China equilibrium *alert* | FT Alphaville

China equilibrium *alert*

All eyes are on the US Treasury bond sell-off (the longest drop since 2006 according to Bloomberg).

Given that, we thought it might make sense to throw this little development into the mixing bowl of the theories that are doing the rounds with respect to what’s driving it.

From Standard Chartered on Wednesday:

This month has brought signals of a subtle regime change in the People‟s Bank of China‟s (PBoC‟s) management of the external value of the Chinese yuan (CNY). We have seen a considerable upturn in the volatility of the daily PBoC fixes for USD-CNY and, more specifically, two sharp fix-to-fix CNY losses.

This new behaviour in the fixes may soon be followed by a widening of the USD-CNY daily trading band. We still expect a doubling of the band width to +/-1.0%, although comments from PBoC adviser Li Daokui have boosted chances of a more modest increase (to +/-0.75%). The impact of band widening should not be judged in too narrow a context.

Strictly speaking, the step does not give direct insight into the future trajectory of USD-CNY, and the impact on implied volatilities in the options market is ambiguous, potentially boosting deliverable option volatility at the expense of cash-settled option volatility. However, this misses the big picture.

The combination of the recent change in the behaviour of the USD-CNY fixes and a likely band widening represents a clear signal from the Chinese authorities that there has been a more decisive shift toward „twoway variability‟ in USD-CNY. The CNY will now likely be managed without any official bias on the direction of the next big move in CNY valuations. Against this backdrop, relative value investors should buy dips in USD in the USD-CNY 6M and 12M NDFs, and buy USD-CNH short-dated call spreads.

And here’s that rising volatility in CNY fixes in chart form:

So what does all this mean in lay speak?

By and large, that China’s highly manipulated currency market is on the verge of ‘equilibrium’.

That’s to say, the country is no longer attracting enough dollar inflows to justify its long-orchestrated currency manipulation, a.k.a Treasury buying… a.k.a Chinese-led US quantitative easing.

As Standard Chartered’s Robert Minikin and team explain:

Given diminished expectations of CNY gains, China‟s overall balance of payments (BoP) is likely not far from equilibrium in the early months of 2012. The heavy short-term capital inflows (likely linked to shifts in corporate hedging behaviour) we saw in H1-2011 are likely not being repeated in H1-2012. Moreover, China typically posts a weak trade performance at the start of the calendar year (Q1-2011 saw a USD 0.7bn trade deficit). With demand and supply for CNY on the mainland now more evenly balanced, this is an ideal time to allow market forces to play a bigger role in driving CNY valuations and to widen the trading band.

Hence why the offshore CNH market’s usual premium has come pretty unstuck of late:

The question is, what happens if those forces take CNY beyond equilibrium? For example, to the point that selling the country’s US Treasury reserves might even start to make sense?

It’s definitely a point some in the market have been making. Take for example the latest post by finance blogger Bruce Krasting:

China’s 2011 total trade surplus was $183B. The surplus with the USA was $270B; the US was 150% of China’s total surplus. China imports lots of “stuff.” Crude oil is high on that list. Increased domestic consumption, plus additional imports for strategic storage, have pushed up imports to 6 million barrels per day in February. At that rate, the 2012 import bill for crude will be $250B, approximately equal to the US trade deficit with China.

The US/China trade deficit is creating USD surpluses for China’s largest crude suppliers, Saudi Arabia. Angola and Iran are the largest providers. These countries are not America’s friends, and they already have too many dollars. When Americans shop at Wal-Mart, they are actually sending dollars to Iran. In 2012, it will come to about $25B of “our” money that ends up with the Ayatollahs. Welcome to the global village.

As a result of the shrinking trade surplus and the need to import expensive crude, China does not have the investable dollars it once had. So it is no longer buying US Treasuries at the previous fast pace. At the same time, the US Treasury is issuing debt at the rate of $100B a month. If the Chinese aren’t buying debt, then it must be sold to other dollar holders.

Furthermore, let’s not forget the comments out of Premier Wen Jiabao this week. As Capital Economics neatly summed up on Thursday:

His comments on the currency are more important. Wen drew attention to the much lower current account surplus and the reduced expectations of currency appreciation now priced into the nondeliverable forwards market to suggest that the renminbi may have reached “an equilibrium level”. That would remove an important barrier to the People’s Bank (PBC) relaxing its hold on the currency’s value.

Unlike those on political reform, the view that the currency is no longer significantly undervalued seems to have widespread support in the government. But policymakers are unlikely to want to relax exchange rate controls all at once. The next major step will probably be a widening of the renminbi’s trading band with the dollar. The renminbi is currently allowed to fluctuate by up to 0.5% in either direction each day, relative to the opening reference rate that is set by the PBC. (See Chart 2.)

A widening of the band would be symbolically important, but its practical significance would be low unless PBC behaviour also changed. In other words, since the renminbi rarely moves anything close to the 0.5% each day that is currently allowed, it will be more important to watch how the renminbi actually performs, rather than assume that a policy reform signals a big shift in thinking. Intra-day movement on the renminbi was hardly any different after the band was last widened, in 2007.

Could the Treasury sell-off be connected after all? Presumably, only time will tell.

Related links:
Yuan Unlikely to See 5%-6% Annual Gains, China Researcher Says – Bloomberg
Chinese CNH – YOURS! – FT Alphaville