Morgan Stanley Warns Of "Real Pain" If Chinese Currency Keeps Devaluing

Tyler Durden's picture

The seemingly incessant strengthening trend of the Chinese Yuan (much as with the seemingly inexorable rise of US equities or home prices) has encouraged huge amounts of structured products to be created over the past few years enabling traders to position for more of the same in increasingly levered ways. That was all going great until the last few weeks which has seen China enter the currency wars (as we explained here). The problem, among many facing China, is that these structured products will face major losses and as Morgan Stanley warns "real pain will come if CNY stays above these levels," leading to further capital withdrawal, illiquidity, and a potential vicious circle as it appears the PBOC is trying to break the virtuous carry trade that has fueled so much of its bubble economy.

Deutsche Bank notes that Chinese equities yesterday hit 1 month lows and are 65% off the all time highs. There's a mix of reasons but one of the biggest stories of the past week or so has been the depreciation of the Chinese currency, both onshore where USDCNY is up 1.0% over the past week and offshore where USDCNH is up 1.25%.

Whilst these moves may not seem large in the context of other EM currencies, they are significant compared to the usual size of Renminbi moves.

As we noted here,  Deutsche adds that whilst there has been some weak Chinese data which might explain part of the depreciation, the broad feeling is that this move has been driven by efforts by the PBOC to shakeout the large long Renminbi carry trade that has been built on the back of the view that the Chinese currency can only appreciate in value.

Indeed worries at the PBOC may have been triggered by one sign of this carry trade in action – the premium with which offshore USDCNH has been trading over the tightly controlled onshore USDCNY value over the course of 2014. This premium has now largely disappeared.

The total size of the carry trade is hard to estimate although even just looking at some of the onshore CNY positions accumulated, DB Asia FX strategist Perry Kojodjojo estimates that corporate USD/CNY short positions are around $500bn. The size of the carry trade and the fact that China saw significant capital outflows during the last period of substantial Renminbi depreciation in the summer of 2012 has led to concerns over what this might mean for both the Chinese economy and financial markets as well as broader global financial implications.

Morgan Stanley believes that one such carry-trade structured product that will be the "pressure point" for this - should the Yuan continue to depreciate - is the Target Redemption Forward (TRF) which has a payoff that looks as follows...

While this is just an example of a product payoff matrix to the holder, the broader point is that the USD/CNH market has a particular level (or range of potential levels) at which three factors can create non-linear price action. These are:


1. Losses on TRF products will (on average) crystallize if USD/CNH goes above a certain level. This has implications for holders of TRF products, who are mostly corporates;


2. The hedging needs of writers of TRF products (banks) mean that there is a point of maximum vega for banks in USD/CNH. Below this level banks need to sell USD/CNH vol; above this level banks need to buy USD/CNH vol;


3. The delta-hedging needs of banks are complex. As we approach the average strike (the 6.15 in the theoretical point of Exhibit 1), banks need to buy spot USD/CNH. Above this point but below the European Knock-in (EKI) (i.e., between 6.15 and 6.20 in Exhibit 1), banks need to sell spot. Then above the EKI, banks don’t need to do anything in spot.

From internal Morgan Stanley data, we estimate that the point of maximum vega is somewhere in the range of 6.15-6.20, and that the 6.15-6.20 in Exhibit 1 is reasonably indicative of the average strikes and EKIs in the market.


In other words, so long as the TRF products remain in place (i.e., are not closed out) and we remain below the maximum vega point (somewhere between 6.15 and 6.20), there is natural selling pressure by banks in USD/CNH vol. When we get above that level, there is natural vol buying pressure.



Of course, in the scenario that USD/CNH keeps trading higher and goes above the average EKI level, the removal of spot selling flow by banks and the need to buy vol means the topside move may accelerate.

Simply put, if the CNY keeps going (whether by PBOC hand or a break of the virtuous cycle above), then things get ugly fast...

