Yuan FX market better get used to volatility
Lu Jianxin and Kevin Yao - Analysis
SHANGHAI/SINGAPORE
Mon May 3, 2010 9:27am EDT
SHANGHAI/SINGAPORE (Reuters) - The bumpy ride in China's onshore yuan markets in the past month may be just the start of a learning curve for the country's big companies and banks on how to cope with currency volatility.
When China relaxes its tight grip on the yuan, widely expected in coming months, Beijing will start stepping back from keeping the currency under its thumb and will likely need to encourage market volatility to take its young financial markets through the next stage of development.
China has never really had to deal with real currency volatility, even after it unshackled the yuan between mid 2005 and mid 2008. Daily moves were often less than 0.3 percent due to the central bank's close management of the yuan, and as such the art of currency hedging remains a new one.
If Beijing is as determined as it claims to make Shanghai a global financial center by 2020 and rebalance the economy away from exports, the country's ruling authorities need a freer currency on the way toward convertibility.
The sudden plunge in onshore yuan forwards this month that caused dollar funding costs to spike for Chinese companies served as a wake up call that more volatility is on the way.
"There's a sort of panic as expectations grow each day for a resumption of yuan appreciation," said a senior dealer at a major Chinese commercial bank in Shanghai. "It's an unprecedented awakening of currency risks for banks and their corporate clients."
Some analysts have said Beijing could announce a one-off yuan revaluation or policy change, like widening the currency's daily trading band, any day. Most expect an end to the virtual peg of the past 22 months between now and July.
A renewed yuan rise is expected to be gradual and smooth to start, perhaps the first few months.
But greater volatility within the current limits -- 0.5 percent either side of the yuan's daily mid-point on the official CFETS trading platform -- should presage a wider trading band and bigger intraday swings.
"A gradual widening of the yuan's trading band is a must, and that will also help increase the volatility of yuan derivative markets," said Liu Dongxiang, currency strategist at China Merchants Bank in Shenzhen.
Liu said that more volatility will force many small and medium-sized Chinese companies to start protecting themselves against currency swings for the first time, following the large state-owned companies and foreign firms that have a bit more experience.
"Trading bands are some sort of daily limit system for a market, and they should be phased out as part of China's efforts to eventually make the yuan fully convertible. Once the yuan can move up or down as much as several percentage points in a day, the Chinese market will become the same as mature markets."
FLUTTERS IN FORWARDS
A bout of heavy selling in onshore currency forwards in April drove the yuan up against the dollar and sparked speculation that big Chinese companies knew something that offshore players did not on how quickly Beijing could act on allowing appreciation.
In fact, the onshore market had been spooked by the offshore market as speculation swirled around President Hu Jintao's visit to Washington.
The domino effect was jarring. The corporate selling caused a shortage of dollars in the Shanghai money markets because when dollars are sold, they are typically handed over to the foreign exchange authorities and not released back into the market.
The subsequent jump in implied dollar rates drove down onshore forwards, forcing some banks and companies to unwind popular arbitrage trades that take advantage of the discrepancies between onshore forwards and non-deliverable forwards (NDFs).
All the while, traders said the sharp drop in dollar/yuan onshore forwards was not a signal that companies saw a yuan rise around the corner but the ripple effect from corporate hedgers and market players getting caught off guard by the move.
Dollar funding costs implied by one-year onshore forwards soared 130 basis points in just a week to a high of 4.635 percent on Monday -- a 19-month high.
By the end of the week, the market had calmed down and the implied dollar rate settled back to 3.93 percent even after the State Authority of Foreign Exchange cut quotes on banks' foreign debt borrowing this week to limit "abnormal" capital inflows, confirming an earlier Reuters report.
Dealers are worried the move -- seen as trying to limit yuan speculation before a policy shift -- would likely cut dollar supply further and squeeze onshore-offshore arbitrage trades.
The shake-out in onshore/offshore arb trades highlighted how the NDF market is driven by more than just speculation about yuan appreciation by foreign hedge funds -- and thus the implied yuan appreciation in yuan NDFs may actually understate how much foreign players are expecting.
One-year NDFs are now implying a 3.3 percent rise in the yuan, while three-month NDFs are pricing in a 1.3 percent rise.
Qing Wang, an economist at Morgan Stanley, said in a note earlier this month that such foreign debt borrowing at Chinese and foreign banks -- totaling $408.7 billion at the end of March, nearly doubling from the previous year -- had served as a powerful source of borrowing for banks since the authorities started cracking down toward the end of last year.
The currency hedging of that borrowing by buying dollar/yuan NDFs would help offset the selling by offshore speculators looking for a yuan rise.
But with those borrowings being cut and the onshore/offshore arbitrage window closing, more volatility may be around the corner, traders said.
The market is starting to brace for more volatility, but only in the short-term.
Implied volatility on yuan options has been rising in short-term tenors, with one-month vols at 3.1 percent and up from 0.8 percent at the start of the year while one-year vols have fallen to 3.8 percent from 5.25 percent.
That has caused the implied vol curve to flatten as far as 0.5 vol, among its flattest levels in the past decade as the market eyes bigger spot yuan swings in the near-term but limited day to day moves has reduced the attraction of buying vol in the one-year tenors, leading to the drop in implied vol.
Local market players in Shanghai recognize that currency market volatility will be a necessary condition for the market to develop the way it must.
"Even bigger volatility will certainly occur in future when China depegs the yuan as the country is poised for deepening reforms of its currency mechanisms.
"Such steep fluctuations are also very much needed to teach Chinese companies, including exporters, about currency risks. The yuan peg to the dollar has protected the Chinese corporate world for too long," said Wang Haoyu, economist at First Capital Securities in Shenzhen.
