Why Stronger Chinese Yuan Would Benefit US Investors

A stronger Chinese currency, which the nation's government indicated could happen in the months ahead, would come at an ideal time for US markets.

As the US economy continues its sluggish recovery, a stronger Chinese yuan would help bolster US exports while offsetting the Federal Reserve's expected increase in interest rates next year, in part to support the weakening dollar.

While it remains uncertain whether China actually will follow through on hints this week that it will let the yuan rise against the dollar, the fact that Beijing is addressing the issue is reason for optimism in the West.

"It would be bullish for everybody but China, really, because it means you'd have better exports and better growth in the Europe and US," says Kurt Karl, chief economist at Swiss Re in New York. "Because it would be stimulative to the economy it would be counteractive to the Fed tightening. It would be wonderful timing if they could do it then, even more helpful if they could do it earlier."

Manufacturers in the US would benefit most because it would make their products cheaper in China and boost their revenue from that country when it is translated back into dollars.

Currency traders could play the move, comfortable that global diplomatic pressure at least would prevent China from allowing the yuan to depreciate any further.

The US also would be able to cut its huge trade deficit with China and narrow its overall current account gap. That would give the US economy a further boost and ease a major political headache for the Obama administration just as the president prepares to visit Beijing next week.

"Very often in a diplomatic leadup to a presidential visit you will try to assuage the high-level visitor on the issues that are really important," says Quincy Krosby, general strategist at Prudential Financial. "It's a disarming mechanism. Considering that it's a very important issue for the US and the president, it's not atypical to hear the Chinese bring it up beforehand."

To be sure, there are drawbacks to a stronger yuan.

It could lead to higher prices on the heavy flow of Chinese goods imported to the US, causing inflation and leading the Fed to have to hike interest rates sooner than desired.

Doubts also abound about China's true intentions.

"The Chinese are going to allow their currency to rise vis-a-vis the US dollar when it's in their interest," Krosby says. "They are never going to go ahead and do it if it's in the other countries' interests. That's not the way the Chinese see the world."

Investors, though, need to keep as close an eye on the diplomatic wrangling as will world leaders, who see Chinese monetary policy as one of the lynchpins in preventing a second leg down in the global recession.

If China doesn't follow through and let the yuan rise, that could thwart the run-up in global stocks this year.

Worries About Global Growth

The Treasury Department said in a recent report that China was stockpiling foreign exchange reserves—effectively boosting their value—at a pace that threatened the global economy.

At the same time, the Group of 20, of which the US is a member, continues to rail against China's continued intervention to keep its currency low against the dollar, a policy that has been critical to maintaining its export pace.

"Next year that will be the central focus of global economies," says Bryan Rich, currency analyst at Weiss Research. "The intensity of this fight is going to increase. Do I think China does anything about it? I don't think so."

In the meantime, Rich says investors can take advantage of likely scenarios by investing in the yuan, which has little downside room left.

Winterizing Your Portfolio - A CNBC Special Report

One way to take advantage is through the WisdomTree Dreyfus Chinese Yuan exchange-traded fund that seeks to replicate money market moves in China and changes in the yuan against the dollar. The ETF is only about 18 months old and somewhat lightly traded but had reached about five times its average daily volume by mid-day Wednesday.

There will be some key incentives for the Chinese to begin backing their currency.

For one, the nation's economy has been on a tear, and tighter monetary policy could be a necessity to control inflation. The World Bank predicts Chinese gross domestic product to hit 8.7 percent in 2010, ahead of previous forecasts.

Also, the Fed is likely at some point to have to start raising its key lending rate, which in turn will boost the US dollar. The strengthening of the greenback would give China some breathing room to boost the yuan.

"If the Fed starts tightening that would make it easier for those guys to do it because then the dollar would be a little stronger," says Uri Landesman, head of global growth strategy for ING Investment Management in New York. "They may wait until the Fed tightens. The question is, when does the Fed tighten?

"I don't think there's any way on God's green earth that they're tightening while there is a 10 in front of the unemployment number."

Still, there will be tremendous pressure on China to make at least some move on its currency, both from within its own economic policy advisers and from the outside world, where international leaders are tired of seeing their exports usurped by the weak yuan.

"At some point the US dollar will rise organically on the back of more and more positive US economic news," Krosby says. "That's going to push the dollar higher as the currency markets believe the Fed will get closer to removing the (tightening) language. That will be the first step and an ultimate tightening will take place. We're not close to that."

As such, investors will have to hope that global diplomatic pressure does the trick.

"Throughout this terrible crisis the Chinese were able to grow their economy and keep it growing at a pretty rapid clip, so it's still very much a command economy," Swiss Re's Karl says. "I don't see (the yuan appreciating) until late next year. They're very keen on keeping their economy growing."