take advantage of the nearly-inevitable run-up in the value of the currency. Hu Xiaolan, the head of SAFE, said that SAFE and the Ministry of Commerce are going to investigate whether FDI has become a channel for hot money inflows. Hmmm, I wonder.

Pettis’ conclusion: a one-time maxi-revaluation of 15-20% is on its way.

ChinaStakes: April 10 report on the RMB exchange rate

ChinaStakes reports that on April 10 the RMB exchange rate to the USD dropped to 6.9920 and that RMB appreciation was “beginning to transform China from a labor power to a capital power.” This represents a 4.06% increase during Q1 2008.

What is amazing is that the RMB dollar peg of 8.28:1 was lifted July 2005, and that the total appreciation to date is 15.6%. So almost one-third of the appreciation has happened in just the last 3 months. If this isn’t accelerating RMB appreciation I don’t know what is!

Who are the winners as the RMB appreciates?

• companies that import raw materials, e.g. crude iron and ore
• companies that import high tech items, e.g. planes and capital machinery
• people who plan international travel or study abroad. (Min, Stanford is getting more and more affordable by the day!)
• people and companies who want to buy foreign real estate
• RMB denominated assets, such as China’s real estate and stock markets

Guardian.co.uk: China exporters feel pinch of rising yuan, costs

Who are the losers as the RMB appreciates?

Answer: export oriented Small and Medium Businesses.

The Guardian covers this:

Deutsche Bank analysts Jun Ma and Wenjie Lu project that 20% of “Up to 20 percent of low-end exporters could go belly-up this year as the harsher operating environment dissolves profits and demand slows in major markets such as the United States and Europe,” they said. “China’s export sector faces multiple shocks simultaneously this year. Many of these are unintended, but the magnitude of these shocks combined is stronger than we had expected,” they wrote in a recent report.

Small and Medium Businesses (SMB or SMEs) who are export oriented are the clear losers. In addition to having thin margins and competition, they are less familiar with hedging options, such as forwards contracts and options markets.

ChristineLu.com: Frank Gong, JP Morgan, at Harvard China Review Conference.

Christine Lu spoke at and blogged about the Harvard China Review Conference. She highlighed a video of Frank Gong, Managing director and China’s Chief Economist with JP Morgan Securities in Hong Kong. He framed the recent 5 year period as an incredible period of achievement in China that has allowed the government to allow the RMB to appreciate vs. the US dollar.

Here’s my summary of his points:

• The stereotype is that China is a “profitless growth story”
• During the last 5 years, that has not been the case.
• Return on Equity (ROE) in corporate sector has increased from 7 to 17%.
• Profit margins have also been rising
• Three years ago, export sector had only 3% profit margin.
• People believed that if the RMB appreciated by 3%, the export market would just go bust.
• When the peg was lifted, the first year saw only 2.1% revaluation.
• However, three years later, the RMB appreciated more than 15% vs. dollar.
• In 2008, the annualized rate of RMB appreciation is 15%, based on Q1 numbers.
• So what happened to export sector? Did they go bust?
• No. In fact, their profit margin is now 6.5% vs. 3.0% in the past.
• The export sector did not die, but became stronger with a stronger currency. They moved up the value chain and became more efficient.
• Same process has been shown with other developing countries like Japan
• For example, Japan was at 400 Yen to USD and now is 100 Y to USD.
• Even with this revaluation of the Yen, Japanese business has remained competitive.
• The same process happening to the chinese economy as companies are moving up to higher value-added work.
• What has powered this growth is 20% productivity growth rate during lats 5-7 years, the highest in the world.
• Labor cost has been rising over last 5 years. Wage growth up 10-12 %
• Oil and commodity prices also rising.
• In the face of all these changes, productivity growth has more than made up for this.

Michael Pettis: Inflation consensus inching higher

Inflation is still high in China, even with the increase in RMB. March appears to have a 8.3% year on year inflation rate. This means 13% annualized influation in Q1 2008, vs 9.2% annualized inflation rate in Q4.

