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The Buy Side

An inside tip on China's currency Add to ...

Every now and then, valuable information comes out in full public view, but gets ignored. If you miss these tips, you may pass up a profit. But how to know which tip is worth listening to? The trick is to mind the source - if it is close to decision-makers, the tip is much more valuable than words of mere commentators, no matter how smart they may be.

Such public tips are rare, but they do happen. And recently such a tip came via WikiLeaks. According to leaked diplomatic cables, last year the chief economist at the state-run China Construction Bank told U.S. officials that the Chinese yuan was likely to rise 3 per cent against the dollar in 2010. The same economist, Hwa Erh-cheng, also projected a 5-per-cent rise of the yuan in 2011.

The yuan actually rose 3.05 per cent in 2010, just about spot-on the forecast. Merely a lucky prediction that panned out? Hardly.

The United States and China are locked in a bitter dispute about the value of the yuan. The U.S. claims China keeps the currency artificially low so it can sell products cheaply and create jobs for Chinese workers at the expense of their U.S. counterparts. Washington, therefore, presses Beijing to let the yuan rise.

The Chinese resist. If the yuan rises too fast, unemployment could cause social instability. Plus, the Chinese government would lose face if it were seen to be caving in to Washington. The yuan's value is, thus, the subject of fierce behind-the-scenes negotiations.

Last year, there were rumours that an agreement was reached during the G20 meeting in Toronto under which the Chinese government would let the yuan rise enough to satisfy the Americans, but quietly, so as not to lose face. Any confirmation of these rumours would be vital for currency speculators, but no news had surfaced - until now.

Mr. Hwa, the China Construction Bank's chief economist with the great forecasting record, was most likely part of the negotiating team. If so, his accurate "forecast" of a 3-per-cent rise reflected a veiled Chinese government commitment, and so did his 2011 forecast of 5 per cent.

Even more interesting was Mr. Hwa's comment that the two-year rise was "unlikely to be a 'one-shot' change." In other words, the yuan is now set to appreciate slowly over more than one year.

How could one benefit from the highly probable rise in the yuan?

First off, short-term bonds denominated in yuan are likely to return an extra five percentage points because of currency appreciation over the next year or two, for those counting in U.S. dollars.

The World Bank just issued its first yuan bonds, selling 500 million yuan ($76-million U.S.) of two-year bonds to Hong Kong-based institutions, companies and wealthy folks. In addition, the Asian Development Bank, Caterpillar and McDonald's also have yuan-denominated debt.

Another way to benefit: yuan futures, traded on the CME. If you buy yuan futures, it's because you are speculating that the yuan will rise against the U.S. dollar. You agree to take delivery of a million yuan, say a year from now, at today's price of about $0.153 (U.S.) a yuan, for a total of $153,000.

Since it's a futures contract, you have to put down a small deposit as margin. You could put down as little as $4,000, since the yuan's price has not been volatile up to now. A prudent speculator, however, always puts up much more than the minimum margin - say, $30,000 to $50,000 in this case, or 20 to 30 per cent of the full contract value.

If the yuan does indeed rise 5 per cent, your return would be 15 per cent to 25 per cent on this levered investment.

Of course, the yuan could also fall, and the leveraged speculator would then lose just as much, perhaps even more.

How could the yuan fall? Perhaps unemployment in China will rise, bringing political instability. Or North Korea will go crazy and start a war. Or the yuan may simply fluctuate more violently than before. Anything may happen.

But if it doesn't, and if Mr. Hwa's "forecast" really represents an informal Chinese government commitment to Washington, then the yuan is likely to be higher by 5 per cent by Dec. 31, 2011, and those who bought it now would benefit.

And they would have learned of the opportunity from WikiLeaks.

Ways to play the rising yuan

1. Yuan bonds

2. Yuan futures

Making the yuan more flexible

- Last week, the yuan hit a 17-year high, at 6.5817 yuan to the U.S. dollar, as Chinese President Hu Jintao met U.S. President Barack Obama in Washington.

- China announced it would let Chinese companies make investments overseas in yuan, expanding the currency's role in the global economy.

- U.S. Treasury Secretary Timothy Geithner said the U.S. would consider Chinese requests for greater investment opportunities in return for movement on the currency and other U.S. concerns.

- Also last week, Bank of China allowed U.S. customers to trade the yuan for the first time. It is the first state-owned bank to do so. Some analysts say this is a necessary step in allowing the yuan to ultimately float freely.

Sonali Verma

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