Efforts by China to damp speculation in the yuan risks driving away investors just as the nation attempts to open up its capital markets in a once-in-a-generation economic overhaul.
After allowing the currency to steadily rise in each of the past four years, China’s central bank let it tumble about 1 percent over the past week, the most since at least 2007. Volatility in the yuan has jumped the most this month among 31 major currencies tracked by Bloomberg.
Policy makers are moving to drive away speculators as President Xi Jinping seeks to liberalize interest rates, allow more room for the yuan to fluctuate and set up currency trading hubs around the world. Further price swings may squeeze bullish yuan bets that Deutsche Bank AG estimates at $500 billion.
“We are not used to volatility in the Chinese currency,” Jens Nordvig, the New York-based managing director of currency research at Nomura Holdings Inc., said yesterday in an interview on Bloomberg Radio’s “Surveillance” with Tom Keene and Michael McKee. “It’s very painful for market participants because, in a low-volatility environment, it’s possible to carry large positions.”
China’s economic fundamentals are sound overall and it’s unlikely there will be large-scale outflows in the future, the State Administration of Foreign Exchange said in a statement today. The volatility seen of late is normal when compared with other currencies, and two-way movements in the exchange rate will be the norm, the watchdog said. Market participants shouldn’t “read too much” into the recent drop, it added.
“The statement serves to comfort the market that yuan declines won’t be excessive and investors have probably overreacted,” Banny Lam, Hong Kong-based co-head of research at Agricultural Bank of China International Securities Ltd., said by phone today.
The yuan gained 0.03 percent to close at 6.1248 per dollar in Shanghai after the release of the SAFE statement, according to China Foreign Exchange Trade System prices. It is now 1.4 percent weaker than the 20-year high of 6.0406 reached on Jan. 14. In offshore trading, the currency was little changed at 6.118 as of 10:19 a.m. in Hong Kong.
Three-month implied volatility, which reflects traders’ expectations of currency swings, rose to 1.78 percent from 1.32 percent at the end of January, data compiled by Bloomberg show.
The yuan’s weakness coincided with a drop in the benchmark seven-day repo rate to a nine-month low of 3.09 percent this week. That’s a sign of currency intervention as the People’s Bank of China bought dollars and sold yuan, adding cash to the financial system and bringing down interest rates, strategists at Bank of America Corp. wrote yesterday in a report.
Before the selloff this month, the inflation-adjusted yuan exchange rate had gained 43 percent against its main trading partners since policy makers scrapped a hard dollar peg in July 2005, according to data compiled by Basel, Switzerland-based Bank for International Settlements. China allows the yuan to trade 1 percent above or below the central bank’s daily reference, known as the fixing.
The currency’s appreciation added to pressure on Chinese exporters as policy makers’ efforts to rein in credit slowed economic growth. A government report on March 1 may show that manufacturing stagnated in February for the first time since September 2012, according to the median estimate of 27 economists in a Bloomberg survey.
“Whenever there’s been a sharp appreciation of the yuan, the PBOC always pulls it back a bit,” David Loevinger, a former senior coordinator for China affairs at the U.S. Treasury Department and now an analyst at money-management firm TCW Group Inc. in Los Angeles, said in a phone interview yesterday. “They want to inject two-way risk into the market and they want to shake out speculative inflows.”
Even with the recent increase, implied volatility remains the lowest among major currencies after the Hong Kong dollar.
Low volatility and currency appreciation added to the appeal of holding yuan-denominated assets for foreign investors. At 3.7 percent, yields on China’s two-year government notes are about 3.39 percentage points higher than U.S. Treasuries.
Investing in the yuan returned 7.3 percent over the past five years after adjusting for volatility, the most among major currencies, according to data compiled by Bloomberg.
Cross-border lending to China increased $320 billion over the past year to more than $1 trillion, partly driven by flows from foreign investors seeking carry trades, according to Mirza Baig, head of foreign-exchange and interest-rates strategy at BNP Paribas SA in Singapore. In the carry trade, investors buy higher-yielding assets with funds borrowed abroad.
Companies and investors hold about $150 billion worth of a currency option, known as a redemption forward product, to speculate on the yuan, according to Morgan Stanley. Investors will lose $200 million a month for every move of 0.1 per dollar in the yuan weaker than 6.2, Morgan Stanley strategist Geoffrey Kendrick wrote in a note today.
Inflows and speculation underscore the challenges China’s policy makers face as they move to open capital markets, including a plan to allow the yuan to float freely in a free-trade zone in Shanghai. China has already signed agreements to trade its currency more freely with Singapore, London and Frankfurt.
Yi Gang, the head of China’s foreign-exchange regulator and deputy central-bank governor, said Jan. 1 that authorities were considering imposing a tax on speculative flows. The PBOC said last week it plans to expand the band in which the yuan is allowed to trade in an “orderly” manner this year.
“One potential goal of recent yuan weakness, and greater two-way risk, is to perhaps discourage hot-money, carry-trade inflows into China that see currency appreciation as a one-way bet,” currency strategists including New York-based Win Thin at Brown Brothers Harriman, wrote in a client note yesterday.
Edmund Harriss, investment director at Guinness Atkinson Asset Management LLC, said demand for yuan assets remain strong.
Companies including Caterpillar Inc. have raised $94 billion from yuan-denominated bond sales in the international market this year, compared with $44 billion during the same period of 2013, according to data compiled by Bloomberg.
“The offshore hasn’t turned particularly bearish,” Harriss, who runs a $100 million yuan bond fund, said in a phone interview yesterday from London. “I don’t think the introduction of some volatility makes the yuan fundamentally unattractive.”
The median forecast of 56 analysts surveyed by Bloomberg is for the yuan to rise 2.6 percent to 5.97 per dollar by the year-end.
That sentiment is echoed by strategists at banks from Goldman Sachs Group Inc. to Morgan Stanley who expect yuan weakness to be transitory as export growth recovers. Rising volatility doesn’t necessarily foreshadow a shift in China’s currency policy favoring a weaker-exchange rate, they say.
“More depreciation? Probably not much more,” Yao Wei, a China economist at Societe Generale SA in Hong Kong, wrote in a research note yesterday. “Although the central bank does not like too much capital inflows, too much outflows will not be its choice, either.”
Yesterday’s decline sent the yuan 0.1 percent weaker than the central bank’s reference rate, marking the first time the market rate dropped below the official quote since September 2012. Until last week, the market exchange rate was 0.8 percent stronger than the official quote on average over the past year, suggesting the appreciation pressure.
The convergence between the market and official rates suggests that the central bank is setting the stage for doubling the trading band to 2 percent within weeks, according to Normura’s Nordvig.
“They’re getting ready for a more flexible situation,” Nordvig said. “They want to have some two-way risk embedded in the market before they take that step rather than hitting the strong end of the band in the new regime immediately.”