Talking Point

End of the one-way bet?

Speculators caught off guard as renminbi rapidly depreciates

CHINA-ECONOMY/PBOC

Zhou Xiaochuan: the central bank governor has made the market aware, the renminbi goes down as well as up

“If you have a bazooka in your pocket and people know it, you probably won’t have to use it,” Hank Paulson explained six years ago, as he asked Congress for the ‘right’ to use taxpayer funds to bail out Fannie Mae and Freddie Mac.

Paulson hoped that the pledge alone would be sufficient to calm financial markets. But his bazooka bombast failed and it was only a matter of time before he had to launch Washington’s largest-ever financial rescue.

Late last month China policymakers started to fire up their own financial artillery, in their case allowing the renminbi to lose value dramatically against other currencies in the foreign exchange markets.

Even as the shrapnel flew around the forex markets, leading finance officials in Beijing queued up to tell the world that there was little to be concerned about.

Zhou Xiaochuan, the governor of the People’s Bank of China, was still doing it on Wednesday this week, assuring media on the sidelines of the National People’s Congress in Beijing that the yuan’s decline was perfectly normal.

Lou Jiwei, China’s finance minister, was one of the first to offer the same view, expressing his confidence in the renminbi at the end of February.

“There will be ups and downs,” Lou admitted, before insisting that the currency’s movement was still “within normal range”.

A few days later the State Administration of Foreign Exchange (SAFE) did its best to sound nonplussed too. “The movement in the renminbi is due to an adjustment of trading strategy by main market participants,” its spokesman suggested. “The yuan fluctuations are normal compared to volatility in developed and emerging market currencies. Don’t read too much into them.”

A common theme here is the use of the word ‘normal’.

But that hasn’t stopped plenty of people wondering what has been happening to the Chinese currency and whether it has more significant implications.

What’s been going on?

The yuan has been on the slide…

China’s currency trades on two different rates: one of them onshore (with the identifier CNY) and the other outside China (the CNH) in places like Singapore, London and Hong Kong.

Exchange rates differ between the two because the yuan floats freely offshore but moves within a trading band under Beijing’s control inside China. The demand dynamics onshore and offshore are different too, although the offshore rate does take its broader cue from onshore benchmarks.

But since peaking in mid-January the yuan has lost more than 1.5% of its value against the dollar in both markets, following a flurry of falls over a number of consecutive days.

That may not sound like much of a decline in percentage terms. But the turnabout follows long periods in which the renminbi has climbed against the dollar (gaining about 35% in total against the greenback since 2005).

Since last month the trend started to reverse. In fact, we’ve just witnessed the largest monthly loss for the yuan since exchange rate reforms were introduced nine years ago and the largest daily loss (0.86% last Friday) since at least 2007.

Some of the daily declines have also come close to hitting the 1% trading limit at times, which by the currency’s usual standards is turbulent stuff. Further, in the space of a few days, the renminbi has given up half of its gains against the dollar over the entirety of last year – another reason why the downwards momentum has sent shivers through the foreign exchange markets.

What’s to blame for the slump?

One interpretation is that investors are losing faith in the renminbi as economic conditions worsen. Certainly, China’s purchasing and manufacturing indices have been showing signs of weakness and there’s evidence that property prices are falling in a number of cities too. Although the trade figures look more solid, a lot of analysts doubt they offer a true reflection. Instead, the suspicion is that the real value of exports is being exaggerated because companies are over-invoicing to bring cash back into the country surreptitiously.

Another concern is a wave of bank loan defaults or the wider implosion of the shadow banking system. But if fears about financial meltdown were really driving the yuan lower, we should be seeing interbank lending rates moving sharply higher too. That hasn’t been the case. Rates haven’t been spiking as they did on various occasions last year.

So could it be a ploy to help exports?

An alternative theory is that Beijing is weakening its currency for tactical reasons. In the past it has tended to put the brakes on the yuan during periods of weaker growth and it may now be responding to concerns about the impact of a stronger renminbi on exports.

Although it’s hard to see why low-digit declines against the US dollar would be much help for Chinese traders, the story is slightly different for emerging market currencies, many of which have been selling off in the same time period that China’s has been gaining value.

