The Yuan has weakened over 250 pips in early China trading. Trading at almost 6.22, we are now deeply into the significant-loss-realizing region of the world's carry-traders and Chinese over-hedgers [12]. Morgan Stanley estimates a minimum $4.8bn loss for each 100 pip move. [13] However, the bigger picture is considerably worse as the vicious circle of desperate liquidity needs are starting to gang up on Hong Kong real estate [14] and commodity prices [15]. For those who see the silver lining in this and construe all this as a reason to buy more developed world stocks on the premise that the money flooding out of China (et al.) will be parked in the S&P are overlooking the fact that the purchase price of these now-unwanted positions was most likely borrowed, meaning that their liquidation will also extinguish the associated credit, not re-allocate it. [16]
While widening the trading bands keeps some semblance of rationality, this is anything but an orderly unwind of the world's largest carry trades:
[17]
For some context, this is the biggest quarterly drop in CNY since Q4 1993...
[18]
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.
[19]
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.
Below we have tried to simplify what is happening as much as possible... (since there are many pathways into and out of all of these positions) to try and enable most to comprehend the problem
Virtuous circle... (last few years)
- Specs sell USD/JPY/EUR, Buy CNY
- Use CNY to buy copper/commodities
- Use copper to finance credit
- Use credit to finance working capital/real estate purchases
- Real estate goes up, more credit available
- Copper goes up, more credit available
- encourages more buying CNY to start virtuous circle...
BUT what happens when one of these chains start to break? OR ALL OF THEM? (now!)
- Thanks to PBOC, can't roll debt via shadow banking system
- Can't rely on local govt to bail out cashflow
- Sell copper/commodities to meet cashflow needs
- Copper price goes down, credit tightens
- Credit tightens, Real estate prices drop
- Real estate prices drop, specs start exiting CNY
- CNY weakens...
And then... (tomorrow)
- Plenty more firms piled on to use the inexorable trend in CNY strengthening as their carry-trade piggy bank (or merely to hedge their export receipts)...
- Those derivative (over-hedges) are now losing money very rapidly...
- Liquidate hedges - downward pressure on CNY
- downward pressure on CNY, more losses...
Remember carry-traders are little more than sophisticated leveraged momentum players - so when the trend is no longer your friend, no amount of carry-arbitrage will cover MtM losses on the notional...
Arguing that the PBOC can defend the currency is moot (they clearly do not wish to); Arguing that the PBOC will manage liquidity via their huge FX reserves is moot (they have done so with the banks - who are awash with liquidity as noted by the low repo rates) - this is about forcing the shadow-banking system to shrink before the bubble becomes totally untenable... unfortunately, we suspect it already has...
Oh dear, remember the Chinese corporation that untenably insolvent but "promised" it would meet interest payments in July and not default... well:
- *BAODING TIANWEI BOND TRADING SUSPENDED BY SHANGHAI EXCHANGE
Uh oh...
All the carry-funded idiocy of the world is starting to uwind
[20]
As the world slowly realizes the Fed's growing hawkishness (what are they afraid of? or do they really believe that the economy is growing organically?)