Easy Currency Bet Gets Harder as the Chinese Yuan Tumbles

27 Feb,2014

A sharp and sudden slide in China's yuan is forcing investors to rethink one of the most reliable trades in financial markets over the past four years: betting on gains in the Chinese currency.

Since China resumed efforts to move the yuan higher in 2010, traders have piled into bets that profited as the currency has staged a seemingly relentless advance. But after hitting a record against the dollar in mid-January, the currency has dropped over 1%, reaching a six-month low on Tuesday.

China's central bank determines a daily reference point for the yuan, also known as renminbi, then lets it trade 1% higher or lower. Since 2005, it has gradually moved the rate up, allowing the yuan to strengthen 33%. A linked currency, called the "offshore" yuan, trades freely in Hong Kong.

It isn't clear how much the recent decline in the yuan reflects economic fundamentals and how much may reflect a concentrated effort from the Chinese government. The economy slowed somewhat in the fourth quarter, to 7.7% year over year, from 7.8% in the third quarter, which is the way the government measures gross-domestic-product growth. On a quarterly basis the slowdown was even sharper, and analysts say the economy is likely to continue to decelerate in the early part of this year.

A number of recent indicators have showed weakness, particularly purchasing-managers indexes, which have indicated broad retrenchment in manufacturing. Trade figures have been bullish, but those numbers may be distorted by exporters overbilling as a way to get more money past China's capital controls.

But the yuan "is basically still driven by policy makers rather than market forces," noted Royal Bank of Scotland Group PLC's Louis Kuijs in an analyst note. He said the central bank is "keen to move to more exchange-rate flexibility and volatility."

Analysts say China may be trying to shake out short-term speculators, part of a broader effort to reduce the amount of cash sloshing around the country's economy. The move could also be a signal to investors that they should prepare for more volatility in the yuan's exchange rate as the country opens up its financial markets to the world. 

While some money managers have held on to their bullish yuan bets, or even added to them, the yuan's recent moves show that, as China's central bank gradually relaxes its grip on the currency, one-way wagers on its appreciation are no longer a sure thing.

China has halted the yuan's rise before. It kept the exchange rate steady for two years after the financial crisis. And in 2012, the yuan was allowed to sink about 1.5% over a roughly three-month period. Since then, it has risen more or less steadily.

Washington has long asked Beijing to give the market a bigger role in the exchange rate, and most of the U.S. political pressure has been for China to let the yuan strengthen, which tends to make American-made goods more competitive by rendering them cheaper by comparison. Policy makers in Washington and other leading economies would be unlikely to criticize China for intervening to push down the yuan unless it led to a substantial depreciation, said David Loevinger, a former Treasury official who is now an analyst at investment firm TCW Group Inc.

A spokeswoman for the Treasury Department declined to comment on the recent weakness in the yuan and pointed toward Treasury Secretary Jacob Lew's recent comments. "They're moving towards market-determined exchange rates," Mr. Lew said Friday in Sydney. "As we've noted in our exchange reports over and over, we still raise concerns about it."

Officials from Beijing and other members of the Group of 20 biggest economies affirmed Sunday in statement released in Sydney that "exchange-rate flexibility can also facilitate the adjustment of our economies."

At the Sydney meeting, Chinese Finance Minister Lou Jiwei dismissed concerns over the yuan's slide, saying that it doesn't reflect fundamental economic changes and that the yuan still trades within its "normal range."

Investors earned small but predictable returns as the central bank allowed the yuan to strengthen steadily. Funds that primarily own the yuan and bonds that are priced in the currency have returned about 5% over the past year, even as the vast majority of emerging-market funds have lost money, according to Morningstar Inc.

The yuan's steady appreciation has also drawn the attention of so-called hot money—short-term speculators looking to turn a quick profit as the currency rises.

Analysts say it was those traders who were stung by last week's selloff. Many wagered on the yuan via options contracts and other derivatives. These investments magnify profits from small gains in the currency but can also lead to big losses when the currency reverses.

Some money managers looking for longer-term investments are also wary of how popular the yuan trade has become. Binqi Liu, a New York-based portfolio manager at HSBC Global Asset Management, which oversees $420 billion, said she reduced her bets in favor of the yuan in January, as she felt bullish wagers were drawing too much money.

"Everybody on the Street likes the renminbi," said Ms. Liu. "Whenever it's this crowded, any change in the market tends to be magnified, and the volatility will be higher. We prefer to stay neutral."

Others are viewing the dip as a buying opportunity. They see little sign of a permanent shift in China's currency policy, which calls for a gradual loosening of control over the yuan. That suggests a stronger currency in the future, since many economists believe the yuan's value is set at an artificially low level. Any further losses may also be limited as China remains under pressure from trade partners, including the U.S., to keep letting the yuan rise.

"The volatility in the yuan can increase for sure, but the general path of appreciation will continue," said Roland Gabert, a Frankfurt-based portfolio manager at Deutsche Asset & Wealth Management, a subsidiary of Deutsche Bank AG.

—William Mauldin and Bob Davis contributed to this article.

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