How Much Is at Stake?
In their previous note, MS estimated that US$350 billion of TRF have been sold since the beginning of 2013. When we dig deeper, we think it is reasonable to assume that most of what was sold in 2013 has been knocked out (at the lower knock-outs), given the price action seen in 2013.

Given that, and given what business we’ve done in 2014 calendar year to date, we think a reasonable estimate is that US$150 billion of product remains.

Taking that as a base case, we can then estimate the size of potential losses to holders of these products if USD/CNH keeps trading higher.


In round numbers, we estimate that for every 0.1 move in USD/CNH above the average EKI (which we have assumed here is 6.20), corporates will lose US$200 million a month. The real pain comes if USD/CNH stays above this level, as these losses will accrue every month until the contract expires. Given contracts are 24 months in tenor, this implies around US$4.8 billion in total losses for every 0.1 above the average EKI.

Deutsche Bank concludes...

Looking forward it’s possible that the PBOC is not attempting to actively engineer a sustained depreciation of the Renminbi but rather is attempting to increase the level of two-way volatility in the market to discourage the carry trade and also excessive capital inflows. In terms of the broad risk going forward the sheer scale of the challenge the PBOC has set out to tackle likely means they will have to move with restraint. This is certainly a story to watch...

As Morgan Stanley warns however, this has much broader implications for China...

The potential for US$4.8 billion in losses for every 0.1 above the average EKI could have significant implications for corporate China in its own right, as could the need to post collateral on positions even if the EKI level is not breached.


However, the real concern for corporate China is linked to broader credit issues. On that, it’s worth reiterating that the corporate sector in China is the most leveraged in the world. Further loss due to structured products would add further stress to corporates and potentially some of those might get funding from the shadow banking sector. Investment loss would weaken their balance sheets further and increase repayment risk of their debt.


In this regard, it would potentially cause investors to become more concerned about trust products if any of these corporates get involved in borrowing through trust products. In this regard, this would raise concerns among investors, given that there is already significant risk of credit defaults to happen in 2014.

Remember, as we noted previously, these potential losses are pure levered derivative losses... not some "well we are losing so let's greatly rotate this bet to US equities" which means it has a real tightening impact on both collateral and liquidity around the world... yet again, as we noted previously, it appears the PBOC is trying to break the world's most profitable and easy carry trade - which has created a massive real estate bubble in their nation (and that will have consequences).


The bottom line is the question of whether the PBOC's engineering this CNY weakness is merely a strategy to increase volatility and thus deter carry-trade malevolence (in line with reform policies to tamp down bubbles) OR is it a more aggressive entry into the currency wars as China focuses on its trade (exports) and keeping the dream alive? (Or, one more thing, the former morphs into the latter as a vicious unwind ensues OR the market tests the PBOC's willingness to break their momentum spirit).

It appears, as Bloomberg notes, the PBOC is winning:

Yuan has gone from being most attractive carry trade bet in EM to worst in 2 mos as central bank efforts to weaken currency cause volatility to surge.

Yuan’s Sharpe ratio turned negative this yr as 3-mo. implied volatility in currency rose in Feb. by most since May, when Fed signaled plans to cut stimulus

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
satoshi123's picture

Isn't this what the USA fuck-heads wanted all along? For the CNY to lose value and not be strong, ...

Be careful what you wish for,

Actually this is brilliant and all perfect for the currency war,... CHINA have an output problem, .. no problem de-value their currency and make themselves competitive.

Must be driving the ASSHOLES running the USA gubmint nuts. :)

Peconic Bay's picture

The US wanted the opposite: stronger yuan vs. the dollar to make Chinese exports less competitive.  If Japan suceeds in debasing the Yen it will set off curreny war in all of East Asia.  I don't think the Chinese and the South Koreans will sit by idly while Japan tries to buy market share with cheap Yen.

satoshi123's picture

JPY is strongest bitch in ASIA, its where the action is,

CNY isn't even fairly traded, ... its not even a real INTL currency,


But I like how you switched to JPY, and like JPY too, and I like CNY,

But for those who want to know, ... I say play SGD ( singapore ) it tracks the CNY nicely, but its freely traded, unlike the CNY.


