So says Morgan Stanley, which believes the prospect of financial deleveraging in China increases the risk of a hard landing.
The bank says the new Chinese government’s policy drive to deleverage the banking sector has become more apparent, and that deleveraging will continue to unfold in the next six to 12 months.
In what Morgan Stanley calls its “super-bear scenario”, it estimates that aggressive policy tightening will reduce Chinese GDP growth to an annual rate of 5.5% in the second half of this year.
“In this scenario, policymakers are also slow to respond to this deceleration, leading to more turmoil in the financial sector,” the bank says.
“Although a low probability event, this would have major implications for global markets. On our estimates, markets are pricing in a one-in-10 chance of a super-bear scenario in China in the coming 12 months, more in equities, less in FX markets.”
For hedges to be worth paying for a low probability event, they naturally have to be cheap.
Indeed, there have been some sharp moves in markets that are sensitive to Chinese economic performance, such as local equities and AUDUSD, since May when worries over the country intensified.
“Not only are most markets down year to date, they have also witnessed a rise in volatility and skew since May,” says Morgan Stanley.
“This means the cost of hedges in general is now higher than they were at the beginning of the year.”
However, the variation in performance means some hedges are more attractive than others. As the chart below shows, it is USDCNY and USDTWD that are the most cost-effective at the moment, making renminbi puts and Taiwan dollar puts the most attractive hedges against a Chinese hard landing across asset classes.
|The most efficient China 'super-bear' hedges|
|Source: Morgan Stanley|
Of course, there are caveats to expecting the renminbi to weaken. That is because, as a managed currency, it implies that the Chinese authorities will at least operate a policy of benign neglect with respect to their currency, if not an outright bias towards a weaker renminbi.
However, Helen Qiao, strategist at Morgan Stanley, believes moderate renminbi depreciation will be allowed in the event of a Chinese “super-bear” scenario.
In such an event, monetary tightening will prompt a deceleration in growth, which is likely to trigger increased outflows in the second half of 2013.
Qiao notes that in the past Chinese policymakers would have resisted any exchange rate depreciation for fear of inducing further liquidity outflow.
“However, some moderate exchange rate depreciation may be allowed when domestic demand weakens significantly on the back of a rapid deleveraging, as the market has been allowed to play a more important role in the exchange rate mechanism,” she says.
However, Qiao believes the pace of renminbi depreciation will be kept under control – not least since even though downward pressure on the currency might become more apparent on the back of weak domestic demand and capital outflows, renminbi weakness will cause political tension with China’s trading partners.
“In our super bear scenario, when China has a hard landing, the global growth outlook will likely become gloomy, which induces protectionist pressure against any further renminbi depreciation,” says Qiao.
“The renminbi will likely weaken against the dollar to Rmb6.40 at the end of 2013 and Rmb7.00 at the end of 2014 at a gradual pace.”
Still with USDCNY stubbornly sitting at record lows around Rmb6.13, despite increased worries over China’s economy, those looking to insure against a crash in the country could find value in the FX market.