What’s Next for the Chinese Renminbi…and What Does it Mean for Investors

If you are to believe U.S. politicians and talk radio hosts, China’s renminbi is managed by a sinister cabal of James Bond villains who intentionally suppress the value of the currency to give their manufacturers an advantage and to hollow-out U.S. manufacturing.

 US Dollar – Chinese Renminbi Exchange Rate

While that view of China’s ruling Communist Party isn’t completely fantastical, the truth is a little more complicated. When China’s leaders decided in the 1980s that “to get rich is glorious,” they decided that a weak currency was a convenient way to make that happen.  From a value of 1.50 yuan per dollar in 1980, the renminbi fell to nearly 9 yuan per dollar before China instituted a peg at 8.27.  The renminbi was pegged at that level from 1997 until 2005, when—pressured by the United States and other trading partners—China opted for a managed float that would allow for a gradual rise.

The precise rules that control the float have changed multiple times as China has become more lenient, and currently the price of the renminbi is allowed to fluctuate within a daily 1% band against a basket of major world currencies.

(Note: I’m often asked why China’s currency has two names: the renminbi and the yuan.  “Renminbi” is the currency’s official name.  “Yuan” is a unit of renminbi.  The price you see quoted in a Chinese store would be, say, 5 yuan.  You would never see a price quoted as 5 renminbi.  This is not too different than the British pound sterling.  “Pound sterling” is the currency’s name, but prices in the UK are quoted in pounds, not sterling.)

As a country with a massive export economy and the largest current account surplus in the world—$214 billion as of 2012—China’s currency should naturally appreciate in value due to market forces (all else equal, a large trade surplus leads to a rising currency as it, in effect, involves selling the currency of the importing country to buy the currency of the exporting country).

And indeed, the renminbi has been gaining on the dollar since it was de-pegged.

Not entirely coincidentally, China has also become less competitive as a manufacturer.  In fact, just this week one of China’s leading shoemakers moved part of its manufacturing base to Africa to take advantage of the lower costs!

The rising value of China’s currency is certainly part of the reason for China’s loss of competitiveness.  A bigger issue—and one for which there is no easy solution—is the rising cost of Chinese labor, which is growing at a double-digit clip.

China’s manufacturing model assumes an inexhaustible supply of cheap migrant labor from the countryside.  But after 30 years of growth—and over 30 years of the One Child Policy—the pool of labor is simply no longer there to exploit.  This means that China will have to invest more in capital in order to boost competitiveness…or simply massively devalue its currency again.

There is a big problem with that second option.  China’s leaders are already worried about inflation, and they are reluctant to do anything that will fan those flames.  And China’s middle classes—which become more assertive every day—are less likely to tolerate high inflation or higher prices for imported goods.

If the Chinese Communist Party wants to keep its grip on power, it has to keep its restive masses happy.  And this means that any devaluation of the renminbi will be gradual, if it happens at all.

What does any of this mean for investors?

If you are going to invest in China, invest in companies that benefit from rising living standards among Chinese workers.  Go for consumer goods and services rather than industrial companies and exporters.

China Mobile ($CHL) is a fine example. China Mobile is the largest mobile phone operator in the world by subscribers, and as Chinese consumers trade up from feature phones to smart phones, the company is well positioned to benefit.  It also trades for just 10 times earnings and yields 4% in dividends.

China will eventually “blow up,” as its aging demographics and persistent asset bubbles virtually guarantee a Japanese-style malaise.  But in the meantime, there is still money to be made investing in the Chinese consumer.

Sizemore Capital is long CHL. This article first appeared on InvestorPlace.

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