Speaking of appreciation, today Zhu Baoliang, chief economist at the State Information Center, a think tank under the NRDC (China’s powerful planning agency), wrote an article in China Securities Journal, the official securities newspaper, saying that China had to speed up the rate of appreciation. He said this was needed to combat inflation. Interestingly enough the same newspaper had a front-page commentary arguing that China needed more than just currency appreciation to control inflation.

China Securities Journal is not the formal voice of government policy, but it does have the reputation of reflecting official opinion, so I assume that it must also be reflecting the ongoing debate about how aggressively the currency must be managed to deal with inflation. What does Mr. Zhu mean about a faster rate of appreciation? Since the RMB is already appreciating fairly quickly, I suppose it might be code for a one-off revaluation.

Fighting inflation is clearly a key reason why the monetary authorities need to keep driving the RMB up.

Brad Setser of RGE Monitor: Could a stronger RMB help limit food inflation in China?

Brad’s answer is yes: a stronger RMB could make food imports profitable, and that would cause domestic producers to lower prices.

Brad Setser: A RMB that isn’t appreciating cannot be killing you

Setser critiques a New York Times article entitled Seeing the Sights of Industrial China: 2 Factories, 2 Future. The article first profiles the Shanghai Jinjue Fashion Company and makes the point that low cost exporters are facing pressure because of the rising RMB. It then profiles ReneSola, a solar panel silicon wafer manufacturer. Chinese exporters believe they need to move up the value chain to survive in the face of increasing costs and RMB appreciation. ReneSola did just that and as a result claims that RMB increases resulted in “trivial” money lost.

Brad makes a simple point: the RMB is appreciating against the dollar, but is going down against the euro and yen. “It is basically flat against a trade-weighted currency basket.” And the RMB is down 4% versus the euro in Q1, according to the Wall Street Journal quoted in Setser’s post.

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.” 

UPDATE 4/11:  Also see my most recent post on RMB Appreciation on 4/11 when the RMB crossed the 7:1 exchange rate level.  Also related as a 3/30 post with more links on the RMB appreciation including Brad Setzer’s point that it hasn’t appreciated vs. the Euro.

I have been generally concerned about the decline of the dollar and specifically concerned about RMB appreciation. But the weekend collapse and the unprecendented Fed bailout of Bear Stearns prompted me to research it further.

The problem: dollar decline driven by US budget and trade deficits

John Mason at Seeking Alpha wrote a good analysis on dollar decline that explained that market participants expect there to be higher inflation in the US than in other countries. He explains that the US has acted as a “large country” with a reserve currency, not subject to market forces that would punish the country for running large Federal deficits and a loose monetary policy to prop up growth. When “small countries” do this, market participants sell off their currency. Well, it seems that the US is now subject to the same rules.

Meanwhile, Michael Pettis at Seeking Alpha reasoned that the fall of the dollar would put pressure on RMB revaluation:

To make matters worse, the fall of the dollar ($1.5580 to the euro, $2.0310 to the pound, and Y 99.77 to the dollar) is putting unbearable pressure on countries who peg their exchange rate to the dollar. Not only does this reduce the value of their currencies in international trade (and so put increasing upward pressure on their trade surpluses), but because the Fed is dropping interest rates and pumping liquidity into the system it can only increase hot money inflows into countries like China. Referring to Chinese Commerce Minister Chen Deming, the China Daily today said:

Chen’s ministry, which oversees foreign trade and domestic consumption, said that during the first two months, investments from the European Union countries rose a whopping 109 percent, while investments from the United States increased 44 percent. Wild expectations abroad that the yuan will continue to rise in value against major world currencies has led to money coming to China.

“When you bring US dollars to invest in China, you need to change it into the yuan. Naturally you would like your funds to enter China at an earlier date. Because, if you are late, the same amount of dollars will turn out to be less yuan bills,” Chen told reporters.

