Conclusion: Given the asymmetry of both the pricing setup and fundamental outlook, secular yuan weakness and a bearish re-pricing of the Dim Sum bond market are two long-term TAIL risks we are flagging to you at the current juncture.
The most topical news out of Asia this morning came with the PBOC’s decision to widen the yuan’s trading band (vs. the USD) to up to 1% from its daily reference rate (from 0.5% prior). In theory, this should increase the volatility of the yuan, especially given the central bank’s desire to “promote price discovery” by enhancing the “two-way flexibility” of the currency. The PBOC did, however, state that they will keep the yuan “basically stable at an adaptive and equilibrium level” – denoting no change from their 2012 policy outlook statement or their actions (the yuan is down only -14bps vs. the USD since the start of the year).
We strongly caution against joining in the consensus hoopla which is still largely stuck on the secular yuan appreciation story. In fact, we are of the view that the China’s currency will likely weaken over the intermediate term as declining trade flows and a dramatically-subdued inflation environment gives the PBOC cover to pursue easing policy in the form of currency devaluation – a method of monetary easing that doesn’t necessarily undermine the State Council’s oft-restated goal of quashing speculation in China’s domestic property market. For a more in-depth look at each of those trends, please refer to our APR 10 piece titled, “China Is Boring”.
Jumping back to the consensus yuan appreciation story, the China Securities and Regulatory Commission’s decision to meaningfully expand its Qualified Foreign Intuitional Investor (QFII) and Renminbi QFII quotas ($80B from $30B; CNY50B from CNY20B) and a rebound in the country’s FX reserves in 1Q12 (+3.9% QoQ after posting their first quarterly decline in 4Q11 since 2Q98) are each contributing to a consensus view that China will continue to allow the yuan to appreciate as it seeks a greater international role for its currency amid unrelenting political pressure.
Per Bloomberg consensus forecasts, the yuan is likely to gain an additional +2.7% vs. the USD through year-end and an additional +4.3% in 2013. Looking to the premium/discount spread for offshore (Hong Kong) vs. onshore (Shanghai) rates, the buy-side is also bullish on the yuan in aggregate – assigning a +12bps premium to obtain yuan in Hong Kong, though down from +58bps in JAN. Because international investors are generally limited to obtaining offshore yuan for exposure to China’s currency, the premium/discount they apply to the onshore rate can be a colorful tool in determining how [collectively] bullish/bearish the buy-side is on the yuan at the present moment.
Lately, however, a noteworthy divergence has emerged in the relationship between the yuan’s present outlook with its future outlook. 1yr non-deliverable forwards (settled in USD) for both the CNY (onshore) and CNH (offshore) USD crosses are trading at a -0.6% and -1.2% discount, respectively, to their present rates – signaling that investors are increasingly hedging for yuan weakness, rather than strength, over the NTM.
The present-day bullishness on the yuan and recent yuan strength (Asia’s best-performing currency vs. the USD and EUR over the LTM) have been a boon the Dim Sum bond market, which are denominated in yuan and traded in Hong Kong (named after the territory’s famous cuisine, which also happens to be this ex-offensive lineman’s favorite food). Per Bank of America Merrill Lynch’s index(s), Dim Sum bonds have returned a record +3.4% in 1Q12, with average yields on corporate bonds falling -63bps YTD to 4.89%. Mean reversion has also been supportive here; Dim Sum bonds fell -3.9% in 2011 according to a Bank of China Ltd. index amid record new supply ($23.7B in ’11; on pace for $33.8B in ‘12), waning demand (yuan deposits in Hong Kong peaked in NOV), and increased scrutiny regarding their creditworthiness (only 37% of Chinese company issues are rated in the BofA index; Moody’s raised “red flags” on all 61 companies it examined in a JUL ’11 report).
Despite those headwinds, a consensus desire to seek exposure to China’s currency appreciation story by any means necessary has contributed to a fair amount of price dislocation in China’s corporate bond market, with top-rated onshore issuers paying an average of 4.81% on their bonds vs. 2.54% for investment-grade Dim Sum issuers. To the extent that the secular, one-sided yuan appreciation story is peaking/has peaked, we would expect to see some degree of arbitrage here over the long-term (i.e. the yuan appreciation premium inherent in Dim Sum bonds is unwound) – especially if the Chinese yuan actually starts to exhibit the two-way flexibility the PBOC claims it seeks.
While we can’t know for sure at the current juncture, who’s to say the Chinese yuan isn’t dramatically overvalued, especially given that capital account flows (while minimal) have been as one-sided [inbounding] as China’s trade flows have been over the last decade or so? What if during the process of China’s liberalization of its capital account its large stock of domestic savings begins to flow offshore in search of higher risk-adjusted real rates of return? Currently, China’s domestic savers’ options for investment are rather limited and unattractive: property market speculation (policy headwinds there); domestic equities (Shanghai Composite Index was down -14.3% in 2010 and another -21.7% in 2011); and savings accounts (negative real interest rates locked up at systemically risky banks). If capital outflows ever sustainably exceed China’s trade and investment income – which are likely both headed lower over the long-term as the country rebalances towards increased consumption (lower net exports) – a secular bear thesis for the Chinese yuan wouldn’t be that difficult to justify.
At the bare minimum, we think those are questions and scenario analyses that neither the buy-side nor sell-side has begun to explore en masse, and given the asymmetry of both the pricing setup and fundamental outlook, secular yuan weakness and a bearish re-pricing of the Dim Sum bond market are two long-term TAIL risks we are flagging to you at the current juncture.