The last 7 days have seen the unstoppable 'sure-thing' one-way bet of the decade appreciation trend of the Chinese Yuan reverse. In fact, the 0.95% sell-off is the largest since 1994 (bigger than the post-Lehman move) suggesting there is clear evidence that the PBOC is intervening.
The fact that this is occurring with relatively stable liquidity rates (short-term repo remains low) further strengthens the case that China just entered the currency wars per se as SocGen notes, intending to discourage arbitrage inflows. For the Chinese authorities, who do not care about the level of their stock market (since ownership is so low), and specifically want to tame a real-estate bubble, this intentional weakening is clearly aimed at trade - exports (and maintaining growth) as they transition through their reforms. The question is, what happens when the sure-thing carry-trade goes away?
BofA notes the puzzling divergence between Yuan fixings and short-term liquidity,
The turn of the Chinese New Year brought the People's Bank of China (PBoC) back into action - it not only restarted repo operations to withdraw liquidity, it actually did it at a much higher rate. The 7d reverse repo rate at which the PBoC injects liquidity is 75bp higher than a year ago, a move considered by the market as a 75bp rate hike over the last year. The new 14d repo (liquidity withdrawal) rate is set at 3.8%, 105bp higher than the rate when 28d repo was last conducted on 6 June 2013. Based on a simple framework, this move is equivalent to another 35bp rate hike (Rate corridor, Chinese style, 18 February 2014).
The puzzle is that both money and bond markets nearly totally ignored such an operation. The 7d repo rate is now fixed nearly 200bp lower since 10 February. Such a massive liquidity improvement in the face of the PBoC's liquidity withdrawal is puzzling, since by 10 February most of the cash used during Chinese New Year should have flowed back into the financial system already.
The FX market move also begs the question as to why liquidity improved over the last couple of weeks. Generally, the onshore repo rate rises as the RMB weakens against fixing; a normal development because FX outflow dries up liquidity. However, the move in February turned things upside down. Look at the sharp divergence between rates and FX
Which leaves 2 possible reasons for the divergence...
It is due to the seasonality of outflows, as this year could be made worse because the onshore rate was much higher before the Chinese New Year. As a result, banks might have borrowed more offshore, helping the RMB to appreciate. After the New Year, this flow reverses and pushes the RMB down. This explains why the CNY leads the CNH in spot selloff. It is also consistent with the large January FX purchase position of CNY466bn. The trouble with this explanation is that as the money flows out, the onshore rate should rise, not drop.
A more popular theory or suspicion puts the PBoC behind the move. As the PBoC buys more USD, it creates natural liquidity in the CNY, leading to much lower repo rates. This explanation is consistent with CNY leading the move, as CNY and CNH spots moved much more than forward, all suggesting a domestic investor-driven rather than foreign investor-driven endeavor. The trouble with this explanation is that the market will have difficulty proving it one way or the other without the central bank explicitly admitting it.
As SocGen notes, the latter makes more sense...
In just short seven days, the once unstoppable appreciation trend of the yuan is reversed. The USD/CNY spot has depreciated by 0.8% since 17 February and the USD/CNH has weakened by more than 1.1%. As for the causes, there is clear evidence of intervention from the People's Bank of China. We think that the recent yuan move is intended to discourage arbitrage inflows. If short-term capital inflows abate, the depreciation will probably halt.
Ending the inexorable carry trade...
The yuan appreciated by nearly 3% against the greenback and 7% against in nominal effective exchange rate terms in 2013. Over the same period, China's FX reserves added another $500bn, despite the repeated talk from officials that China has had enough reserves. These seemingly contradictory messages and signs, in our view, suggest that the PBoC never really wants too much yuan appreciation, especially if it is driven by short-term speculative capital inflows.
Which is crucial...
The yuan possesses the very two qualities of a carry trade currency: high onshore interest rates and a gradual but steady appreciation trend. The first quality is partly caused by the Fed's easing policy and partly by the PBoC's reluctance to ease domestic liquidity conditions out of concerns over debt risk. This condition is unlikely to weaken significantly in the near term. However, the PBoC is capable of altering the second condition and it seems that it is doing exactly so by reversing the appreciation trend and pushing up the volatility of the yuan.
If we are right about the reason behind the surprising deprecation of the yuan, what will follow next?
- Band-widening? Maybe, but as we have argued before, what matters is how the PBoC manages the currency. To make real difference, we think that the next step in yuan reform should be bolder: the PBoC should move from daily to weekly (or even monthly) setting of the reference rate, while at the same time widening the currency band.
- More depreciation? Probably not much more. Although the central bank does not like too much capital inflows, too much outflows will not be its choice either. The monthly FX position data are something to track for any change in the capital flow direction. A timelier indicator is the spread between CNH and CNY spot rate. If the offshore rate stays persistently weaker than the onshore one by a certain margin, that will be a sign of capital outflows. Then the PBoC will most likely choose to stabilise the yuan again.
The end-result is a concern:
Should the RMB weakening last a while longer, the cross border carry arbitrage flow which has been massive could reverse and lead to higher repo rates. Such a flattening force is a real threat, especially when the PBoC has shown no sign of lowering the repo rates in its operations.
But this certainly will not please the Japanese (trying to devalue and manufacture their own recovery) or any other beggar thy neighbor nation. Welcome to the Currency Wars China... (and we warned here, prepare for more carry unwind and a potential risk flare).
Potential asset deflation is a risk, as the carry trades diminish/unwind. Property prices are at risk – the collateral value for China’s financial systems. This is not a dire projection – it simply seeks to isolate the US QE as a key driver of China’s monetary policy and asset inflation, and highlights the magnitudes involved, and the transmission mechanism. Investors should not imbue stock-price movements and property price inflation in China with too much local flavor – this is mainly a US QE-driven story, in our view.
And lastly, as a bonus chart, we thought the correlation here was interesting...