Chart: 5 year change in RMB to USD exchange rate

source: Yahoo! Finance

Well, Chen’s comment describes the situation that I’ve faced as we’ve been projecting our 2008 RMB denominated expenses for my company. We’ve elected to advance our payment to vendors so they can convert USD to RMB immediately so we can lock in the current exchange rate. But obviously, this solution is not great for most China vendor relationships! (Why? hint: trust issues)

After researching this, I started to feel that dollar decline was a potential risk to our own personal investments.

1. Limited Solution: establish RMB bank account and convert USD

A limited solution is to set up an RMB bank account in China, wire in USD, and convert and hold RMB in that bank account. With Min’s help I set up an account at China Merchants Bank, which several other friends had recommended. This is only a limited solution because there is a USD $50,000 limit to incoming USD per person per year, as I understand it.

2. Potential solution: hedging USD through exchange traded notes (ETNs) tied to foreign currency

Note: this blog post does not constitute investment advice nor a recommendation/endorsement as to any specific legal, tax, investment or other matter. Do not blame me if you invest and lose your shirt.

This week, March 17, Morgan Stanley and Van Eck Global announced the launch of a new Chinese RMB/USD Exchange Traded Note (ETN) and a new Indian Rupee/USD ETN (BusinessWire, discussion at SeekingAlpha). Detailed information is at their MarketVectorsETNs website.

ETNs tied to foreign currency has been in the market for a while. CurrencyShares from Rydex Investments has FXA (Australian Dollar), FXB (British Pounds), FXC (Canadian Dollar), FXE (Euro), FXY (Japanese Yen), FXM (Mexican Peso) FXS (Swedish Krona), and FXF (Swiss Franc). But this is the first time I’ve seen a Chinese RMB/USD ETN.

There is a FAQ on the official MarketVectors website but here are a few that help frame what this is:

What is an ETN?

An ETN is an Exchange Traded Note, senior, unsecured debt issued by a bank or other financial institution. In this case, they are issued by Morgan Stanley. There is credit risk associated with purchasing these notes.

How does the value of the note relate to RMB?

Notes do not pay interest. Instead, the issuer promises to redeem the notes based on the performance of the S&P Chinese RMB Total Return Index (ticker:SPCBCNY), which tries to stay as close as possible to the Chinese RMB Spot Market. More about S&P’s indices here and here .

What are the risks?

• ETN is debt, and as such is subject to the solvency of the issuer, in this case Morgan Stanley.
• The IRS requires investors to calculate gains or losses on ETNs each tax year, and pay tax on the “notional interest” even though the ETN does not pay out any gains until you sell the note. So this is bad for cash flow (and your net return).
• The net return is also reduced by the fees related to the instrument. There are lots of examples on their Website.
• Many other risks. Read the risk factors in the prospectus.

So is it a good investment? Not sure. But I’ll be considering this and other options while trying to hedge out my USD risk either via going long on RMB or other foreign currencies. Anyone else out there worried about the dollar? or worried about RMB appreciation? Is the ETN a good option for hedging?

UPDATE 03/23/2008

Related analysis on RMB appreciation:

Michael Pettis, professor at Peking University’s Guanghua School of management, blogged about More, or Less, RMB appreciation. He argues that the Chinese government needs to allow the RMB to appreciate to fight inflation. But as it appreciates, more hot money will enter the country:

If Chinese inflation is a monetary problem, which I think it is, I it seems clear to me that the only way to reduce inflationary pressures is to reduce monetary growth, and that means of course reducing the net capital and current account inflows into China. A more rapid rise of the RMB is not only unlikely to reduce those inflows (at least until the RMB is much more expensive than it is now), but on the contrary it will actually increase net inflows by encouraging hot money faster than it reduces the trade surplus (and anyway so far the trade surplus hasn’t declined).

My conclusion is that either a slow, gradual appreciation of the RMB happens or a one-time large-magnitude RMB revaluation happens. Either way, it makes RMB a good investment for the individual investor.