Lu Jianxin and Kevin Yao - Analysis
SHANGHAI/SINGAPORE
Mon May 3, 2010 9:27am EDT
SHANGHAI/SINGAPORE (Reuters) - The bumpy ride in China's onshore yuan markets in the past month may be just the start of a learning curve for the country's big companies and banks on how to cope with currency volatility.
When China relaxes its tight grip on the yuan, widely expected in coming months, Beijing will start stepping back from keeping the currency under its thumb and will likely need to encourage market volatility to take its young financial markets through the next stage of development.
China has never really had to deal with real currency volatility, even after it unshackled the yuan between mid 2005 and mid 2008. Daily moves were often less than 0.3 percent due to the central bank's close management of the yuan, and as such the art of currency hedging remains a new one.
If Beijing is as determined as it claims to make Shanghai a global financial center by 2020 and rebalance the economy away from exports, the country's ruling authorities need a freer currency on the way toward convertibility.
The sudden plunge in onshore yuan forwards this month that caused dollar funding costs to spike for Chinese companies served as a wake up call that more volatility is on the way.
"There's a sort of panic as expectations grow each day for a resumption of yuan appreciation," said a senior dealer at a major Chinese commercial bank in Shanghai. "It's an unprecedented awakening of currency risks for banks and their corporate clients."
Some analysts have said Beijing could announce a one-off yuan revaluation or policy change, like widening the currency's daily trading band, any day. Most expect an end to the virtual peg of the past 22 months between now and July.
A renewed yuan rise is expected to be gradual and smooth to start, perhaps the first few months.
But greater volatility within the current limits -- 0.5 percent either side of the yuan's daily mid-point on the official CFETS trading platform -- should presage a wider trading band and bigger intraday swings.
"A gradual widening of the yuan's trading band is a must, and that will also help increase the volatility of yuan derivative markets," said Liu Dongxiang, currency strategist at China Merchants Bank in Shenzhen.
Liu said that more volatility will force many small and medium-sized Chinese companies to start protecting themselves against currency swings for the first time, following the large state-owned companies and foreign firms that have a bit more experience.
"Trading bands are some sort of daily limit system for a market, and they should be phased out as part of China's efforts to eventually make the yuan fully convertible. Once the yuan can move up or down as much as several percentage points in a day, the Chinese market will become the same as mature markets."
FLUTTERS IN FORWARDS
A bout of heavy selling in onshore currency forwards in April drove the yuan up against the dollar and sparked speculation that big Chinese companies knew something that offshore players did not on how quickly Beijing could act on allowing appreciation.
In fact, the onshore market had been spooked by the offshore market as speculation swirled around President Hu Jintao's visit to Washington.
The domino effect was jarring. The corporate selling caused a shortage of dollars in the Shanghai money markets because when dollars are sold, they are typically handed over to the foreign exchange authorities and not released back into the market.
The subsequent jump in implied dollar rates drove down onshore forwards, forcing some banks and companies to unwind popular arbitrage trades that take advantage of the discrepancies between onshore forwards and non-deliverable forwards (NDFs).
All the while, traders said the sharp drop in dollar/yuan onshore forwards was not a signal that companies saw a yuan rise around the corner but the ripple effect from corporate hedgers and market players getting caught off guard by the move.
Dollar funding costs implied by one-year onshore forwards soared 130 basis points in just a week to a high of 4.635 percent on Monday -- a 19-month high.
By the end of the week, the market had calmed down and the implied dollar rate settled back to 3.93 percent even after the State Authority of Foreign Exchange cut quotes on banks' foreign debt borrowing this week to limit "abnormal" capital inflows, confirming an earlier Reuters report.
Dealers are worried the move -- seen as trying to limit yuan speculation before a policy shift -- would likely cut dollar supply further and squeeze onshore-offshore arbitrage trades.
The shake-out in onshore/offshore arb trades highlighted how the NDF market is driven by more than just speculation about yuan appreciation by foreign hedge funds -- and thus the implied yuan appreciation in yuan NDFs may actually understate how much foreign players are expecting.
One-year NDFs are now implying a 3.3 percent rise in the yuan, while three-month NDFs are pricing in a 1.3 percent rise.
Qing Wang, an economist at Morgan Stanley, said in a note earlier this month that such foreign debt borrowing at Chinese and foreign banks -- totaling $408.7 billion at the end of March, nearly doubling from the previous year -- had served as a powerful source of borrowing for banks since the authorities started cracking down toward the end of last year.
The currency hedging of that borrowing by buying dollar/yuan NDFs would help offset the selling by offshore speculators looking for a yuan rise.
But with those borrowings being cut and the onshore/offshore arbitrage window closing, more volatility may be around the corner, traders said.
The market is starting to brace for more volatility, but only in the short-term.
Implied volatility on yuan options has been rising in short-term tenors, with one-month vols at 3.1 percent and up from 0.8 percent at the start of the year while one-year vols have fallen to 3.8 percent from 5.25 percent.
That has caused the implied vol curve to flatten as far as 0.5 vol, among its flattest levels in the past decade as the market eyes bigger spot yuan swings in the near-term but limited day to day moves has reduced the attraction of buying vol in the one-year tenors, leading to the drop in implied vol.
Local market players in Shanghai recognize that currency market volatility will be a necessary condition for the market to develop the way it must.
"Even bigger volatility will certainly occur in future when China depegs the yuan as the country is poised for deepening reforms of its currency mechanisms.
"Such steep fluctuations are also very much needed to teach Chinese companies, including exporters, about currency risks. The yuan peg to the dollar has protected the Chinese corporate world for too long," said Wang Haoyu, economist at First Capital Securities in Shenzhen.