Data from the Hong Kong Monetary Authority suggests that the yuan rose 13% in the year to January against currencies from its main trading rivals, The Economist pointed out this week. It then surged another 2.6% in January alone.

The Wall Street Journal agrees that help for exporters might be encouraging a weaker yuan policy, especially as higher levels of debt are making Beijing reluctant to use more credit stimulus to keep the economy moving. Instead a falling currency could assist China’s manufacturers in selling more overseas and boosting growth.

But the majority of economists haven’t been trumpeting exports as the reason for the yuan’s decline. Choosing to devalue in this way would also mean backtracking on other goals: i.e. reducing China’s reliance on export-driven growth and focusing more on stimulating domestic consumption.

In fact, high-ranking officials are denying that economic malaise is influencing the renminbi’s slump. “The fundamentals of China’s economic growth are good, “ Yi Gang, deputy governor at the central bank, told reporters on Monday, as he joined the queue of senior officials keen to reassure the markets. “Please do not worry. The fluctuation in the yuan is normal.”

Why is the currency falling?

So what does Yi mean by “normal”? The most common explanation for the yuan’s recent declines is that Beijing wants to teach the markets that they can’t expect a one-way bet on an appreciating currency.

In particular, the authorities want to target speculative ‘hot money’ that has been arriving in the domestic economy in hope of benefiting from a combination of higher interest rates and foreign exchange gains.

By introducing more volatility into the market – the lesson that the yuan can go down, as well as up – the authorities may also be laying the ground for further changes in the exchange rate rules too, including widening the band for currency trading.

“We maintain that the renminbi’s weakness isn’t a policy move to help support growth, but believe there is a policy willingness to curb speculative inflows before introducing foreign exchange reform,” Paul Mackel, head of Asian foreign exchange research at HSBC, explained last week.

The central bank flagged similar goals at a two-day meeting in February, when Hu Xiaolian, another deputy governor at the central bank, called for greater efforts to reduce risks from “hot money” inflows, says China Securities Journal.

In the days immediately following that meeting, the central bank intervened in the currency markets, directing state banks to buy more dollars as it guided the benchmark forex rate lower.

It achieved its goal: any sense of complacency from speculators that the renminbi trade was a one-way bet was shaken.

“For 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,” Christopher Cruden, CEO of Insch Capital Management, told Euromoney this week. “In fact, a lot of players would have these tucked into the bottom drawer in sizeable amounts, content to let it roll.”

The financial benefits of the trade were obvious, says CBN, a Chinese business newspaper. A one-year deposit at a Chinese bank was delivering an interest rate of about 3.25%. Factor in another year of currency appreciation at 3% and a consolidated return of 6.25% was on offer, minus the initial cost of borrowing in the foreign currency.

One of the most profitable carry-trades (for interest rate differentials and forex gains) has been with the Japanese yen, Henny Sender writes in the Financial Times this week. It became especially lucrative after Abe Shinzo pushed down the value of the Japanese currency. The strategy was straightforward: borrow yen, leverage up by a factor of five and invest the proceeds in renminbi. With so little volatility, the risk-adjusted returns have been even greater, Sender says.

Profits can be even higher if the capital is ploughed into sectors like shadow banking, where James Kynge, also writing for the FT, says that hot money has been thwarting Beijing’s efforts to clamp down on informal lending.

For example, loans from trust companies in January stood at twice the levels of a year earlier (see WiC223 for our most recent coverage of trust firms).

“It is easy to borrow abroad at around 1% annual interest and then change that money into renminbi and bring it onto the mainland,” a banker from Ningbo explained. “You can get around 10-12% by lending it to a trust or around 20% by putting it with an underground bank. On top of that you get whatever the renminbi has appreciated by the time you need to repay the foreign loan.”

That makes it possible that another objective of the current campaign was to drive down the yuan so as to stymie hot money flows into the financial sector.

But why force the issue now?

