China Bulls Gain on Record Structured Notes for Yuan

Investors turning bullish on China are buying record amounts of structured notes tied to the yuan as the country recovers from a two-year economic slowdown.

Individual investors in the U.S. bought $79.9 million of notes since December that rise and fall in value based on swings in the offshore Chinese renminbi, according to data compiled by Bloomberg. The nine notes created by HSBC Holdings Plc use the highest leverage for such securities since Bloomberg began compiling the data in January 2010 to generate yields as much as five times more than the yuan’s appreciation.

The Communist nation’s economic growth accelerated last quarter for the first time since 2010, fueling speculation that the government would allow the currency to rise at a faster pace. The median forecast of analysts surveyed by Bloomberg was for the yuan to gain 2 percent by the end of 2013, following a 1 percent advance last year, the slowest since 2009.

“In the last six months, we have seen increased demand from high-net-worth investors looking for ways to access the growing Chinese market,” Todd Fruhbeis, managing director and head of structured-product sales for the Americas at HSBC in New York, wrote in an e-mail. “We expect this trend will continue given China’s continued growth prospects.”

Yuan Hubs

The offshore exchange rate, known by the symbol CNH, tracks the official rate in the domestic market, or CNY. The official rate is allowed to fluctuate a maximum 1 percent on either side of a reference rate set by the People’s Bank of China.

China has pledged to support offshore yuan hubs as it seeks a greater role for the currency in global finance at a time when monetary easing in the U.S., Europe and Japan is boosting the supply of dollars, euros and yen.

The Bank of England is ready “in principle” to agree a swap line with China’s central bank that would help London become a center for offshore yuan trading, its chief cashier, Chris Salmon, said in a speech in London last week. Taiwan banks will be able to take deposits of and lend in the Chinese currency by the Lunar New Year, a weeklong holiday that commences Feb. 11.

Offshore trading for the Chinese currency started in Hong Kong in 2010, where the average volume of yuan deals has doubled in the past year to at least $6 billion a day, according to Standard Chartered Plc. Transactions in offshore options in yuan swelled to between $300 million and $500 million per day, J.P. Morgan Private Bank said.

Dim Sum

The offshore rate was little changed today at 6.2211 per dollar after a seven-day slide of 0.7 percent. It touched 6.1735 on Jan. 11, the strongest since its 2010 debut. The domestic rate rose to a 19-year high of 6.2124 three days later and traded at 6.2243 today in Shanghai.

The U.S. currency slipped against most its 16 major counterparts today as the Federal Reserve prepared to start a two-day monetary policy meeting. Minutes of the Federal Open Market Committee’s December meeting showed officials were “approximately evenly divided” between those who said it would be appropriate to end its third round of asset purchases around mid-2013 or to continue beyond that date.

Sales of yuan-denominated, or Dim Sum, bonds in Hong Kong reached a record 175.8 billion yuan ($28.2 billion) in 2012, up from 152 billion yuan the previous year, Bloomberg data show.

The securities have gained for a record seven consecutive weeks since China’s central bank announced plans to accelerate the opening up of capital markets to foreigners and allow cross-border yuan loans, a Deutsche Bank AG index shows.

Record Size

“China has indicated that their priority now is to increase liquidity in the currency,” said Axel Merk, founder and president of Merk Investments LLC in Palo Alto, California, who oversees about $20.8 million of Chinese currency. “That’s a very important precondition to make the currency more convertible and also for future currency appreciation.”

Merk, who manages the Merk Asian Currency Fund, said he invests in time deposits, a kind of bank deposit, for the offshore currency and nondeliverable forwards, a derivative for some currencies, for the yuan in Shanghai.

Banks create structured notes by packaging debt with derivatives to offer customized bets to retail investors while earning fees and raising money.

In one deal, HSBC sold $36.8 million of one-year notes tied to the offshore yuan, the largest single offering involving the currency. While investors can realize returns five times the rise of the yuan versus the U.S. dollar, according to a prospectus filed with the U.S. Securities and Exchange Commission, they are exposed to any depreciation of the currency and can lose all of their investment. JPMorgan Chase & Co. distributed the notes for a 0.9 percent fee.

Criticism Abates

The People’s Bank of China has been selling yuan and buying foreign exchange to prevent the currency from strengthening, leading to a record $3.31 trillion in foreign reserves in December, the world’s largest holding.

The U.S. Treasury Department said on Nov. 27 that China isn’t a currency manipulator under U.S. law, though the yuan “remains significantly undervalued” and needs to rise further.

Criticism over China’s exchange-rate system has abated in recent months. Lawrence Summers, the former top economic adviser to President Barack Obama, said Jan. 14 the yuan is no longer as undervalued as it was five years ago.

Raising Forecasts

Currency strategists have been raising their forecasts for the yuan after reports showed retail sales increased last month at the fastest pace since March and industrial production growth accelerated in the largest country in the world by population.

The yuan will strengthen to 6.1 per dollar by year-end and extend its gain to 6 by the end of 2014, the median forecast of 36 analysts surveyed by Bloomberg shows. In September, they were expecting the currency to appreciate to 6.23 per dollar.

Optimism over China’s growth picked up in November as data started to show a recovery in manufacturing, with the official purchasing managers’ index climbing at the fastest pace in seven months.

That same month the ruling Communist Party had its once-in-a-decade power handover, with Vice President Xi Jinping appointed party general secretary before he is forecast to succeed President Hu Jintao as the nation’s head in March. Xi has called for speedier economic reform, a narrowing of income inequality and a crackdown on corruption.

Transparency Risk

It’s the lack of transparency in the one-party state that poses the largest risk to investors in China, according to James Rickards, a senior managing director of Tangent Capital Partners in New York.

“I wouldn’t touch China with a 10-foot pole in terms of a lot of investment products coming out,” Rickards said during an interview from Vail, Colorado.

Rickards said he has no concern with the HSBC notes, calling them “a pure play on the yuan, and my view is that it’s going to go up.” He said he expects the currency to appreciate about 10 percent to 15 percent this year.

The number of bearish bets on the currency declined as a government report on Jan. 18 showed that the world’s second largest economy grew 7.9 percent in the fourth quarter from a year earlier, from 7.4 percent the previous three-month period.

Yuan Convertibility

It was the first acceleration since 2010 and higher than the 5.8 percent forecasted averaged growth across the so-called BRIC nations. The economy is set to expand 8.1 percent this year, according to the median estimate of 47 economists surveyed by Bloomberg News.

“It’s clear to investors now that China will keep making progress on yuan convertibility, so concerns on any sudden hiccups are gone,” Tommy Ong, a Hong Kong-based senior vice-president of Treasury and markets at DBS Bank (Hong Kong) Ltd., said by telephone on Jan. 25. “Liquidity of the yuan market and acceptance of the currency have been rising.”

A stronger currency will help raise the purchasing power of Chinese residents, which coincides with the government’s goal to boost domestic demand, Dariusz Kowalczyk, a senior strategist at Credit Agricole CIB in Hong Kong, said in a Jan. 7 phone interview.

Kowalczyk, the most-accurate forecaster on the yuan for the past six quarters based on data compiled by Bloomberg, upgraded his end-June forecast on the yuan to 6.16 from 6.20.

DBS’s Ong said he’s aware of “stronger demand” from the U.S. on yuan-related structured products.

“Expectations of stronger yuan gains, say 2 percent or more, have returned,” he said. “Investors are no longer skeptical of China’s determination on making the yuan a global currency.”

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