Adjusted for volatility, China now offers the highest FX carry in the world, and according to Deutsche Bank, returns on the renminbi carry trade are now reaching extreme levels that could signal a potential crash.
Indeed, the performance of the renminbi carry trade is now reaching levels seen before unwinds of leading carry trades in the past: AUDJPY before the collapse of Lehman Brothers and USDJPY in 1998. On both occasions, steady returns during a sustained period were wiped out as a wave of deleveraging prompted violent drawdowns in the strategy.
Bilal Hafeez, global head of FX strategy at Deutsche, says many would not think of the renminbi as a carry currency, but rather a heavily managed policy tool.
Yet, he says, with the development of the offshore deliverable renminbi market in Hong Kong (CNH), liberalization of the capital account and offshore trade settlement in renminbi, there is much greater scope for foreign investors and domestic Chinese institutions to treat USDCNY like any other currency.
“More importantly, since the end of 2011, the rate differential of the renminbi versus the dollar – the carry – has flipped to positive,” says Hafeez. “So by selling dollars and buying yuan, one can gain not only from expected appreciation but also earn carry.”
As Hafeez points out, although the size of the carry is not the highest in the world, volatility in USDCNY is very low, meaning the renminbi delivers the highest volatility-adjusted carry in the world.
|Renminbi boasts highest volatility-adjusted carry globally|
Perhaps unsurprisingly, there has been a surge in flows into the renminbi by onshore and offshore institutions.
For onshore institutions, this requires “extra manoeuvring”, according to Hafeez, given that China does not have a fully open capital account, and has segmented interest rate markets.
The most popular approach recently has been for companies to disguise the USDCNY carry trade by over-invoicing exports. The scale of the activity can be seen in the gap between Chinese exports to Hong Kong and Hong Kong imports to China, which has surged since carry turned positive.
|Overinvoicing surges as carry turns positive|
Offshore investors have a simpler way of exploiting the carry, by selling USDCNH.
Fuel for the USDCNY carry trade has been provided by the Federal Reserve’s massive quantitative easing programme, which has not just kept US rates low but resulted in a surge of global liquidity that has found its way to China.
Also feeding the renminbi carry trade has been the relentless decline in the USDCNY fix from the People’s Bank of China. This has continued to fall in 2013, even as the dollar has appreciated against other emerging market currencies.
|Renminbi carry trade reaches yen carry trade extremes|
However, Hafeez says the challenge for the renminbi carry trade is that, when adjusted for volatility, returns are reaching those seen in AUDJPY in the 2002 to 2008 period, and have surpassed those seen in USDJPY between 1995 and 1998.
“In both cases, the carry trade started to unwind violently,” he says. “The triggers for an unwind could come from each aspect of the carry trade.”
With US rates going up, and liquidity being withdrawn, that could pressure those borrowing in dollars, for example. Alternatively, a widening of the trading USDCNY trading band by the Chinese authorities could increase currency volatility and force deleveraging. More fundamentally, a broader dollar uptrend could assert itself, which breaks the downtrend in USDCNY.
The bottom line, says Hafeez, is that a new carry trade is in play.
“Most believe it is low risk thanks to the ability of China to manage its cross-border flows and its currency, but history suggests caution is warranted,” he says.
“USDCNH is perhaps most vulnerable to a rally, but more ominously the demise of the carry trade could end an important source of cheap credit for China.”
Given the recent turmoil on the world’s financial markets, and the FX price action in 1998 and 2008, this bubble would appear to be worth watching.