Yuan devaluation a horror story for "Carry-Traders"

Wednesday 26th August 2015

 Yuan devaluation a horror story for "Carry-Traders"

Ref : "China's Yuan Shock Gives Carry-Trade Crowd Worst Year Since '08", Bloomberg Online.

We're going to take a step back from the panic and take a look at one the less-talked about effects of the recent events in China, in non-professional circles anyway.... and we're going to keep it simple.

One of the basic principles of banking (to do it successfully, at any rate !) is to borrow money at a lower rate and lend it at a higher rate. A no-brainer, right ? The same applies if you borrow in one currency and lend in another, though this obviously requires foreign exchange transactions and is known as a carry-trade.

So for a hypothetical example, a trader might :

Borrow in Currency A at 1.00% for a certain period ---  Sell Currency A, Buy Currency B  --- Lend in Currency B for the same period at 5.00%  ----  At the end of the period, Sell Currency B, Buy back Currency A  ---  Repay original loan in Currency A.

Thus he has made 4.00% in interest rate differential over the period. The danger is that there is an obvious foreign exchange risk : if Currency B weakens during the period, he'll have to pay more to buy back Currency A, which depending on the extent of the depreciation could make the deal a serious loss-maker. So it can be dangerous, and has been likened to picking up pennies in front of a steamroller. Relatively stable conditions are required, and volatility is a "NO,NO". Guess what we've got now .... highly volatile conditions.

Two popular recent examples (actual ones, this time) :

Borrow in Jap Yen at near-zero rates, lend in Aus $ .... this worked just fine for a while until weaker growth in China and the subsequent rout in commodity prices saw the Aus $ tumble to 6-year lows.

Borrow in Swiss Francs at near-zero rates, lend almost anywhere else.... You can imagine what happened when the Swiss lifted the cap on the Franc, causing it to rocket in value overnight.

Back to China.... the backbone of carry-trades in recent times has been to borrow in a number of low-interest bearing currencies (US$, Jap Yen, Euro, UK£) and lend in China's Yuan, knowing that with the Yuan effectively fixed at around 6.2 to the dollar, exchange rate risks have been strictly limited. But the devaluation of the Yuan has put a stop to all that. In the greater scheme of things, its depreciation has so far been minimal but this is a game of fine margins. More to the point, the move to see the exchange rate decided more by market forces than by Chinese officials opens the way for further weakness. The Yuan carry-trade is off the agenda.

ADDENDUM : One can't help feeling that China's authorities have taken some unfair stick for the devaluation, largely from protectionist US politicians. It's true that the move has been seen as a tacit admission by the authorities that the economy is struggling more than they've let on, and that this has contributed to the panic now gripping world markets. But despite the unpleasant consequences now so apparent, most (including Pres. Obama and the IMF) were only too keen to encourage the Chinese to free up their markets. Like we've said before, you can hardly blame them if they comply.