China is succeeding in making its currency less predictable. Investors are paying the price.
Clients of U.S. commercial banks have lost about $2 billion this year on $332 billion of options betting the yuan would appreciate, while Chinese companies lost $3.5 billion on $150 billion wagered on a benchmark forwards contract, according to data compiled by Morgan Stanley and the Depository Trust & Clearing Corp. in Washington. These contracts, when including bearish bets, account for more than a third of global trading in the Chinese currency.
After almost a decade of gains, speculators had come to regard the yuan as a one-way trade, leading to a surge in capital inflows that stands to leave the country vulnerable to a sudden shift in investor sentiment. Policy makers responded by selling the yuan and widening its trading band, encouraging a record 2.4 percent quarterly decline that was the biggest among Asian currencies.
“The depreciation was engineered to burn the fingers of speculators,” said David Loevinger, a former senior coordinator for China affairs at the U.S. Treasury and now a Los Angeles-based analyst at TCW Group Inc., which oversees $132 billion. “The People’s Bank of China wants two-way volatility embedded in the market.”
PBOC’s press office in Beijing didn’t answer telephone calls seeking comment on the yuan’s swings.
The yuan started to weaken in mid-February and declined the most in any quarter since China unified official and market exchange rates in 1994, according to China Foreign Exchange Trade System prices and data compiled by Bloomberg.
It slipped to a one-year low of 6.2370 per dollar on March 21 from a 20-year high of 6.0406 on Jan. 14, and has almost erased last year’s 2.9 percent gain. It traded at 6.2068 today, about 33 percent stronger than in July 2005, when the PBOC dropped its peg to the U.S. dollar.
The losses in the options market were on outstanding yuan call options reported by U.S. banks, which clients took out to hedge or speculate on the Chinese currency. The contracts lost money as the yuan weakened beyond the median pre-arranged exchange rate, known as the strike price, of about 6.05 per dollar, data compiled by Bloomberg show.
The yuan’s decline also caught out investors -- 90 percent of them Chinese companies -- in the Target Redemption Forwards market, known as TARF. These contracts pay a monthly income as long as the yuan remains above its strike price, and lose double the amount if the currency falls below a certain level, which was about 6.2 to the dollar, according to Morgan Stanley.
Investors have been complacent about the yuan’s losses, meaning a disorderly unwinding of yuan bets remains a possibility, according to Geoffrey Kendrick, the Hong Kong-based head of Asian currency and rates strategy at Morgan Stanley.
“People have taken this way too easily so far,” Kendrick said on Bloomberg Television on March 20. “It’s very clear now that at least for the next three, six months, we are going to continue to have this currency to weaken.”
The yuan will drop to 6.38 per dollar, which would swell TARF market losses to $7.5 billion, Kendrick predicted, without specifying a timeframe. The median estimate of 40 strategists surveyed by Bloomberg has the currency strengthening to 6.09 by June 30 and to 6 by year-end.
Any acceleration in the yuan’s declines may cause concern among China’s trading partners. Pressuring the government to allow the yuan to appreciate is a “high priority” for the Obama administration, U.S. Trade Representative Michael Froman said in an interview in Brussels on March 22.
U.S. lawmakers have criticized China for keeping the yuan weak by selling it in the foreign-exchange market to make exports cheap. Goldman Sachs Group Inc. estimates that the currency is 6.5 percent overvalued on a trade-weighted basis.
“The PBOC clearly doesn’t want the renminbi to get out of control,” Ju Wang, a Hong Kong-based senior strategist at HSBC Holdings Plc, said by phone on March 18. “I don’t think the currency will depreciate big time.”
The PBOC doubled the band in which the yuan is allowed to fluctuate versus a daily reference rate to 2 percent in March, accelerating declines and sending a gauge of price swings to the highest in two years. Implied three-month volatility in the Chinese currency rose to 2.62 percent on March 20, the highest closing level in two years and up from 1.78 percent at the end of 2013, according to data compiled by Bloomberg.
The declines in China’s currency coincide with signs the economy is slowing. The government is targeting gross domestic product growth of 7.5 percent this year, which would be the weakest expansion since 1990. The currency’s decline also threatens to spark capital outflows at a time when some Chinese companies are already short on cash. Shanghai Chaori Solar Energy Science & Technology Co. in March became the first company in China to default on onshore corporate bonds.
Deutsche Bank, the world’s largest currency trader, said the yuan’s slide risks becoming a “slippery slope” with other investors unwinding their bullish bets on the currency.
“The policy intent to shake out speculative positions appears significant,” Perry Kojodjojo, a Hong Kong-based strategist at the German bank, said in a March 21 client note. He predicted the yuan will weaken beyond 6.3 per dollar, without specifying when.