Fragility Fears Weigh on Renminbi
As concerns over the outlook for the Chinese economy intensify, currency traders have scaled back their bets that the renminbi will continue to strengthen against the U.S. dollar.
Investors have also ramped up purchases of hedges against the risk that Beijing could devalue its currency were the economy to suffer an unexpectedly severe slowdown.
The bearish market moves stand in contrast to the rosier consensus among economists that the renminbi will appreciate at an annual rate of 3 to 5 percent over the coming years.
Since Beijing cut the renminbi’s de facto peg to the dollar in June 2010, policymakers have allowed the currency to rise 5.3 percent with little volatility.
Stephen Green, China economist at Standard Chartered, has little doubt that Beijing will continue to let the renminbi appreciate by an annual 4 or 5 percent for the next two years at a minimum. “Unless there’s an emergency, that’s going to be the policy,” he said.
While there are growing fears that China’s property boom is about to collapse and local governments will end up defaulting on a large proportion of their $1,650 billion in debt, dealing a double blow to the banking system, most market participants reckon such an outcome is unlikely.
Mr Green believes China’s economy is slowing but will have a “soft” rather than a “hard” landing. Either way, the fate of the economy and its impact on the path of the renminbi will have repercussions far beyond China.
Foreign investors have been piling into renminbi-denominated assets over the past year through whatever means possible, in the expectation of virtually risk-free gains as the currency moves higher against the dollar. At the same time, Chinese companies have rushed to take on large amounts of dollar-denominated debt in the belief that currency moves will shrink their liabilities.
Many of these companies, dozens of them in the property sector, would “get toasted” if the renminbi fails to move higher against the dollar as rapidly as expected, said one Asian bond investor.
The exchange rate is also a point of contention with the U.S., which has for years pressed China to rebalance its economy away from exports and towards domestic consumption by adopting a stronger currency.
While there is no perfect market-based barometer of appreciation expectations, traders say offshore currency derivatives are the best indicators of sentiment available.
Non-deliverable forwards (NDFs), which are linked to the renminbi but settled in dollars, have stopped moving in tandem with the renminbi’s rate of appreciation. These forwards were on Wednesday pricing in a 1.3 percent gain in the Chinese currency against the dollar over the next twelve months. That compares with implied appreciation of more than 3 percent in May.
Traders caution that NDF prices reflect a range of factors besides appreciation expectations, and are increasingly being influenced by the small but fast-growing offshore market in deliverable renminbi forwards. Unlike NDFs, the prices of deliverable forwards are based purely on interest rate differentials.
But there has also been a significant shift in the options markets (where investors trade the right, but not the obligation, to buy or to sell a currency at a specified date in the future.) For the first time in more than a year, renminbi puts granting the right to sell the currency are selling at a premium to calls, which allow for purchases.
Graphs showing the implied volatilities of renminbi put and call options used to have a lop-sided curved shape known as a “smirk”; now they look like a smile, indicating that bearish bets have caught up with bullish ones.
While the options market is small, it serves as a useful indicator of longer-term views because its participants tend to look further into the future than those trading in the spot market.
“It’s a more intellectual side of the market rather than the day-to-day noise,” said Simon Smollett, options strategist at Crédit Agricole.
CQS, the $11 billion London-based hedge fund, has a bullish outlook on China and global growth. But Michael Hintze, CQS founder, disclosed in a recent investor presentation that he had been buying medium-term options to sell the renminbi, in a move to hedge against the tail risk of a severe Chinese slowdown.
Indeed, traders say the bulk of the purchases of renminbi puts have come from investors hedging their long positions on China, rather than bears making “naked” bets that the Chinese economy will run into serious trouble.
Even if bears such as Jim Chanos, the hedge fund manager who famously said China was on a “treadmill to hell”, prove to be correct in their views, economists say there is no risk of a forced devaluation of the renminbi. Any devaluation would be in the hands of policymakers in Beijing.
Unlike in 1994, when Beijing devalued the official value of the renminbi by 50 percent to catch up with rates in the black market following a huge credit boom that unleashed double-digit inflation, China is now on more stable footing.
The country now has more than $3,000 billion in foreign reserves with which to fight any potential outflow of money from its economy, as well as extensive capital controls.
Yet the outlook for the renminbi over the longer term may not involve the sustained rises that many expect.
Ben Simpfendorfer, founder of Silk Road Associates, a consultancy, says that with inflation running high, the renminbi will probably appreciate at an annual rate of no more than 5 percent for the next couple of years, then stop.
“Two years out from now China’s trade balance will look a lot smaller, if only because the scope for growth in domestic demand and imports is much greater than the scope for growth in exports,” he said.
The great unknown is what happens to China when global interest rates eventually start rising from their record lows. Bears believe it will trigger waves of capital outflows from China and cause the property market to collapse.
No-one is worrying about that scenario now. But when it happens, all bets are off.