Recently, there has been a lot of news and evidence supporting the likelihood of the Chinese authorities allowing the Chinese currency, the yuan or renminbi (CNY), to trade within a wider trading band.

Why?

China is unlikely to allow its currency to appreciate because of external pressures, such as U.S. political pressure; we believe China will move when Chinese policy makers deem it in their national interest. While this is not a certainty, we anticipate that inflationary pressures will force the Chinese authorities' hand. In our opinion, currency appreciation would be a more effective tool to help manage domestic inflationary pressures, as opposed to the relatively draconian bank regulations presently in place. Indeed, the Chinese have recently conducted studies on the likely impact a stronger CNY would have on the domestic economy.

Implications for the Chinese yuan

Presently, the Chinese maintain a managed currency regime, whereby they purchase U.S. dollars (USD) in the open market to "peg" the value of the CNY to the USD. Should they allow the value of the CNY to trade within a wider band, they would likely buy less USD. As this would reduce the overall demand for USD, simple supply and demand dynamics infer that the net result may be a lower USD relative to the CNY. Said another way, the CNY may appreciate relative to the USD.

What is the appropriate exchange rate for the Chinese yuan?

Ultimately, the only appropriate rate is the one set by free markets. A floating exchange rate is a healthy valve that, amongst others, reduces inflationary pressures. We doubt Chinese policy makers will move to a free floating exchange rate in the short-term, but moving towards a wider trading band is an encouraging step in that direction.

One only needs to look to the Japanese yen (JPY) as an example of the appreciation potential for the CNY. After Japan allowed its currency to float freely, the JPY experienced significant strength, despite weak economic growth. Given a backdrop of significant Chinese economic growth, we consider there may be attractive upside potential if and when the Chinese allow the CNY to float freely.

Implications for Asian currencies and Australasia

We believe currencies of nations exporting to China will benefit. On a net basis, with a stronger CNY, imports into China become cheaper; Chinese businesses and the Chinese government will be able to afford to purchase more foreign goods with a stronger currency, likely increasing Chinese demand for these foreign goods. Our analysis suggests the likely beneficiaries are those countries whose Chinese exports make up a substantial proportion of the exporting country's overall GDP, as well as those nations who are experiencing solid, sustainable growth in exports to China. As such, currencies we believe well placed to benefit from a widening of the CNY trading band include the currencies of: Australia, New Zealand, Taiwan, Malaysia, South Korea, Singapore, and Japan.

Furthermore, we believe that Asian countries producing goods and services at the mid to high-end of the value chain are better positioned than those countries producing low-end goods and services. Higher-end producers have greater pricing power, whereas low-end producers compete predominantly on price; in our assessment, low-end producers are more likely to instigate competitive devaluations of their currencies. China, in our analysis, has long allowed its low-end industries to fail and migrate to other lower-cost producers within Asia. As a result, we believe Chinese exporters may have pricing power should their currency appreciate.

Implications for Commodities

We believe Chinese demand for commodities will continue to rise over time, even if occasional economic slowdowns might come in between (despite the recent global economic crisis, China's demand for iron ore continued to grow at double digit annualized rates). If the Chinese allow the CNY to appreciate, commodity prices will become cheaper when denominated in CNY, all else equal, giving China greater purchasing power; the Chinese will be able to afford to purchase more commodities with a stronger currency, likely increasing the demand for commodities.

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As China's purchasing power increases, we believe it is quite likely that commodity prices will rise unless there is a sharp slowdown in Chinese economic activity. In our assessment, Chinese policy makers may err on the side of caution with respect to minimizing the anticipated economic implications of a stronger CNY. To maintain control, the ruling Communist Party of China is incentivized to sustain social stability. Social stability, in our opinion, is largely influenced by a healthy economy. As such, we would not be surprised to see expansionary policies to counter any anticipated potential economic slowdown. Moreover, the Chinese actually have the ability to afford any such policies, should they deem them necessary.

Implications for the U.S. Economy

While commodity prices may be cheaper when denominated in a stronger CNY, the same commodity price may rise when priced in U.S. dollars (USD). Officials at the Federal Reserve (Fed) seem not to be particularly concerned about commodity price inflation, arguing that the U.S. economy is far less dependent on commodity prices these days than in decades past. However, in our humble opinion, commodity prices can have significant implications for the U.S. economy.

When faced with a stronger CNY, Chinese exporters have a choice of either lowering the price of their exports (sell their goods and services at the same U.S. dollar level), or alternatively, they can try to pass on what is effectively a higher cost of doing business in the global markets.

Fed Chairman Bernanke has indicated in the past that Asian exporters are likely to absorb the higher cost of doing business and that a weaker U.S. dollar is not inflationary. We beg to differ and point to the dramatic rise in import costs in the spring of 2008. At the time, it was not just oil reaching over $140 a barrel, but the cost of many imports from Asia also soared. At some point, Asian exporters may no longer be able to absorb the higher cost of doing business; at that point, they either disappear from the market (fail) or raise prices. As shown in the spring of 2008, Asian exporters have substantial pricing power. China, because of its positioning at the higher end of the value chain within Asia is particularly well positioned. From a U.S. economic standpoint, we expect inflationary pressures to rise should the CNY strengthen.

We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. This analysis is a preview of our annual letter to investors; to learn more about the Funds, please visit www.merkfunds.com.