A New Era for China

Tuesday August 16, 2:16 am ET

By Jonathan Bernstein, ETFzone Trading Specialist

It is just over three weeks since the Chinese government announced the revaluation of its currency the yuan (also known as the renminbi). On July 21st, the yuan was taken off the dollar peg and tied to a basket of currencies -- primarily the dollar, euro, yen and South Korean won. Pegged for a decade at 8.28 yuan to the dollar, the yuan was allowed to depreciate a mere 8.11 or 2.1%, an amount not uncommonly seen in a single day of dollar fluctuation against the euro, yen, or pound. In fact, on the day of its revaluation, July 21st, the dollar fell further against the yen (2.3%) than against the yuan.

As the yuan is still undervalued 25-40% against the dollar, according to most estimates, many market watchers called the revaluation by the Chinese government purely symbolic. However, though trifling, the very fact of this move by the Chinese government is more important than its size. Since the revaluation, the Chinese market and Chinese ETFs have reflected this new paradigm, skyrocketing far beyond the paltry move in the currency. What excites post-revaluation investors in Chinese companies is that China now appears formally committed to a full integration with the world economy, a change that most investors expect will eventually lead to a freely floating currency and unprecedented, and almost unimaginable opportunity. The yuan revaluation to many signals a shift to this fundamental new reality and a young-hearted excitement about the future.

The new popularity of Chinese stock is apparent from the price chart below showing the performance of the iShares FTSE/Xinhua China 25 Index Fund (NYSE:FXI - News), itself a newcomer to the market since mid-October of last year.

As the chart above shows, despite all the hype regarding China, since its inception FXI has been trading within a five dollar (10%) range. The revaluation broke this trend pushing the FXI since July 21st up 10% to new all-time highs.

Since the revaluation, the pace of investor interest in China has increased significantly. In the three weeks since the revaluation, Shanghai's B-Index, which contains shares open to investment from foreign investors, has soared 31%. The biggest news last week was the sizzling IPO of Baidu.com (Nasdaq:BIDU - News), the internet search portal and so-called 'Chinese Google'. This week China was in the news again, as two key Chinese ADRs leap ahead: oil company Cnooc (NYSE:CEO - News) on the news that Unocal (NYSE:UNC - News) shareholders would agree to a Chevron (NYSE:CVX - News) takeover, and China Mobile (NYSE:CHL - News), now the world's top mobile phone carrier on a subscriber basis, which posted a 35.5% increase in quarterly profits.

The chart below compares the returns last week of CEO, CHL and FXI, which holds large stakes in both.
News of both the Chevron merger and the profit release from China Mobile came out pre-market Wednesday. The news positively impacted FXI, which holds 9.87% of its assets in China Mobile and 7.42% in Cnooc.

China continues to have the one of the best growth stories of today, with an economy expanding at a 9% annual pace, but like the shares of Chinese internet search engine Baidu.com, there are some signs that in the near term Chinese stocks may be getting a little ahead of themselves. Although the perception among investors is that China will not stop at a 2.1% revaluation, economists predict that the yuan will continue to devalue by 3% or less against the dollar by the end of 2005. This slight dollar appreciation does not alone merit the 31% increase in the Shanghai ADR market.

The difference, then, is anticipation of further revaluation, and the perceived new reality for China. Judging by the last three weeks, that perception looks real enough, but the reality is not yet here. The revaluation of the currency may have fundamentally changed the demand for Chinese securities forever. But the Chinese market has moved so far, so fast, that there may be a cooling off period here before the market trends higher. Investors seeking to diversify into Chinese ETFs may want to procede cautiously, staggering their China allocations at these recently elevated levels.

Jonathan Bernstein,PhD has specialized in short-term trading of equities and equity options since 1998.