The U.S. has pressured China for some time to allow its currency, the yuan, to appreciate. China, in our assessment, will not allow the yuan to appreciate at the request of U.S. policy makers, but rather when China deems it to be in its own national interest. Indeed, we believe this time has come.

Domestic demand

Much is said about encouraging domestic demand in China to achieve a less export dependent economy. The U.S. and China, however, have a different understanding of what stimulating domestic demand means; we propose a third strategy:

• It appears to us that U.S. policy makers would want the Chinese government to hand out credit cards to boost domestic demand. If the Chinese only spend more, they could buy more U.S. made goods. This has to be taken with a grain of salt; while the Chinese love American brands, most of them are made in China or elsewhere in Asia. Those items China would like to buy, say commodity producers or nuclear technology, the U.S. is far more reluctant to export. Further, the Chinese reject this approach because they don't want to promote a U.S. style, debt driven consumer boom.

• The Chinese, in contrast, like to build consumer spending the old-fashioned way. By raising the standard of living, consumers may be able to afford more and thus spend more. So far, so good. But to boost growth, China almost exclusively seems to focus on infrastructure building, along the lines of: if you build a highway prosperity will come. That approach has been very effective in executing a stimulus plan that actually works; however, we believe infrastructure spending alone is insufficient in fostering a more balanced economy.

• We believe China needs a Ronald Reagan. We are not entirely kidding: Ronald Reagan gave the U.S. a vision, unleashing a major entrepreneurial boom. China is a world leader in marketing (a nicer term than propaganda). Most Chinese believe their fate depends on exports to the U.S., though few Chinese know that more is exported to Europe than the U.S.

  In our assessment, China could easily unleash a major domestic boom by giving its citizens a vision of the future that encourages entrepreneurship. If the term entrepreneurship is unfitting to the Communist Party, let's call it a patriotic "invest in China" program. The point is that it does not take a debt driven boom to promote a domestically driven economic boom; there is sufficient untapped potential to drive domestic investment and ultimately demand.

A strong currency encourages domestic demand.

Inflation

China's inflation has reached a 16-month high. The government is struggling to cool what may be runaway loan growth, increasing wage pressures and property prices that are rising at an alarming pace. One of the ways to bet on a stronger yuan is to buy real estate; such "hot money," or speculative funds, would go away if the exchange rate reflected market forces.

If the yuan is not allowed to appreciate as a valve to contain inflation, the government has to restrict loan growth at banks and try to tame inflation using regulation. These tools are inefficient and, in our assessment, may ultimately fail to contain inflation.

It has become almost a ritual that loan growth explodes early each year, as borrowers fear the government may step in to restrict lending later in the year. It would be far more efficient to work with market forces, i.e. a stronger yuan, than to regulate economic growth. An economy driven by regulation encourages abuse. People will find ways around the rules, causing further distortions and, depending on the scale, they will turn to further regulations and even scandals. Allowing the yuan to appreciate and ultimately float would free up forces to focus on building competitive businesses.

Australia's central bank just issued a report on the importance of flexibility; the analysis credits the floating exchange rate - and it has been a volatile ride for the Australian dollar - to keep inflationary pressures low.

Value Chain argument

China may be concerned that an appreciating yuan could be too effective in slowing economic growth. After all, many businesses may only be staying alive because their exports are subsidized through an artificially cheap exchange rate. Also, China is concerned about Japan's experience of having a soaring yen cripple its economy. However, this fear must not be the only guide. China's economy has long embarked on a course to be ready for a stronger yuan. In particular, China's low-end industries have gradually moved to lower cost countries in Asia. It is the low-end, low-margin industries, such as the toy industry, that are most price sensitive. Indeed, we fear that countries like Vietnam or the Philippines may engage in competitive devaluation of their currencies should U.S. consumer spending not rebound as we fear.

China, however, is rapidly moving towards what we call the higher end of the value chain. Europe has long ago learned that it can't compete on price, but has to compete on value-added goods and services. Those in the U.S. calling for a weaker dollar should be reminded that it is unlikely we will export sneakers to Vietnam: it's simply not possible to depreciate yourself into prosperity.

In the spring of 2008, when import prices in the U.S. rose at a rate of over 20% year over year, it wasn't only commodity prices that soared: Chinese exporters raised their prices and there was little the U.S. could do about it. Although China and other exporters to the U.S. will always attempt to absorb a higher cost of doing business, such as what a stronger yuan would pose, there comes a point when that is no longer possible. Just as with the experience in the spring of 2008, we believe China has far more pricing power than it recognizes.

Further, a stronger yuan will promote further investment into value added goods and services.

Commodity prices

Needless to say, a stronger yuan would allow China to lower the cost of its imports, particularly commodities. While inflationary pressures may convince China to allow its currency to appreciate, it is access to commodities that will be China's primary concern over the coming decades. A stronger yuan is in China's interest to satisfy its appetite for resources.

China is ready

Ask any businessperson in Asia, and they likely love a fixed exchange rate as it is easier to run the business. Businesses have to get used to floating exchange rates. As a result, we don't expect the Chinese government to rush into a floating exchange rate; however, the sooner China begins on that path, the healthier it is for China's long-term growth.

Importantly, China has laid the foundation to allow for a stronger yuan. Its currency watchdog, China's State Administration of Foreign Exchange (SAFE), has been preparing China. Some of the more recent developments include the use of the yuan in international agreements; also, yuan denominated debt is being issued in Hong Kong.

In our assessment, China currently has an opportunity to move to a stronger yuan out of a position of strength. If China does not move, who knows in what position China will be when the next financial crisis hits.

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Axel Merk's book, Sustainable Wealth: Achieve Financial Security in a Volatile World of Debt and Consumption is available now.

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Role of the U.S.

Policy makers in the U.S. should focus on communicating the benefits of a strong currency to China. The U.S. would be more credible in such a debate, if it pursued a strong dollar policy itself. These days, to qualify for the position of U.S. Treasury Secretary, a key credential is to be able to keep a straight face while uttering the words, "a strong U.S. dollar is in the interest of the United States." It would be helpful if more effort were spent encouraging Congress and the Federal Reserve (Fed) to pursue policies to support a strong dollar.

We have a stake in this debate as we manage the Merk Asian Currency Fund, a mutual fund that invests in a basket of currencies, including the Chinese yuan. To be informed as we discuss other currencies, from the Swiss franc to the yen to the Australian dollar, subscribe to our newsletter at www.merkfunds.com/newsletter. We also manage the Merk Absolute Return Currency Fund and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com.