Silver Rock, the private equity (PE) firm that I represent in China, generates investment capital in US dollars, but our portfolio companies earn renminbi. Many of them will ultimately be publicly traded in the US. When we sell our shares, the value of a particular company is often determined as a multiple of its net profit, which must of course be calculated by converting renminbi to US dollars.
This is just one of the ways that, for better or worse, our return on investment is affected by changes in relative value between the two currencies. So my morning routine includes a glance at the current US dollar-renminbi exchange rate.
It is a routine that had, until recently, become boringly predictable. Responding to the global financial crisis and the body blow it dealt exporters, China pegged its currency at 6.83 to the dollar in July 2008, ending three years of slow appreciation. The view of Western policy makers was unchanged, however: Protectionist China was guilty of currency manipulation.
The first indication of movement came earlier this year when the central bank acknowledged the peg as a temporary remedy for the first time since its implementation. Experts told us the government was waiting on three developments before removing the peg: the return of solid domestic economic growth, a revival in exports, and stability in the US and Europe. Steps one and two were reached with relative ease, but the crisis in Greece appeared to push Beijing back toward intransigence.
But by the time you read this, it is likely the renminbi will have resumed its gradual rise following a central bank statement on June 19 that it would "increase … exchange rate flexibility."
The statement referred to the recovery in the domestic economy as well as a gradual improvement in the global economy. Unsurprisingly, there was no mention of the groundswell of international pressure for appreciation: The announcement came shortly before a G20 summit at which China’s currency was expected to be a major topic of discussion.
When, not if
Beijing won’t countenance being pushed around by foreign politicians, but it recognizes that appreciation is in the long-term interests of all parties. It was always a question of when, not if, my mornings were once again graced with some variety.
And of course I am concerned with the impact of a rising renminbi on Silver Rock’s existing portfolio, and our future returns. The good news is that any previous investments made by offshore funds investing US dollars into Chinese companies will see a parallel rise in the value of their holdings. Put simply, all things being equal, the investment will generate a return simply by selling a renminbi-based asset after the currency has appreciated. This logic has been sufficiently compelling to drive waves of "hot money" into China, which is sunk into assets such as property with a view to making a sharp – and profitable – exit once the renminbi rises.
But that may be where the good news stops. As the dollar shrinks relative to the renminbi, all future investments are going to become increasingly expensive. Our investment dollars, in other words, are going to buy smaller and smaller slices once they are converted into local currency. This is strong motivation for foreign investors to explore the emerging opportunities to set up a renminbi-based fund whereby not only is the process of investing in a domestic Chinese company less encumbered, but the fund is held in an appreciating currency as it is deployed.
Emerging local powers
For the same reasons, on a macroeconomic level, the renminbi’s rise is likely to help boost China’s domestic private equity (PE) industry, both at home and abroad. Local funds, whose capital originates in renminbi, will gain an increasing advantage with more purchasing power when competing against foreign funds for domestic deals. This will further shift momentum toward local players in an area that has for years been foreign-dominated.
It may also boost the standing of Chinese investment funds – both private and government-owned – abroad.
For example, the impending appreciation of the renminbi is pushing some of China’s largest state-owned enterprises (SOE) on a spending spree. With an astounding US$2.4 trillion in foreign exchange reserves, Beijing has a strong motivation to shed dollars before they depreciate without drawing too much attention to the fact. One means of doing this is to sanction SOEs to invest in foreign assets, especially those that China needs most, and those which will be most likely to appreciate.
Coal is a case in point. Coal-burning power stations supply 70% of China’s electricity and the country is widely expected to overtake Japan as the world’s largest coal buyer. Imports of the commodity jumped 212% to 125.8 million tons in 2009 and came in at 50 million tons for the first four months of 2010.
In response, several of China’s largest coal producers have been looking to buy coal reserves abroad. These deals will likely be financed from cash on the balance sheet of the SOEs involved as well as from state-backed investment funds, enabling the government to spend dollars on a commodity that will almost certainly appreciate.
That said, any exuberant rush to buy renminbi should be tempered by the fact that the currency will, as the central bank put it on June 19, continue "to use the already-announced exchange rate floating band." Appreciation could be as little as 0.2% a month according to one estimate.
My morning routine has just become slightly more interesting – but it may be some time before I start spilling coffee.