By Patrick Heller
Liberty's Outlook

       In 1995, the Chinese government fixed the value of its currency, the renminbi yuan, to the U.S. dollar at a rate of 8.28 yuan to $1.00. The rate has held steadfast ever since.
        In 1995, the U.S. government held the world's largest reserves of gold and foreign exchange - $167 billion. China was down the list behind Japan, Germany, Taiwan, Switzerland, France, and Singapore at $57 billion.
        In the years since, the U.S. dollar has risen and fallen. Here's how the value of the dollar has changed against some currencies since the beginning of 1995: Mexico peso +97.8%, India rupee +39.4%, South Korea won +27.2%, Taiwan dollar +19.6%, Singapore dollar +14.6%, Japan yen +8.0%, Australia dollar +2.0%, Euro -0.5%, Switzerland franc -4.9%, Canada dollar -10.6%, and British pound -14.0%.
        Although it might look like the U.S. dollar has fared relatively well over the past ten years, you must consider that the dollar has gained nearly 10% against many of these currencies in the past two months.
        Also, the largest gains were against currencies where the government mismanaged its currency (Mexico), or those of the Far East Asian nations that were clobbered in the currency crisis of 1997 (and who also have an incentive for their currencies to be cheaper than others in order to stimulate exports and economic growth), or against the yen where the Japanese government has spent hundreds of billions of dollars trying to hold down the value of the yen versus the dollar.
        When you compare the value of the dollar against currencies from economically mature nations, the results are not good. Even with the recent surge in the dollar, it is still down compared to the Euro, Swiss franc, Canadian dollar, and British pound.
        Which also means that the value of the Chinese currency has fallen against these same currencies.
        The relatively cheap Chinese currency has helped fuel that country's massive growth in exports. China now has over $660 billion in foreign exchange reserves plus acknowledged (which may be lower than actual) gold reserves valued at more than $8 billion. Total reserves are increasingy by a half billion dollars every day! China's central bank has the world's largest reserves, by far.
        Most of the increase in China's reserves has been in U.S. dollars and U.S. Treasury debt. The Chinese government has even propped up its weak banking system by infusing U.S. dollars into troubled banks to hold as their reserves.
        In a free market, the Chinese yuan would have long since appreciated against the U.S. dollar. It has stayed fixed only because it has been fixed by the Chinese government.
        The relatively weak yuan has helped Chinese exports to the U.S. grow substantially, to where they now account for 10% of all U.S. imports.
As China industrializes, it has leveraged its low labor costs to out-compete more developed nations, including the U.S.
        With part of the manufacturing job losses in the U.S. attributable to Chinese competition, there has been some political backlash.
        Top U.S. officials have been urging the Chinese government to let the value of its currency rise for at least a year.
        U.S. government pressure soared within the past two weeks. The Treasury Department released a report May 17 that called China's currency policies "highly distortionary" and called for "substantial alteration" of those policies within six months.
        This "request" was made as import quotas were being reimposed on some Chinese textiles.
        It is clear that the U.S. government is ordering the Chinese government to raise the value of the yuan soon, or risk a protectionist backlash.
        Within days, China's prime minister, Wen Jiabao, referred to the currency policies as a matter of "China's own sovereignty." He said, Any pressure or effort to politicize an economic matter will not help solve problems."
        It makes perfect sense for China to determine its own currency policy. It is also true that a rise in the value of the yuan will not magically erase America's huge and growing trade deficit.
        For instance, if the yuan appreciates by 10%, that would only increase the cost of all U.S. imports by 1%. That would not be enough to cut the flood of imports into America.
Political rhetoric aside, the Chinese have reasons to want the value of the yuan to rise against the dollar. An undervalued currency causes too many resources to be devoted to exports and too little to meeting domestic consumption.
        China's current-account trade surplus was 1.5% of Gross Domestic Product (GDP) in 2001. It rose to 4.2% of GDP last year and is expected to be even higher in 2005. From this perspective, a more valuable yuan is needed to balance the economy.
        However, any increase in the value of the yuan carries substantial risk. It will create uncertainty and lead to some financial stress in parts of the economy that depend on growing exports. No doubt some businesses would decline and jobs would be lost.
        If the Chinese yuan did appreciate against the dollar, the value of China's foreign exchange reserves would decline, as would the U.S. dollar-denominated capital infusions to the major banks.
        The Chinese government is facing a situation with no perfect answers. To allow the yuan to appreciate will cost the government billions of dollars and cause economic turmoil.
        To do nothing would simply let the problem grow even larger with an even higher cost to manage it in the future.
        On balance, there is every reason to think that the Chinese government should let the yuan appreciate soon. Perhaps that only reason to not do so is that it might be interpreted as the Chinese taking orders from Washington. The Chinese are also not eager to reward speculators who have been taking long positions in the yuan. As a result, look for China to make changes when foreign governments and the markets least expect it. By the way, the various forecasts I have seen project a rise in the yuan somewhere between 7% to 25% this year.
        On May 18th, a long-scheduled foreign exchange trading system began in China, allowing Chinese banks to trade in eight currency pairs. Seven involve the U.S. dollar and the other is a euro-yen pair. This could have been the ideal time for China to announce a change in their currency policy. But no change was announced.'
        In July, China's president, Hu Jintao, may attend the G8 summit in Britain. He is also scheduled to visit America in September. These visits would go much easier if some move in currency policy were announced beforehand.
        There are various ways that the yuan could be appreciated, from simply being fixed at a new higher rate to becoming a completely free floating currency. It is more likely that any move would be between these extremes, such as setting a higher target value but, for example, letting the currency fluctuate within a 10-20% range.
        While I think it is likely that the yuan will be allowed to appreciate against the dollar, I am not really concerned about the nature of the change. However it changes, there will be effects on the U.S. dollar and the U.S. economy:

• Any change will result in the outright decline in the value of the dollar on a world-wide basis. The price of gold is almost certain to rise. If the value of the yuan rose 20%, for instance, gold could climb at least 10%. Remember, when the dollar falls against other currencies, that also knocks down the price of gold in other countries. Foreign investment demand for gold will almost certainly increase.
• U.S. Treasury debt will be less attractive to foreign governments and investors because of the potential for further decline in the value of the debt. As a result, interest rates will have to rise, quite possibly sharply.
• The higher interest rates will put a brake on consumer spending, causing a slowdown in the economy at a minimum and possibly a serious market crash.
  
• The higher interest rates will also likely hurt the real estate market.

        As the yuan may be allowed to appreciate as early as a month from now, I recommend that you re-evaluate your total investment portfolio to see what you can do to better protect yourself against the risks I just listed. Adding to your precious metals and rare coin positions sooner rather than later would be a good idea.
        Editor's Note: Patrick Heller is editor of Liberty's Outlook, a publication of Liberty Coin Service, 300 Frandor Ave., Lansing, MI 48912, 1 year, 12 issues, $79. Liberty Coin Service has been a dealer in rare coins and precious metals since 1971. www.libertcoinservice.com.