One suggestion – already noted – is that the leadership is set to announce further reforms to exchange rate policy at the National People’s Congress, which began its meetings in Beijing this week. The central bank has already indicated plans to widen the band in which the yuan trades against other currencies, perhaps doubling it to 2%. This supports the broader effort to internationalise the renminbi but would also allow the Chinese to argue that the nation’s currency policy is moving in a more market-driven direction. That might be useful in advance of President Obama’s visit in April and could influence the tone of the US Treasury’s upcoming report on China’s foreign exchange regime.

What’s the likely impact?

There’ll be some short-term pain for the speculators, especially the hedge funds and wealthy individuals at private banks offshore who have bought structured products anticipating further strengthening of the yuan.

One of the most popular bets is the ‘target redemption forward’ which pays out every month if the currency keeps rising but starts to incur losses if it dips below specific levels. Estimates in the media are that $350 billion worth of these contracts have been sold since the beginning of last year.

“It was like free money,” Greg Matwejev, a sales director at Newedge Group in Hong Kong told the Wall Street Journal. Now many funds have been forced into selling. “There is still a lot more pain before this trade shows signs of stabilising,” Matwejev warned. “Very few funds are contrarian on this trade, and all are seeing red at the moment.”

Chinese investors won’t escape either. Reuters has reported that many buyers of the leveraged bets on yuan appreciation are Chinese firms with large dollar receivables, who saw the trade as an opportunity to boost their bottom lines.

Will it work?

Waging war on the speculators might also have been designed to address at least one obvious concern about loosening the trading band further: that China could end up with the yuan rising faster as investors bet on further appreciation. That in turn might spur more hot money inflows. By injecting a bit of volatility into the currency’s trading history, the central bank wants traders to be warier about assuming the yuan’s direction is inevitably upwards.

Policymakers will be cautious about how they proceed. When they last widened the band in April 2012, they hoped for signs of greater fluctuations in exchange rates. But it didn’t happen. Volatility fell and the currency continued to strengthen.

But longer-term, HSBC’s Mackel thinks that changes to the reference rate might need to be bolder if the speculators are going to be kept at bay. In November he argued that there was a case for the trading band to be abandoned completely, although he accepted that it was unlikely to happen. At the very least, the authorities need to allow the fix to move more freely and the spot rate to deviate further from the fix, he says.

Opening the capital account wider would also be helpful in encouraging more foreign exchange outflows. The Qualified Domestic Institutional Investor scheme launched in 2008 was supposed to allow financial institutions to buy international assets, with about $80 billion allocated as investment quota. But it has suffered from weak demand after QDII products plunged during the global financial crisis, damaging its reputation among Chinese investors.

There was talk last year of a second version of the scheme for individuals (to be piloted out of Shenzhen and Guangzhou) although it seems to be waiting for final approvals from the State Council.

In the meantime, what do China’s economic fundamentals suggest about the yuan’s prospects? All eyes were focused this week on Premier Li Keqiang statement to the National People’s Congress. He announced that the growth goal for 2014 is 7.5% – less than the 7.7% the economy grew last year. The lower number spooks some.

But there are two caveats. First, last year’s growth goal was also 7.5% and it was exceeded. Second, as China’s economy gets larger, even a declining rate of growth still produces larger absolute gains in GDP. For example, back in 2003 when double-digit growth was still the norm, the addition to GDP that year was Rmb1.55 trillion, according to data from the National Bureau of Statistics. But last year the economy added Rmb4.94 trillion (growing to Rmb58.66 trillion in size). That’s a huge gain in economic activity and above the 10-year average, which works out at Rmb4.33 trillion. Pundits talked incessantly about China ‘slowing’ last year, but in absolute terms the economy performed above the average for the prior decade.

Besides, even if China comes in below target this year, growth is still likely to be the strongest of the large economies by some margin. And if the economy continues to run solid current account surpluses and pull in more foreign capital than it invests overseas, the yuan looks unlikely to weaken much.

So despite the recent downturn most forex strategists are forecasting a stable exchange rate for the yuan, with many expecting it to make further gains. Indeed, the yuan recovered some of its lost ground in the final days of this week. Medium term, HSBC thinks the renminbi will strengthen to 5.98 against the dollar by the end of the year (it traded at a rate of 6.12 on Thursday).


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