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.
“Should data continue to weaken [such as the latest – the February PMI, which came in at 50.2, against January’s 50.5, so barely above the economic expansion level of 50] and credit issues worsen publically – such as sizeable defaults – then USD/CNH upside momentum could continue,” says Geoffrey Kendrick, head of Asia FX and rates strategy for Morgan Stanley, in Hong Kong.
“Specifically, if we start to breach 6.1500 in USD/CNH, then Chinese investors involved in structured products – which can potentially be worth up to hundreds of billions of USD – will begin to lose money and, as such, CNH weakness through 6.15 and above can potentially beget further weakness should barrier levels hit.”
The reasons for this are twofold. First, and most obviously, a weaker CNH relative to USD will prompt many small and medium-sized enterprises – which own these products – to begin losing money, increasing credit risk. Such a development might then spur offshore selling from speculative investors.
And, second, should investors close out of their structured products once they become loss-making, this might also exacerbate USD/CNH upside as dealers need to adjust hedge positions as a result.
“Dealers have needed to sell USD/CNH spot and USD/CNH vol in order to hedge their underlying Greek exposure as USD/CNH moved higher last week, which explains why back-end USD/CNH implied vol has remained so well contained, despite the realized volatility witnessed over the past week,” concludes Kendrick.
Although he expects the market to stabilize into the remainder of this month, as the National People’s Congress meeting kicks off on Thursday for two weeks, he says there is a reasonable chance that risk surfaces again in the second quarter of this year, given that potentially more than CNY500 billion of trust products will mature in the quarter.
“Given that policymakers view defaults as a positive step in the reform plan to correct capital misallocation in the system, there is higher chance for official default to happen from 2Q,” says Kendrick.
Looking at how the ripples of these scenarios might break out into the broader regional market, the Asia ex-Japan currencies most affected by the mini-contagion in China were the SGD, KRW and TWD.
The Philippine peso also shows high correlation with the CNY as, although the export link to China is small, the PHP is impacted by the broader risk appetite in Asia.