Today's comment is by Jack Crooks, our Currency Director and Editor of Crooks Currency Options and Crooks on Currencies.

Dear A-Letter Reader,
 
I recently had chat with a friend of mine just back from a trip to China. My friend is a currency trader for a hedge fund based out of New York. He spent some time talking and haggling with the street vendors in China -- looking for deals of course.

In the process, he learned something surprising: Almost every vendor he haggled with wanted to be paid in U.S. dollars instead of their own currency -- the yuan. Isn't that a bit odd because everybody knows the Chinese yuan is going higher against the dollar? Hmmm! It makes me question whether the black market in China knows something the rest of the world's currency traders don't.

My currency trader friend also told me that the Chinese vendors wanted 10 yuan for items priced at a single U.S. dollar. Just for the record: That's about a 25% premium above the official rate. So the rate on the street, to exchange dollars for yuan is substantially higher than the official exchange rate. Apparently local citizens don't value their currency as highly as their own government does. 

We already know the Chinese are happy to let the money come into the country. There are many "billions and billions," to steal a phrase from the late great Carl Sagan, which have poured into China. This massive wave of assets is arriving just in time for the 2008 Olympics in Beijing. Not to mention, this wave of investment capital puts China in the perfect position for a slam-dunk revaluation of the currency.

But when a particular region is sailing along with that kind of capital, you always have to be mindful of hidden risks. Anything could happen. China could have a little stock market crash that needs to be cleaned up. Investors could ditch the Chinese markets as soon as the Olympics end, if they decide the risk is too great. International investors could decide to bolt back out of the country just as fast as they came in.

Maybe these are some reasons why the Chinese government won't let the average citizen invest money offshore. (They have to go through a qualified intermediary -- like an insurance company or bank.) Just think of the implications if hundreds of millions of loyal Chinese serfs started draining local bank accounts to send yuan to distant lands. Suddenly they could exchange their yuan for dollars and euro and pounds -- oh my! 

If such a scenario was played out it would lead to a massive disruption to the Chinese economy, as massive amounts of domestic cash would flow out of the country -- it's called "flight capital."

Although the People's Bank moved recently to loosen their draconian currency controls on citizens -- China is still a LONG WAY from having a truly open financial system. Signs of this are clearly evident in the two-tiered stock market in China. As my colleague Mike Burnick recently described foreigners investing in China trade by one set of rules, while domestic investors face different restrictions.

But for now at least, "disruption" is not a word your average Chinese communist block captain uses in his everyday language. This seemingly risk-free existence must continue or hundreds of millions of migrant workers, and another billion or so in the countryside eking out a meager existence, might expect more given the taste of "freedom." 

I know it sounds odd to suggest the yuan is "overvalued." But when it comes to real-life economics, I'd take a street vendor's opinion any day over the average economist sitting in his air-conditioned office at the International Monetary Fund. I'm using my friend's firsthand experience as a warning to keep my eyes glued to Chinese policy for any sign that these vendors might indeed know more than your average currency trader. 

JACK CROOKS, Currency Director

P.S. You never know where your next burst of insight will come from to help you navigate the currency markets. I watch dozens of complex indicators every single day, from the latest economic data, to incremental changes in interest rates around the world. But sometimes, the best indicators come by word of mouth -- like my currency trader friend's experience in China.

That's why I spend a good portion of my time in my service, Crooks on Currencies , educating you about what happens in the currency markets and why. I also explain how to make long-term currency investments in exchange traded funds (ETFs). I tell you when to buy, sell and hold so all you have to do is sit back and enjoy the gains. Click here to read more about my service.