Decline of yuan-way bets triggers financial stability fears

Simon Watkins
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The longstanding one-way bet on USDCNY has been in disarray, but worse might be to come, as China looks to its FX regime to cope with credit issues, and likely defaults this year, threatening volatility in the structured-product market.

In the tightly managed FX regime that is China’s onshore and offshore currency market – CNY, and CNH and CNT, respectively – the near 1% depreciation in the CNY and the 600 pip fall in CNH against the US dollar in the past couple of weeks rank as virtually cataclysmic – and greater volatility could be on the cards, imperilling financial stability, say analysts.

After hitting an all-time low on January 14 – of USD/CNY spot at 6.0406, and fixing at 6.0930 – the CNY’s days as a unidirectional trade appear over for good, with the People’s Bank of China (PBoC) looking set on reverting to a two-sided volatility regime to mitigate the near-term pressure of capital inflows, says Haibin Zhu, head of Greater China economic research for JPMorgan, in Hong Kong.

"CNY appreciation, together with notable onshore-offshore interest-rate differentials, has led to large capital inflows, with banks’ [total] FX position [the CNY accumulated in FX transactions for the purposes of either lending on at high local rates or holding on for FX appreciation] having increased by Rmb2.78 trillion in 2013, compared to Rmb495 billion in 2012," he tells Euromoney.

"[The accumulation of CNY] adds another layer of complexity on the operation of domestic monetary policy."

With the PBoC having started to slow down credit growth in 2H13 to contain credit imbalances and to address financial stability concerns, the weight of these capital inflows, fuelled by the traditional one-way bet on renminbi appreciation, threaten such efforts, he adds.

Whatever the reason for the fundamental reason for the apparent shift in the CNY’s policy, the recent unflagged and unsuspected depreciation caught market players, leveraged and real money funds alike, off-guard. 

"For around two years, the yuan carry trade has been a mainstay of the everyday trading book for many, guaranteeing a reliable income when other carry trades could not," says Christopher Cruden, CEO of hedge fund Insch Capital Management, in Lugano. "And, in fact, a lot of players would have these tucked into the bottom drawer in sizeable amounts, content to let it roll, so they would have suffered."

Paul Robson, senior FX strategist for RBS, in London, adds: "Chinese onshore players have borrowed very large amounts of dollars – eg in HK – to bring back onshore and convert to CNY to then lend on at much higher local currency rates and/or to hold for FX appreciation. And offshore too – the short USD/CNH has been the biggest carry trade out there."

In fact, the yuan has gone from being the most attractive carry trade bet in emerging markets to the worst, with its Sharpe ratio turned negative this year as three-month implied volatility in the currency rose in February by the most since September 2011. The Sharpe ratio for the CNY went from plus 8.4 in the fourth quarter of 2013 to a low of minus 8.4 in February.

Meanwhile, the US dollar-funded carry trades in the yuan have lost 1.1% this year, compared with a gain of 5.6% in the Indonesian rupiah and a return of 2.1% in the Brazilian real.

"The level of complacency has run very high that soon USD/CNY and USD/CNH will be back to normal – ie falling – but any other scenario could see fragile market-nerves shredded," says Robson.

In fact, given concerns over China’s shadow banking systems and further defaults of certain trust products as credit growth slows, according to JPMorgan’s Zhu, this new two-way volatility regime is likely to persist.

"We do not expect that idiosyncratic defaults will evolve into a full-blown crisis," he adds. "However, in the near term they may cause shift in investor sentiment and cause tentative market turbulence."

This turbulence is likely to be especially dramatic – in the first wave – in structured FX products, particularly target redemption forwards (TRFs), before knocking on to other, plainer products, says Perry Kojodjojo, senior FX strategist for Deutsche Bank, in Hong Kong.

Also known as target profit forwards, TRFs make up the bulk of the structured products market, allowing the owner to sell USD/CNH at a strike price much higher than the prevailing spot price at the time, with 24-month tenors, and offering monthly settlement.

"The RMB complex has been thrown into complete disarray and, despite the fact that it was probably policy-engineered to curb speculative inflows, close the basis between USD/CNY post-the-fix and to create two-way FX volatility, it does not come without risks of a more disorderly move, and TRFs would likely be unwound in certain conditions, which could lead to more CNY weakness," adds Kojodjojo.

Indeed, using internal flow data and applying a conservative proxy on its own market share, Morgan Stanley estimates $350 billion of total notional outstanding of USD/CNH TRF products have been bought since the beginning of 2013.