My orginal point was that the CNY had been getting stronger, albeit slowly for 20 years and it became a universal known-known that you could only make money holding CNY on leverage,... and now for 2 months the CNY is dropping like a rock, and that has GOT to be HURTING a lot of the SURE-THING school and hard, and this is GOOD :)

Berspankme's picture

I moved to China in 2005- Yuan was 8.38/1 USD when I arrived.

ArkansasAngie's picture

With the Abester saying a 115 yen, Can China afford to lose market share?  Their market is down 65%.  Some folks might be getting pissed off about that.  

I guess we will see


robertsgt40's picture

Too bad MS can't apply this same critical analysis to US markets.

kaiserhoff's picture

You mean markets can go down as well as up?  Unpossible.

We'll get Mr. Yellen on this right away.

satoshi123's picture

Whoopee shit, ... for 20 years the CNY ( chinese YUAN ) only went up and dumb fucking wall street created ton's of product sold to MUPPETS where they got guaranteed ROI,

Now along comes this change in PARADIGM, and holy fucking shit.

All I can say is this is the kind of thing that can really BREAK the USD, and US  economy,  cuz its just gotten that much harder for Wall Street to pull money out of its ass.


NOW we'll see even MORE NYC brokeers jump out of windows, and note  I said BROKERS, not BANKERS.

fonzannoon's picture

this is bullish for facefart

disabledvet's picture

yeah, exactly. "explain that please"?

"whatever you do be certain about it."
there has been nothing but risk going on 5 years now...forget "Wall of Worry"...this is Climbing Mt. Everest.

Gives people ideas...that's fer sure.

Admit "we've moved beyond explanation itself"?

Grande Tetons's picture

Up arrow for the cool tune. I saved it to favorites. 

NoDebt's picture

Yeah, it probably is.  Most things are bullish for Facefart nowadays.  Why should this be any different?

The trashier the investment the better.

moonstears's picture

long DLTR, long canned food Cos, long Kraft, long silver. That is all.

I Write Code's picture

Interesting.  The strengthening of the CNY I suspect was negotiated personally by The Bernank and it held for a long time.  But the question is, which is better for China, short and long term.  He convinced them that long term they'd win with a strong currency.  However short term, all their US holdings rise in value when the CNY goes down, not to mention their trade balances.

So did Morgan Stanley take a big position on this?  Good going, fellows.

fijisailor's picture

OK so some big banks will lose money on the carry trade.  Old Yeller will bail them out with QE4EVA.  I'll be dreaming about what Yellen's "vega point" is tonight.

medium giraffe's picture

Deleted: anger management.

RaiZH's picture

Currency wars about to turn seriously ugly. Aunt Yellen, fire up those printers! 

Berspankme's picture

Bullish for Tesla.........oh....wait... everything is bullish for Tesla- J Cramer

Leveraged Algorithm's picture

There will be once again "unintended consequences" - Yellen will now have her turn saying she didn't understand the derivative trades by banks. Hard assets don't have that problem - maybe it will be time for TBTSave....

The Wisp's picture

Nothing goes on Forever... DO I smell a few Derivatives Burning ?

bulldung's picture

Who cares, what's 14 billion amongst Feds? Just shut up and keep printing.<SARC on>

besnook's picture

the victim is the dollar, the intended target. china once again asserts itself as the real master of the universe.

BASTERDO's picture

How much loses will the big US banks make if the CNY continues to depreciate? Billions? Maybe that why they are trying to talk it up.

Iam Yue2's picture

MS - Six months behind the curve as per usual.

The Final Straw's picture

Let them eat rat, on a stick from a street vendor. It shall be mislabled as cat.

The Final Straw's picture

Consequently, I've eaten Dog Soup (Boshintang in Korea), and it tastes like mild roast beef. The fat is rancid. I blame the lack of deliciousness on the slaughtering. Nowadays they use electrocution. Traditionally, the dog was hung by its hind legs and beaten to death, because the dog's terror makes the meat taste better.