from Follow the Money

The latest sign the apocalypse is upon us … CNY funded carry trades

January 26, 2007

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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If what rational world does it make sense for the currency of a high-investment, fast growing, still quite poor country to be the funding currency for a carry trade?

The Japanese yen and Swiss franc as funding currencies I get, even if it is hard to pin down the size of yen-funded carry trades using the balance of payments data.    Japan and Switzerland are wealthy slow growing economies with lots more capital than people.  China not so much. 

Though – picking up on something HK raised in the comments on a previous post, the notion that CNY appreciation would push up the currencies of all of Asia, including Japan, doesn’t necessarily seem to be holding.   Most of emerging Asia has been appreciating along with or faster than China.   But Japan hasn’t been.  And still isn’t.   Japan hasn’t been a good proxy – at least in the fx sense – for China.  Now the weak yen seems to emerging along side the weak RMB as a constraint on the willingness of a country like Korea to allow further appreciation.

The yuan carry trade is apparently financed with offshore yuan – which are a lot cheaper than onshore yuan.   Philip Bowring in the Asian Sentinel

The latest throw of the dice proffered as an “investment idea” is to take advantage of the low cost of borrowing in yuan in the offshore market. The implied cost of 12-month money is just 0.7 percent, which makes it about as cheap a funding currency as the yen.

But if banks can lend offshore yuan at 0.7%, someone else must be willing to hold yuan denominated accounts that pay even less in the hope of currency appreciation.   There are two sides to this trade.   And, well, funding a carry trade in the currency of a country facing enormous appreciation pressures is kind of risky.  But it is increasingly hard to make a buck.  Borrowing short-term in dollars and lending long-term in dollars doesn't cut it any more.

While I am on the topic, the WSJ’s oped on the “People’s Investment Corporatation”  wasn’t totally off the wall.  Which is a little unusual. But it wasn’t totally unobjectionable either.

Technically, foreign currency reserves are a central bank asset, not a liability (the Journal wrote: “Foreign-exchange reserves are liabilities on a central bank's balance sheet, not found money”). But the broader point the Journal was trying to make is right.    The PBoC has issued liabilities (sterilization bills, currency) to finance its growing assets, and it cannot just give away its assets … if someone else wants to manage some of the reserves now managed by the PBoC, it needs to buy the reserves off the PBoC with cash (which would allow the PBoC to reduce its liabilities). 

More importantly, the Journal tries to argue that China’s rapid reserve growth requires a lot more capital account liberalization while remaining silent on the bigger issue of whether the RMB needs to appreciate.   

That is a mistake.  Why?  China may still have more controls on outflows than on inflows (though I am not sure about that) but the recent trend has clearly been to loosen outflow controls and tighten inflow controls.   And, as the Journal notes, so far lifting controls on capital outflows hasn’t had much effect.   Investors aren’t flocking to the qualified to China's  “Qualified Domestic Investor Initiative” scheme. Chinese savers prefer to hold appreciating RMB than depreciating dollars.  Letting Chinese investors buy US stocks may not change that much either: Chinese stocks recently have been rising far faster than US stocks. 

More importantly – as Stephen Jen notes – the undervalued RMB currently makes Chinese assets, not just Chinese goods, incredibly cheap.  Jen:

A cheap CNY not only makes Chinese products cheap, but also makes Chinese companies cheap.  In a way, Chinese enterprises are being offered to foreigners at discount prices.  At the same time, the purchasing power of domestic investors looking to invest overseas is compromised by the cheap currency. 

That is why China limits capital inflows.  Greenfield FDI is welcome.  Foreign purchases of existing Chinese businesses generally are not.  Absent those inflow controls, there would be a lot of demand for Chinese assets at current exchange rates.

Liberlizing China’s capital account while holding the exchange rate constant would just generate outflows.  It would also permit big inflows.

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