China's yuan could tumble 10% or more

China's yuan devaluation does not have to be a unilateral negative for portfolios. Investors should consider taking positions that are likely to benefit from the yuan's decline.

Right now, one U.S. dollar buys 6.59 yuan. We see the exchange rate rising slightly to 6.80 yuan by the beginning of 2017.

China is trying to let the yuan float more freely in a broader attempt to introduce free-market practices and enable international investors to invest more in its onshore financial assets.

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Despite the yuan's fall a week ago, we do not believe the government wants to let it depreciate too far against its target basket of currencies, including the U.S. dollar. This might trigger counterproductive devaluations in other emerging-market currencies and send a negative signal to markets about Chinese stability.

However, the risks still appear skewed toward a greater-than-expected depreciation of 10 percent or more over the next six to 12 months. China's struggle to rein in onshore asset prices last week, including stocks as well as the yuan, has heightened the perception that its policy makers no longer control markets to the extent they did in the past.

During the first six trading days of this year, the onshore A-share market tumbled 16 percent in U.S. dollar terms. This further inflamed volatility, which already averaged 40 percent on an annualized basis in 2015, or about twice that of the S&P 500 index.

Yet certain other factors make this correction "special." On Jan. 4, the Chinese authorities established a circuit breaker that suspended stock trading if the market fell 7 percent or more. As early as Jan. 7, they were forced to abandon the circuit breaker following repeated trading suspensions.

Chinese data announcements also disappointed. Manufacturing purchasing managers' indices (PMIs) pointed to a contraction of activity in December. In the same month, China revealed its foreign-exchange reserves also dropped $108 billion. Reserves have now shrunk by $663 billion since peaking at $4 trillion in June 2014.

With both data and market behavior disappointing, investors should consider trades that will profit if the yuan depreciates slightly – our base case – but profit even more if the value of the yuan comes under unexpected pressure.

In our view, there is not a single most attractive way to position for the risk of a significant yuan devaluation, but rather a range of attractive trades with different risk and return characteristics. While we expect each of the following trades to perform individually over our six- to 12-month investment horizon, we see the best value in an equally weighted basket of all three.

The first trade is an outright position – long U.S. dollar versus short Chinese yuan. This is meant for investors who want direct exposure to the yuan and are willing to accept the cost incurred by earning lower interest rates on U.S. dollars compared with the yuan.

The second is a proxy trade – long U.S. dollar versus short Taiwanese dollar. This is for investors who wish to reduce the cost incurred by the interest-rate difference and are willing to take only indirect exposure to the yuan via a closely correlated currency.

The third trade requires a greater tolerance for risk – long Russian ruble versus short Australian dollar. Rubles pay higher interest rates than Australian dollars. While both currencies are exposed to commodities, Australia is more exposed to the slowdown in China, while Russia is more exposed to the recovery in Europe.

While the risks of a greater-than-expected devaluation have been rising, there are economic reasons why it is not our base case. A closer look at the Chinese economy leads to less worrisome conclusions than those implied by the headline data. Despite the soft manufacturing PMI, both the official and Caixin services PMIs are still in expansion territory.

The GDP slowdown will continue as the manufacturing and industrial-led economy transitions to a services one, but a hard landing is unlikely. Fiscal policy should help avert it, as should monetary policy. We expect one or two interest-rate cuts, a 3 to 5 percentage-point reduction in the reserve requirement ratio (RRR) and a 0.5 to 1 percentage-point drop in the standing lending facility (SLF) rate this year. We anticipate GDP expanding by around 6 percent.

However, the debate about the yuan's future is more complicated. Last year the government started allowing the yuan exchange rate to be "fixed" by taking into account market forces. On Dec. 11, the People's Bank of China introduced a trade-weighted basket in which the U.S. dollar has only a 26-percent weighting.

Both measures promise more yuan volatility to come, especially relative to the U.S. dollar. Any greenback appreciation against major currencies will now look more like devaluations of the yuan versus the U.S. dollar. Further volatility is likely as markets and investors continue to digest China's new currency trade regime.

Commentary by Jorge Mariscal, the emerging markets chief investment officer at UBS Wealth Management, which oversees $1 trillion in invested assets. Follow UBS on Twitter @UBS.