Some other posts by Pettis include:

How do you turn this thing off?

5% revaluation of the RMB? Are you crazy?

More attention on the RMB

Section 988 Tax Issues related to ETNs

I’m still investigating the US Federal tax issues related to these ETNs. The default position of the IRS is that all gains and losses must be treated as Ordinary Income/Loss each tax year, unless a Section 988(A)(1)(b) election is taken, in which case some portion of the gains and losses can be treated as capital gains/losses. But I called MarketVectors and they couldn’t explain this provision even at a high level. The customer service rep asked me who I was with, concluded that I was a small-time individual investor (which I am), and then said “I’ll get back to you” with a tone of disregard. I’m now researching this with my accountant.

Everbank WorldCurrency Access Deposit

Via another SeekingAlpha review I discovered EverBank WorldCurrency Access Deposit Account. It provides for up to $100k in FDIC insured deposits at FDIC insured bank. No interest is provided for. However, this may be better than the drag of management fees with the ETN, and the tax questions highlighted above. I’ll be calling them to learn more about this product.

One downside to the EverBank product is the RMB account doesn’t provide any interest rate. To compare, current time deposit interest rates in China Merchants Bank are as follows: 3 months - 3.33% interest rate; 6 months - 3.78%; 1 year - 4.1%. Still, for the amount beyond the $50k convertible,the EverBank product may still be a reasonable option to hedge against dollar depreciation.

HSBC Renminbi Bank Services

HSBC also provides a variety of RMB related banking services. According to the footnotes on that page, “Renminbi Switching Service shares the same transaction limit of RMB20,000 per person per day with the Renminbi exchange services through HSBC accounts.” This doesn’t appear to provide a better option for large scale RMB exchange either.

ETRADE Global Trading

I’m also looking at the ETRADE Global Trading product that provides for trading into 6 currencies: Japanese Yen, Canadian Dollar, Swiss Franc, Euro, Hong Kong Dollar, British Pound.

UPDATE 03/24/2008

Found out more about the EverBank World Currency Deposit Access Account:

• Basic account is a deposit account backed by $100,000 of FDIC bank insurance.
• Value of principal is based on the spot market for RMB non-deliverable forward contracts.
• Transaction cost: they take a “spread on wholesale spot rate of 75 bps going in and out” according to the EverBank sales rep.
• Account has a $10,000 minimum to establish, and funds can be moved between currencies. Other currencies supported include: Austrailian dollar, British pound, Canadian dollar, Czech koruna, Danish krone, Euro, Hong Kong dollar, Japanese yen, Mexican peso, New Zealand dollar, Norweigian krone, Singapore dollar, South African rand, Swedish krona, Swiss franc.
• For Chinese RMB, the account is non-interest bearing, vs. the 1 year time deposit rate of 4.1% at China Merchants Bank at this time.
  No 1099 will be issued because it is not an interest bearing account. Any gains or losses must be reported as capital gains or losses.

From my perspective, the advantages vs. the ETN are as follows:

• ETN gains are treated as ordinary income unless a special Section 988 election is taken (which I don’t understand what that is right now). According to EverBank, Deposit gains are treated as capital gains. Need to confirm this with an accountant. But if this is the case, then the long term capital gains (LTCG) rate would be 5% for taxpayers in the 10% and 15% tax brackets and 15% for taxpayers in the 25%, 28%, 33%, and 35% tax brackets (source: about.com).
• EverBank takes a 75 bps spread when the currency is bought, and again when the currency is sold. The ETN charges 40 bps asset management fee. So it looks like the ETN is better for a shorter term hold.
• But with these 2 factors, it looks like with a 3 year hold, EverBank is better than the MarketVectors ETN by a slight amount.

