Leadership Transition and the Chinese Yuan

Chief Investment Officer, Fixed Income and Model Portfolios

On November 14, 2012, the Chinese yuan traded at an all-time record exchange rate against the U.S. dollar.1 As investors continue to digest the impact of the U.S. elections, fears of the pending fiscal cliff and the recent transition in Chinese leadership, now could be a prudent time to reassess portfolio exposure to foreign currencies and to the world’s second-largest economy, China. The leadership transition in China has refocused many investors’ attention not only on China but on emerging markets in general. Xi Jinping and Li Keqiang, the newly appointed Chinese party leader and premier, respectively, face the difficult task of continuing the transition from an export-driven, lower-middle-income economy to a consumer-based, high-income economy.2 Chinese policy makers have long embraced moderation and pragmatism in reforms, principles we are currently seeing in the Chinese currency market. However, as China continues its economic expansion (albeit at a slower pace than during the previous 30 years), several policy goals have been made abundantly clear.3 For Chinese policy makers, the next five years will be focused on: 1) Expanding economic prosperity more broadly 2) Avoiding a “middle income trap” through greater consumption and less reliance on exports 3) Expanding Chinese influence in the region4 Increasing the amount of trades settling in Chinese yuan is central to all three of these stated goals. Given your investment positions in the Chinese currency, what does increased yuan trade settlement mean for your portfolio? The aim of increased trade settlement is to increase the use of Chinese yuan more broadly. A series of steps (including wider adoption for trade settlement; larger, more liquid financial products denominated in yuan; larger number of trading centers transacting in yuan) must gradually take place, but the groundwork for these developments is being laid now. The new Chinese premier has been a driving force behind the CNH (Chinese yuan in Hong Kong) initiative currently expanding to Taiwan and Singapore. In recent speeches, he signaled that China would continue to focus on initiatives to regionalize, and then internationalize, the Chinese yuan. Oftentimes, investors ask where the Chinese yuan fits in their portfolio. The volatility of the Chinese yuan is definitely being managed, given that China maintains a 1.00% daily trading band on its currency.5 In fact, since August 20056 volatility in non-deliverable forward currency contracts (“forwards”) has averaged 1.97% per year.7 Over the past year, amid concerns of slowing Chinese economic growth, expectations for an appreciation of the Chinese yuan have faded. However, this has created a different opportunity in the market. From 2005 to 2011, foreign investors trying to position themselves for an appreciating yuan were limited to investments in forwards. This “one-way” trade at times became “crowded,” resulting in forwards failing to completely capture movements in the spot currency. Now that appreciation expectations have moderated and investors have multiple means of accessing yuan investments, the market is providing positive interest rates for investors waiting for appreciation. As of October 31, 2012, the implied interest rate on 12-month forwards was 2.11%, over seven times the rate of 2-year U.S. Treasury bonds.8 Given the current level of U.S. interest rates, investors’ positions in short-term U.S. fixed income have limited return potential. With comparable levels of volatility, it could make sense for some investors to invest a portion of their assets in vehicles that offer exposure to the Chinese yuan. Historically low levels of volatility, positive exposure to upside surprises in Chinese gross domestic product (GDP) growth, and positive interest rate carry all support the case for increasing investor allocations to the Chinese currency, where suitable.   1Bloomberg, 2012. 2World Bank, 2012. 3The policies were announced September 24, 2012, in China’s 12th Five-Year Plan. 4“China Unveils Financial Reform Plan for 12th Five-Year Plan Period,” Xinhua News Agency, September 24, 2012. 5On April 16, 2012, the Chinese government loosened the intraday trading band on the Chinese yuan, allowing the currency to vary within a 1.00% daily trading band, compared to the previous 0.50% band. 6China has allowed the yuan to fluctuate against a basket of currencies since July 21, 2005. 7JPMorgan, October 31, 2012. 8Bloomberg, 2012.

Important Risks Related to this Article

Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. CYB focuses its investments in China, thereby increasing the impact of events and developments associated with the region, which can adversely affect performance. Investments in emerging or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments. Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations. Derivative investments can be volatile and these investments may be less liquid than other securities, and more sensitive to the effect of varied economic conditions. As this Fund can have a high concentration in some issuers the Fund can be adversely impacted by changes affecting those issuers. Unlike typical exchange-traded Funds, there are no indexes that the Fund attempts to track or replicate. Thus, the ability of the Fund to achieve its objectives will depend on the effectiveness of the portfolio manager. Due to the investment strategy of this Fund it may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.
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About the Contributor
Chief Investment Officer, Fixed Income and Model Portfolios

Rick Harper serves as the Chief Investment Officer, Fixed Income and Model Portfolios at WisdomTree Asset Management, where he oversees the firm’s suite of fixed income and currency exchange-traded funds.  He is also a voting member of the WisdomTree Model Portfolio Investment Committee and takes a leading role in the management and oversight of the fixed income model allocations. He plays an active role in risk management and oversight within the firm.

Rick has over 29 years investment experience in strategy and portfolio management positions at prominent investment firms. Prior to joining WisdomTree in 2007, Rick held senior level strategist roles with RBC Dain Rauscher, Bank One Capital Markets, ETF Advisors, and Nuveen Investments. At ETF Advisors, he was the portfolio manager and developer of some of the first fixed income exchange-traded funds. His research has been featured in leading periodicals including the Journal of Portfolio Management and the Journal of Indexes. He graduated from Emory University and earned his MBA at Indiana University.