How The Chinese Yuan ETF (CYB) Could Drive TIP

by on June 8, 2010 | ETFs Mentioned:

Following massive injections of liquidity into the global financial system in recent years, the number of investors concerned about the ravages of inflation on asset values has surged. Although recent CPI readings have been tame–deflation is more of an immediate concern–expectations for an uptick in inflation have hardly been alleviated (see Beyond TIP: Ten ETFs To Protect Against Inflation).

The significant increase in the global money supply over the last two years may be the most obvious argument for a surge in inflation, but many investors are becoming increasingly concerned over the ramifications of another macroeconomic trend on their portfolios. The biggest driver of U.S. inflation in coming years may not be the result of the Fed’s rate decisions, but of changing dynamics in factories halfway around the world. “The cost of doing business in China is going up,” writes David Barboza. “Coastal factories are raising salaries, local governments are hiking minimum wage standards and if China allows its currency, the renminbi, to appreciate against the U.S. dollar later this year, as many economists are predicting, the cost of manufacturing in China will almost certainly rise.”

There are signs that the days of low cost-manufacturing in China–a boon to companies around the world in recent decades–may be numbered. Anecdotal evidence of extreme wage increases are abundant, and the Beijing municipal government recently announced that it would hike its monthly minimum wage by about $140 per month. With an astounding number of global companies now maintaining some form of operations in China, ot doesn’t take long for salary increases to ripple throughout the global economy, ultimately resulting in higher costs for everything from children’s toys to iPhones.

Barboza notes that there are a number of explanations for the sudden upward momentum in salaries. Inflation in China has eroded purchasing power for local workers, who have watched prices of food and real estate skyrocket. But analysts also note that the Chinese government has supported wage increases “as a way to spur domestic consumption and make the country less dependent on low-priced exports,” as well as erasing some of the widening wealth gap in the country.

Yuan Difference

The strength of the Chinese currency has been a hot issue in recent months, with global leaders mounting a campaign to convince Beijing to let the yuan, which is essentially pegged to the U.S. dollar, fluctuate. Those efforts, including some not-so-subtle hints from Treasury Secretary Geithner, appear to be making progress. A floating yuan would make Chinese goods more expensive overseas, partially offsetting the competitive advantages held over other economies. But such a move could also increase the cost of goods manufactured in China, placing further upward pressure on global prices.

Interest in the Chinese currency is perhaps best evidenced by the WisdomTree Dreyfus Chinese Yuan Fund (CYB). At the end of May, assets stood at nearly $770 million, up from just over $100 million 12 months earlier (see all Chinese yuan ETFs).

So what’s the link between the popular Chinese yuan ETF and the Barclays TIPS Bond Fund (TIP)? If the Chinese currency is allowed to float–or, more likely, appreciate in a controlled manner–the repercussions would be felt throughout the global economy. It’s not tough to make the case for a surge in inflation as it is. If the yuan begins to strengthen, the “inflation bugs” will no doubt multiply, and TIP, along with other ETFs designed to perform well in inflationary environments, could see a surge in interest.

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Disclosure: No positions at time of writing.