China's Stock Carnage Solution

Strengthening its currency could reverse the capital outflows plaguing China.

Here's a thought for Chinese politicians and regulators as they gather for the National People's Congress this week: If they want to prop up their stock market, they need to boost the currency.

Using monthly data, the 55-day correlation between the yuan and the MSCI China index touched 40 percent today, the highest in at least a decade. It's been positive for most of the past two years also. Which is the driver and which is the passenger isn't clear but quite obviously China's currency and its stocks are tied to each other, so an increase in one benefits the other:

Hand in Hand

The yuan and the MSCI China stock index haven't moved so closely in at least a decade

Source: Bloomberg

* Based on monthly data

In fairness, that's pretty much how most emerging markets work. Statistically speaking, a regression of monthly data going back 15 years using the currency, and relating it to stock and bond returns, shows that 79 percent of the MSCI Brazil, 60 percent of the Russian index and 54 percent of the Indian benchmark are related to moves in the real, ruble and rupee respectively. Similar outcomes can be found for bonds using Bank of America Merrill Lynch's corporate plus indexes. In layman's terms, whenever the currencies in these countries rise or drop, so do their global stock gauges, although there may be a lag sometimes.

Bending Like EM

Studies of emerging markets show high correlation with currency moves, a path China is treading

Source: Bloomberg

While that's kind of obvious -- if a currency is falling, foreign investors are more likely to take profits and exit -- it doesn't mean it's not important.

As Societe Generale credit analyst Imtiaz Shefuddin noted in a report Tuesday, ``Currency weakness, together with weak commodity prices, could exacerbate financial stress, defaults and distressed credits.'' The bank sees a 35 percent probability the yuan will end 2016 at 7.5 per dollar, and says foreign-exchange movements will drive Asian credit markets.

Anyone who disagrees need only look at Brazil, where a 33 percent drop in the real last year was accompanied by the largest amount of defaulted bonds in the country's history, according to data compiled by Bloomberg.

In other words, besides losing money when exchanging dividends and proceeds from share sales into dollars, investors are now faced with the prospect of more bankruptcies and distress.

Shorting the yuan has become a pretty common trade, as reported by Bloomberg News last month. The three-month implied volatility for the offshore yuan, a measure of bearishness toward the currency, rose to the highest in at least five years on Feb. 12.

Panda Bears

The perceived risk of investing in the offshore yuan hit a five-year high on Feb. 12

Source: Bloomberg

That also means that a consistent move to strengthen the currency could prompt a short squeeze and quickly reverse the vicious cycle of outflows, which were cited by Moody's on Wednesday as one of the reasons it changed its outlook on China's government credit ratings to negative from stable. As Bloomberg View's Noah Smith put it: ``If there’s a larger number of Chinese investors out there who trust the central government to maintain the value of the currency and bring the unfolding crisis under control, then these capital outflows could soon slow or reverse.''

That, in turn, would keep more money invested in local stocks and bonds, and attract more foreign capital, helping to accelerate the virtuous cycle of wealth that Chinese regulators want. Simply put, it could do Beijing a lot of good to bolster the yuan.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Christopher Langner in Singapore at

    To contact the editor responsible for this story:
    Katrina Nicholas at

    Before it's here, it's on the Bloomberg Terminal.