(Repeats item first carried late on Thursday)
By Vidya Ranganathan
SINGAPORE Jan 30 When China averted a default
in its shadow banking industry last week in the midst of an
emerging market meltdown, investors globally heaved a sigh of
They may however be overlooking another major stress point
in China's backyard: a mountain of foreign money invested in the
yuan carry trade.
The foreign dollars invested in China's high-yielding yuan
and credit stayed there through the past week's emerging markets
selloff from Argentina to Turkey, taking comfort in the
currency's stability, China's unstated support for its banking
sector and the view that Beijing will not let the economy stall.
That confidence could be put to the test if the emerging
markets selloff continues and China shows any signs that its own
outlook is darkening. Such a test could come this weekend, when
China releases its official monthly survey of manufacturing in
the wake of a private-sector report that showed the sector was
The emerging world's biggest economy has been an anchor for
Asian markets so far in the selloff, providing relative
stability to the region's currencies and preventing what has
been so far a hasty but selective exit of investors from turning
into an indiscriminate stampede.
"It is a very large trade and part of it is carry driven, so
if it unravels then you are talking of a Lehman crisis here, I
think," said Mirza Baig, the head of Asian rates and currency
strategy at BNP Paribas in Singapore.
"But I don't think it will unravel. To get that trade to
unravel, you need a complete credit meltdown in China, something
that causes a run on the currency."
Confidence that the yuan carry trade - essentially foreign
investment chasing yuan appreciation and yield - will not
unravel, stems from how tightly China's authorities manage the
Technically, it is a highly managed floating currency, but
in reality it rarely strays far from a daily fixing set by the
Still, there are several factors that could spook investors
and put the yuan positions at risk.
One is that the emerging markets selloff becomes
indiscriminate. So far sellers have focused on the weakest
developing economies and most of emerging Asia has avoided the
worst of the selling.
Another risk is that the central bank's campaign to
clampdown on risky lending leads to a more pronounced slowdown
in China's economy. A corporate default could raise the spectre
of financial instability and rattle nerves in markets worried
about high debt levels in China.
"The highest risk is over-tightening," said Craig Chan,
rates and currency strategist with Nomura in Singapore. "For
instance, if there is a big clampdown, and there is a credit
slowdown, investment slowdown and the risks of defaults rise."
Chan however also believes the Chinese authorities would
step in pre-emptively to prevent a financial sector crisis.
A purchasing managers' report on Thursday on Chinese
manufacturing in January revealed shrinking output and new
orders, adding to a sense economic growth is easing.
The government's official version of how the manufacturing
sector did in January is due to be published on Saturday.
THE MASSIVE CARRY TRADE
Estimates of how much foreign investment is parked in the
yuan carry trade can only be vague at best because of the
numerous routes investors can use to get around China's opaque
systems and rigorous capital controls.
The most straightforward bets on yuan appreciation are
buying the yuan in forward markets, either through the offshore
yuan market largely centred in Hong Kong or in
non-deliverable forwards, another offshore market.
Volumes in these two offshore yuan markets on average are
about $6 billion each day.
But the biggest bets are through the options market, where
dollar puts, or options to sell the dollar for yuan, permit
investors a cheap gamble on yuan appreciation, traders said.
Then there are wealth management products sold by Chinese
banks, which offer offshore investors the opportunity to lend
yuan onshore at attractive yields averaging about 6 percent.
These are typically structured products routed through banks in
The claims Hong Kong banks have on mainland counterparts
give a rough idea of the size of these yield-seeking structured
products. As of October, those claims were a record HK$2.3
trillion ($295 billion) and had climbed 53 percent since the end
of 2012, a rise many analysts said reflected speculation on the
Another potential hit to the carry trade could come from
within China. Some onshore exporters and importers have been
inflating their receipts and under-stating their payments in
order to earn more yuan. That would stop if their bullish
outlook for the yuan changes.
Those camouflaged trade flows are also difficult to
estimate. But hot money flows into China in the final quarter of
2013 were about $38 billion, based on the difference between the
rise in China's dollar reserves and the total for trade and
Still, a 50 percent growth rate in trade financing by Hong
Kong banks, the trillion yuan that depositors have placed with
those banks and the jump in the value of Chinese exports - all
point to how big the carry trade might be.
There is little doubt China can defend its currency, given
it has $3.8 trillion in currency reserves.
If and when the yuan carry trade unwinds, analysts expect
volatility will increase first, causing some of the options
trades to reverse. That will be followed by investors trimming
their long-yuan positions, and some hedging of payments by
Even then, the yuan exchange rate might at the most move
lower and stop trading at a premium to the central bank's fixing
rate. The offshore yuan was quoted at 6.0350 on Thursday and the
onshore rate was 6.0594, firmer than the daily fixing of 6.1050
"There might be an increase in volatility, and people will
need to de-lever their portfolios and they will need to cut
their short dollar-yuan positions," said Baig.
"But that won't drive China to devalue the yuan. It won't
drive them to take the fixing higher. After the initial
correction, when people realise that fixings aren't going up,
then they will go back and buy China."
The odds of China becoming a source of stress for emerging
markets are still low, but China will dominate sentiment,
News this week that a Chinese trust firm had reached an
agreement to resolve a troubled high-yield investment product to
avoid a default relieved markets fearful that one default could
trigger others and so undermine China financial stability.
But China's 10 trillion yuan shadow banking market, or
non-bank lenders, is seen as a big source of risk, and one that
is directly linked to the prospects for the economy and policy.
"We are sceptical that we will see any fundamental rebound
in emerging markets before we get more transparency on the
outlook for the Chinese economy and the Chinese financial system
and that could take some time," said Lars Christensen, a
strategist at Danske Bank in Copenhagen, in a note to clients.
"Therefore, caution is still very much warranted."
(Additional reporting by Saikat Chatterjee in Hong Kong;
Editing by Neil Fullick)