Morningstar Advisor - December/January 2012 - (Page 51)

if China is a currency manipulator the Fed is certainly an interest-rate manipulator. Both forms of intervention are akin to price fixing. While the term “manipulation” denotes a devious plot, the truth is that the supposed manipulation is implemented with a simple open-market purchase of plain-vanilla U.S. Treasuries. All the U.S. Treasury needs to do to put a halt to the game is stop selling bonds. Given the U.S. debt addiction, that is unlikely to happen. Pegging a currency at an artificially low value is not without costs. The Chinese themselves bear the cost of this domestic financial repression as importers are forced to pay an artificially high price for foreign goods and Chinese consumers face a lower standard of living. By pegging their exchange rate, China also gives up some control over its monetary policy and has a much more difficult time controlling inflation, which again negatively has an impact on both consumers and savers. As a developing nation, these policies are reasonable if the goal is to spur export orientated economic development. But as China ascends the ranks to economic prominence, its citizens will push for the better quality of life that wealth affords. Liberalization mainland China, the CNY (mainland) version can trade at a different price than the CNY (Hong Kong) version. In 2005, China switched from a pegged currency to a tightly managed float, allowing the renminbi to appreciate by 2%. Although the float paused during the financial crisis, in 2010, further liberalization encouraged the renminbi’s use outside of mainland China; this enabled trade settlement and allowed foreign corporations to issue renminbi bonds (dim sum bonds) in China. With these reforms, foreign investors have more efficient options including renminbidenominated bank accounts and bonds. Over time, it is likely that the renminbi will continue to slowly rise in value. This will help reduce trade imbalances and encourage domestic consumption. Further, it will make U.S. manufacturing more competitive, providing a boost just when it is most needed. Exports have been one of the few bright spots of the recovery, contributing 14% of GDP, up from just 10% in 2004. At the height of the global financial crisis in March 2009, Zhou Xiaochuan, the governor of the Central Bank of China, questioned the continued use of the U.S. dollar as the reserve currency and suggested a more equitable choice, special drawing rights backed by a basket of currencies. But since that time, instead of moving toward increased use of the special drawing rights, China has instead encouraged the use of the renminbi, such as for bilateral trade settlement. Over time, as China’s economy grows and it continues to dominate global trade, a shift may occur where the renminbi becomes an international reserve currency. But, as Arvind Subramanian of the Peterson Institute for International Economics points out, the use of renminbi as an international reserve currency would require a net outflow of renminbi to the rest of the world. Thus, China would need to run a net current account deficit. While it may seem like the transition to Exhibit 1 Currency Trilemma: Picking two policy choices in the triangle determines the third. Each set of policy choices is connected by a policy goal. Closed Financial Markets Monetary Independece Exchange Rate Stability Floating Exchange Rate Financial Integration Giving up Monetary Independence another currency for international trade would take decades, it can happen faster than one would expect. Barry Eichengreen suggests that it took just 10 years after the formation of the Federal Reserve in 1913 for the U.S. dollar to surpass the pound sterling. Still, China’s government lacks the basic transparency and trust that global investors demand. Rather than replace the dollar, it is more likely that the renminbi will play a larger role as the dollar’s dominance ebbs. K Michael Rawson, CFA, is an ETF analyst with Morningstar. He specializes in currency funds. One way to assess how nations attempt to deal with the realities of the trilemma is the Chinn Ito Index of financial openness. By this measure, China is one of the most tightly controlled financial markets among 180 counties. Despite having the world’s secondlargest economy, China is as tightly controlled as Zimbabwe and Libya. However, the index was last updated in 2009, which does not capture recent steps that China has taken to open its financial markets. In 2003, China implemented a two-currency system to help facilitate cross-border trade yet prevent massive in- and outflows. While the renminbi is used in both Hong Kong and in MorningstarAdvisor.com 51 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - December/January 2012

Morningstar Advisor - December/January 2012
Contents
Contributors
Letter From the Editor
Seduced by Complexity
Is China Exposure Important for a Portfolio?
A Niche Built on Trust
How to Find Your Client’s Investment Style
Taking the Long View
Consensus on Europe Elusive
Four Picks for the Present
Investment Briefs
Is Perception Reality for Active Managers?
Be Alert for Basic-Materials Bargains
Investment Boom Unsustainable
Digging Moats in China
Where China’s Domestic Companies Stand to Benefit
Arising Opportunities
China Strong Long Term
From Currency Manipulation to International Acceptance
The Keys to China’s Fortune
Wedgewood’s Lessons Pay Off
Reading the Evidence on Indexing
Scouting for Investments Abroad
Yield, Please (Hold the Europe)
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
China Fund Managers Eat Elsewhere

Morningstar Advisor - December/January 2012