That’s the ominous title of an FX note posted by George Saravelos of Deutsche Bank on Friday morning.
It seems something is up in the big emerging market arbitrage window of the sky known as the onshore/offshore Chinese currency market.
To recap on the processes in hand…
The closed nature of China’s currency market creates a fragmented valuation process for the Chinese renminbi, and many different forward prices. At the heart of it, you have three different markets: the closed internal market (totally controlled by the Chinese government), the non-deliverable forward market — a derivative market created by outsiders wanting exposure to the Chinese currency — and most recently, the Hong Kong deliverable market, a new endeavour designed to allow some (supervised!) interchange between the two.
In many ways, that market — known as the CNH offshore market — operates a bit like a massive exchange traded fund. For example, international flows are able to impact prices, which can lead to premiums and discounts versus the home currency. But only one authorised (national) market maker is allowed to bridge the two markets.
To ensure the two markets trade in tandem, this designated clearing bank (Bank of China’s Hong Kong arm) buys and sells currencies in line with official quotas in an attempt to make sure that the CNH market ultimately follows the CNY currency at home (and official policy rates). All arbitrage opportunities between the two markets are in this way captured by the state, and kept out of reach of evil speculators.
Generally speaking, if a premium appears in CNH versus CNY, the clearer delivers more CNY to the Hong Kong market. In the reverse scenario, the bank delivers CNY to the home market in order to support the offshore market.
The tendency, of course, has always been for the bank to deal with premiums on the offshore side of the trade, due to a general robust demand for yuan internationally. (And a general depreciation policy domestically.)
But as Saravelos notes on Friday this trend apprears to be reversing quickly (our emphasis):
Irrespective of European progress, we believe developments on the other side of the Eurasian continent will be of equal importance to the euro outlook going forward. H2 has seen a meaningful drop in China’s FX reserves, also reflected in the constant upward pressure on USD/CNY spot relative to the daily fix (chart).
The last few days have also seen a sharp deterioration in the availability of offshore CNH liquidity, leading to a spike in USD/CNH forwards. Not only does this point to funding pressures in markets outside of Europe, but it is likely to further encourage outflows from onshore China.
* At the margin, a lack of reserve accumulation reduces rebalancing demand for euros, a dynamic which we beleive has already been at play over the last few months across most EM. A broadening of this theme on the back of increased risk-aversion would generate reserve rebalancing supply, rather than demand for euros, and would only serve to accelerate the EUR/USD weakening trend which we have been arguing for some time.
That’s to say, the CNY market is trading super weak due to low demand from US and European investors.
Standard Chartered echoed the point earlier this week:
Why is the Chinese yuan (CNY) trading weak? Since the middle of September, USD-CNY has traded fairly consistently below the morning fixing. It has tested the weak end of the daily +/0.5% band five times to date, and generally in the last two weeks the CNY has ended the day with no offer.
Weirdly enough, the key problem for the Chinese is that it’s much easier to debase the offshore market than to support it. Especially if you’re not receiving the USD and EUR inflows you’ve previously been used to. The clearing bank, accordingly, has official quotas on how much offshore money it can channel into the domestic system.
With a lack of USD and EUR inflows, Deutsche Bank for one believes China might be tempted to start selling euro or dollar reserves to overcome what is becoming a very ugly disturbance in the arbitrage mechanism.
Indeed this chart from Standard Chartered aptly illustrates the situation:
As the analysts at Standard Chartered explain:
Chart 1 shows the percentage difference between the day-end USD-CNY price to the fix (we use the 5-day moving average to smooth out some of the volatility). This price action suggests that the market is not selling US dollars (USD) as it once did and that the People‟s Bank of China (PBoC) could be selling USD from its FX revenues. The FX reserves fell in September and initial indications for October suggest that this trend has continued. With China still running a sizeable trade surplus (USD 17bn in October), some suggest that CNY weakness could be evidence that „hot money‟ is leaving the country. The recent falls in bank deposits have added to this view (we examined that concern in On the Ground, 5 September 2011, ‘China – The rise of wealth management products’).
But while hot money reversal might be seen as a tempting explanation, Standard Chartered are actually of the opinion that all this could be the result of changing FX preferences among exporters:
CNY appreciation expectations have fallen again, and some in the market even look for CNY depreciation. Importers are now buying more USD again. Importers‟ behaviour is also affected by the new offshore CNH market.
———————— In mid-September, just when USD-CNY began to trade weaker onshore, the CNH moved sharply into discount, and it was at this point that exporters, rather than importers, had a big incentive to sell their USD offshore rather than onshore. (Chart 10 shows the USD-CNY/USD-CNH dynamics.)
Suddenly, exporters onshore stopped selling their USD to the banks, and importers suddenly started buying more, the results of which we show in Chart 7.
Either way, beware of prospective Chinese euro or dollar sales in the very near future.