Some more links:

• Brookings Institution report dated July 2007 discussing the tradeoffs between currency appreciation and inflation. Written by Geng Xiao, Director, of Brookings-Tsinghua Center.
• China Daily article stating that USD will stay the anchor of China’s foreign reserves and was at around 70% at the time of the article, dated November 2007.
• China Daily article dated 3/24/08 stating that central bank advisor Fan Gang “opposes the use of another one-off revaluation of the Chinese currency, or yuan, according to the Shanghai Securities News. Widespread expectations that the yuan would register further sharp gains against the dollar have been encouraging inflows of speculative money into the country.”

I just returned a few days ago from a 10-day trip to Shanghai and Beijing. I’ve got a lot to blog about but I’ve been busy catching up on my work at Kango these last few days. And I’m still fighting jetlag and insomnia. One night, instead of doing any real work, I picked at my Google Reader feeds and via Micah Sittig’s blog, discovered James Fallows’ analysis about the Chinese government’s $1.4 trillion buildup of US dollar reserves. This has been a personal topic of fascination since I have seen my own spending power in RMB terms drop from about an 8:1 RMB:USD exchange rate in late 2006 to today’s 7.14:1 ratio (which is continuing to fall). I responded to this depreciation by transferring the maximum of USD 50,000 into RMB in a China Merchants Bank account but still don’t feel fully hedged against USD depreciation, and I have to wait a full year before I can make any further transfers.

Fallows frames the situation as follows:

Through the quarter-century in which China has been opening to world trade, Chinese leaders have deliberately held down living standards for their own people and propped them up in the United States. This is the real meaning of the vast trade surplus-$1.4 trillion and counting, going up by about $1 billion per day-that the Chinese government has mostly parked in U.S. Treasury notes. In effect, every person in the (rich) United States has over the past 10 years or so borrowed about $4,000 from someone in the (poor) People’s Republic of China.

In Fallows’ understanding of the situation, starting in the 1990s when the current buildup of USD reserves began, the Chinese government made a policy decision to maintain a lower value for the RMB than would have otherwise occurred if the currency were allowed to float. By maintaining an artificially low-valued RMB, a higher level of export-oriented manufacturing and employment resulted. To maintain this currency level, banks in China who receive USD must “surrender” it to the People’s Bank of China (PBOC) who in turn delivers it to the State Administration for Foreign Exchange (SAFE) who then invests an estimated 70%-75% of the money in USD, and the remainder in Euros and Yen. In the beginning, this strategy made sense as China was able to build up a war-chest of foreign reserves to protect itself from the kind of currency crisis experienced by countries like Thailand during the Asian financial crisis in the late 90s.

But today, China holds far more foreign reserves than necessary to protect its currency. And yet China cannot afford to revalue the RMB to its likely market value because of two reasons. First, a higher-valued RMB would cause dislocation from “expensive” areas of China like Shanghai to lower -cost areas in China, and even to lower-cost countries like Vietnam and Cambodia. Second, a higher-valued RMB would increase consumption as everything from cars, cosmetics, and San Francisco family vacations become less expensive. This would further accentuate the rich-poor split that is already evident everywhere in China.

So neither country has an interest in a currency shock, that would create significant social pressures on both sides of the Pacific. And yet it seems unlikely that the situation can continue indefinitely. Even if you can argue that the first $1 trillion of foreign reserves is OK, it gets increasingly harder to argue that the second trillion makes sense let alone the third! But that is the direction we are heading. Meanwhile, Chinese consumers are getting a raw deal because their buying power is artificially held down in order to minimize the perception of rich-poor split and to maximize the creation of export-oriented manufacturing jobs.

The implication on a personal level is the need to diversify away from USD denominated assets. This is easier said than done because so much money is required to purchase and own residential real estate in Silicon Valley, and that is just where we happen to live. Also, there are limited ways to invest directly in RMB denominated assets, and plenty of ways to lose your money on unwise “China” plays. So I will just live with a certain degree of nervousness that our USD valued assets will not plummet because it is not in the interests of any government to see that this happens. Does anyone have any advice on this?