The Coming Revaluation of the Yuan

Recently The Economist presented its annual survey of the price of a Big Mac hamburger in various countries where it is sold around the world. In economic terms, this analysis is called 'purchasing power parity'.

The theory is that a Big Mac in New York is no different from a Big Mac in London, Hong Kong or any other city where one can be purchased. Therefore, by comparing the price of Big Macs in different countries, one can get an indication about the relative valuation of each country's currency. In other words, if a Big Mac costs 57% more in the US than it does in China, the US dollar is 57% overvalued compared to the Chinese currency, the yuan.

To put it another way, the yuan is 57% undervalued compared to the dollar, which happens to be the purchasing power disparity reported by The Economist. Clearly, the yuan is undervalued compared to the dollar, and has been for some time.

The yuan is fixed to the dollar at 8.27 yuan to 1 dollar, so under this present arrangement, the market process does not automatically adjust the disparity as was the case under the classical gold standard. Instead, governments have to intervene in the currency market and set the rate for their respective currency, and we don't know when the Chinese government will step in to correct the disparity by revaluing the yuan. However, I think we can assume it is coming soon, and may be delivered to Mr. Bush just before the November election, giving him a PR coup by enabling him to claim victory in his fight to create jobs in the US, jobs that otherwise have been moving to China because the yuan is undervalued.

The interesting aspect is that an October revaluation of the yuan would be the ideal time from the Bush administration's point of view. The publicity garnered from the revaluation would deliver to him a pre-election fillip. But the consequences of a Chinese revaluation would not occur until after the election has passed, which is a good thing given that the consequences will probably on balance be bad for the US consumer, which has been the beneficiary of cheap Chinese goods.

If for example the yuan revalues 57% to bring purchasing power parity back into line, Chinese goods - which have become the mainstay of Walmart and some other retailers - will increase 57% in price, all other things being equal. A price increase like that would put a serious dent in consumer confidence, but it will take time to run-down existing inventories of Chinese made goods and replace them with new ones which will take more dollars to purchase. So the price rise resulting from a yuan revaluation and therefore the hit to consumer confidence would occur after the election.

What brings me to this conclusion is news that the Chinese have been reducing the quantity of dollars in their foreign exchange reserves. Why? It may to an extent be prudent diversification out of the dollar into stronger currencies like the euro, sterling or yen. But the reduction in dollar holdings may also be in preparation for a revaluation of the yuan to the dollar. The Chinese are good traders, and their strategy of dumping dollars before their revaluation makes good sense from a trading point of view. Anything they dump now can be bought back after their revaluation with less yuan, 57% less yuan if the purchasing power disparity of The Economist is to be eliminated.

The important point though is that the same number of yuan can buy 57% more of ANYTHING nominally dollar denominated. So the dollar price of gold will look very cheap indeed to Chinese with yuan to spend. A revaluation of the yuan would indeed be very bullish for gold.

Published by GoldMoney
Copyright © 2004. All rights reserved.
Edited by James Turk

This material is prepared for general circulation and may not have regard to the particular circumstances or needs of any specific person who reads it. The information contained in this report has been compiled from sources believed to be reliable, but no representations or warranty, express or implied, is made by GoldMoney, its affiliates, representatives or any other person as to its accuracy, completeness or correctness. All opinions and estimates contained in this report reflect the writer's judgement as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. To the full extent permitted by law neither GoldMoney nor any of its affiliates, representatives, nor any other person, accepts any liability whatsoever for any direct, indirect or consequential loss arising from any use of this report or the information contained herein. This report may not be reproduced, distributed or published without the prior consent of GoldMoney.