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By

Matthew Garrett
@MattGarrett3

11/13/14

An Offshore Swan: Could the next financial crisis be sparked by


China being pulled into the Currency War?

The Context
- For nearly a decade Chinas maturation from a major exporter into a global
economic dynamo has occurred with the embedded assumption that CNY
will continually strengthen. This made sense given the backdrop of a
currency that has been held well below a market driven rate by the peg to the
USD and then managed float. Chinas Yuan policy also included strict foreign
capital controls that significantly limited outside investors avenues to
partake in this compelling carry-trade.

Outperformance of CNH Carry Trades (Sharpe Ratios)


China has begun to liberalize its financial system and Yuan policy. One major
step was greatly relaxing restrictions on the Hong Kong based offshore Yuan
(CNH). While this currency is somewhat tethered to the onshore Chinese
Yuan (CNY), it is at the end of the day a market driven currency. The CNH
became the funnel for foreign money to participate in the carry and for
onshore entities to borrow in foreign currency.


CNY-CNH Spread




The Currency War Stresses
- As the PBOC pursues internationalization of the CNY the currency has been
freed to appreciate in increasingly looser trading bands, currently 2% from
the fix. This has occurred while the Chinese economy attempts to pivot from
largely being export and investment driven to more consumption and
services driven.
- Currently Chinas export sector is under significant pressure from some of its
largest trading partners via the BOJ and ECBs forward balance sheet
expansion, driving down their currencies. Exacerbating this move is the FED
ending QE and speaking to further policy normalization putting upward
pressure on the USD and by extension CNY.


The chart below shows CNYs spot return (%) against major trading
partners

The stresses from exchange rates are likely not in synch with the PBOCs
timeframes for allowing services and consumerism to fill the gap left by
exports.

This puts direct pressure on Chinas exports during a time when aggregate
demand out of EU is weak and Japan is very shaky. That said, Chinas pivot in
trade and economic ties is directed at AXJ (Asia ex-Japan).


Internal Credit Market Stresses
- The PBOC has gone to great lengths to provide funding facilities to the
overextended and cycling down credit markets while avoiding a wholesale
policy cut (Benchmark rates and required reserve ratio). The latest iteration,
the Medium-Term Lending Facility, provided 3-month liquidity at 350bps to
the tune of 769.5B Yuan in Sept and Oct.
- The heavily levered Chinese corporates (w/ debit-GDP levels of 124%, as
noted by BAML) have increasingly turned to USD bond issues.

A continued deterioration in credit markets would warrant a move on


benchmark rates and required reserves. As this possibility grows it is likely
to be reflected by higher vols.



Positioning and Market Structure Risks.
- Given the long running, strong performance of the CNY and CNH carry trades
over the past few years and the rapid growth in the offshore currency
market, it reasonable to expect net exposure is large and leveraged with
investors and financial institutions. Furthermore, the size of cross border
trade with China has led RMB to be the 2nd largest trade finance currency.
This leads me to believe that foreign corporates may have large expsure to
the carry via RMB trade finance arrangements and evidenced by over-
invoicing. Furthermore, this could be resulting in a favorable and potentially
fleeting skew to the underlying economics of trade with China.
- Anecdotally, having spoken with a businessman who imports from China, I
sensed more excitement about his exposure to the currency than the
underlying business.



Summing it up
- As described above, a confluence of events and circumstances exist that
cause me to be weary of the engrained (but increasingly questioned)
assumption of a one-way path (and trade) for the Chinese currency. In fact, I
would put a far better than 50/50 chance that the CNY and CNH will
experience a period of unprecedented depreciation and volatility over the
next 12 months. Future volatility will likely exceed the bout of volatility
experienced in 1Q2014 brought on by the PBOC to shake out one-sided bets.
The implications would be hugely disruptive to global markets.

USDCNH 2 week historical volatility vs. 1 month implied volatility


Implied vol rerated higher with the PBOC doubling of the USDCNY trading
band to 2% on March 17, 2014.



Possible Triggering Scenarios for Disruptions

1. An external market shock- This could be broad market volatility brought on
by the FEDs positioning away from ZIRP that will have spillover on the
EMEs and carry trades. Market volatility (risk-off environment) could also
come in the form of credit market contagion stemming from the energy
space (which makes up ~18% of N.A. HY).
2. PBOC broad based monetary policy loosening (this includes changes to FX
trading bands and/or new cheap money lending programs)- This can come
in response to; (a) further credit market deterioration; (b) weak economic
and inflation prints; and (c) pressures exerted by the current round of
currency devaluation by other central banks.
3. Emergence of an alternative regional or global currency scheme, outside of
the existing system.

Potential Mitigants

1. Large pools of incremental foreign capital that would find local currency
products attractive if a risk-on environment firmly takes hold.
2. Strong growth in Chinese consumption and services sector offsetting export
weakness.
3. Remaining policy levers at the PBOCs disposal.

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