The Big Short Is Back in Chinese Stocks

China's Big Short: Bearish Bets Mount as Yuan Weakens
  • Short interest in CSOP FTSE China A50 ETF is highest in a year
  • Yuan is heading for its biggest monthly drop since August

Chinese equities are once again in the cross hairs of short sellers.

Short interest in one of the largest Hong Kong exchange-traded funds tracking domestic Chinese stocks has surged fivefold this month to its highest level in a year, according to data compiled by Markit and Bloomberg. The last time bearish bets were so elevated, such pessimism proved well-founded as China’s bull market turned into a $5 trillion rout.

QuickTake Short Selling

While trading in the Shanghai Composite Index became subdued this month amid suspected state intervention, pessimists are betting that equities face renewed selling amid a slumping yuan. The Chinese currency is heading for its biggest monthly loss since last year’s devaluation as the nation’s economic outlook worsens and the Federal Reserve prepares to raise borrowing costs, driving a rally in the dollar.

"Some macro funds are seeking opportunities to short index futures to play the currency movement," said Wenjie Lu, Shanghai-based strategist at UBS Group AG. "A higher chance of a Fed rate hike means there’s pressure for the yuan to soften."

Short interest in the CSOP FTSE China A50 ETF climbed to 6.1 percent on May 25, the highest level since April 2015, two months before Chinese equities peaked, and up from 1.3 percent at the end of last month. Bearish bets in the U.S. traded iShares China Large-Cap ETF jumped to a two-year high of 18 percent of shares outstanding on the same day, up from 3 percent a month ago, data compiled by Bloomberg and Markit show.

Even as Chinese equities rallied on Tuesday, traders were rattled by a sudden plunge in index futures. Contracts on the CSI 300 Index dropped as much as 10 percent at around 10:42 a.m. local time, recovering almost all of the losses in the same minute. The move had little effect on the underlying stock gauge, which rose 3.3 percent.

To read more about the sudden slump in CSI 300 futures, click here.

The yuan has declined 1.6 percent this month as China’s April economic data trailed estimates and the odds the Fed will raise interest rates as soon as June rose to 30 percent from 12 percent. The currency fell 0.1 percent to about 6.58 per dollar as of 3:39 p.m. on Tuesday, within 0.2 percent of its five-year low in January, as a gauge of the greenback’s strength traded near a 10-week high.

Investors may be "hedging out their positions and they’re using the ETF to have short exposure to China," said Brett McGonegal, chief executive officer of Capital Link International Holdings Ltd.

Currency Discount

The bearish bets on stocks stand in marked contrast to the currency market, where the discount on the yuan’s offshore rate versus its level in the onshore market, a key gauge of pessimism among global traders, has almost disappeared after reaching a record 2.9 percent at the start of the year.

While the yuan’s losses escalated in the past three weeks, the Shanghai Composite was unmoved. The index barely strayed from the 2,800 level through Monday amid speculation state-backed funds are preventing further losses, helping send 30-day volatility on the gauge to its lowest level since December 2014.

Some investors may be betting China’s domestic equities, known as A shares, will fall further if yuan losses deepen, according to Sam Chi Yung, senior strategist at South China Financial Holdings Ltd. in Hong Kong.

While the gauge is the world’s worst performer this year among 93 global benchmark indexes with a decline of 18 percent, valuations remain elevated. The Shanghai measure trades at 12 times estimated profits for the next 12 months, a 20 percent premium versus its five-year average.

“Investors think there is some risk in A shares," the strategist said. “If the yuan keeps falling that would affect the value of Chinese shares."

Watch next: Is the Yuan Successfully Being Managed?

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