The hugely popular yen carry trade crashed this month as the Japanese currency rose. A lesser-known version of the strategy may be more immune to such shocks.
Trades in which yuan is borrowed to buy higher-yielding assets are likely to be more stable as China’s central bank maintains its loose monetary policy, the Royal Bank of Canada says. The yuan carry trade is different from the yen carry trade because it mainly involves exporters and multinationals, not speculators, data from Macquarie Group Ltd. show.
Carry trades, which seek to capitalize on differences in global interest rates, took center stage in financial markets in early August as the unwinding of the yen fueled a sell-off in risky assets. Investors bought their assets after a rate hike by the Bank of Japan strengthened the local currency, which in turn depressed the value of higher-yielding target currencies such as the Mexican peso and Brazilian real.
“It still makes sense to short the yuan against a basket of emerging market currencies, as it would be contradictory to allow the currency to strengthen when the central bank is trying to ease its monetary policy,” says Alvin T. Tan, head of Asian currency strategy at the Royal Bank of Canada in Singapore.
“China’s economy is in trouble and the PBoC is widely expected to ease its policies further in the coming months and has signaled this,” he said.
A carry trade that borrows yuan and invests it in a basket of eight emerging market currencies has returned 0.5 percent this quarter, while the yen-funded alternative has fallen about 7 percent, according to data compiled by Bloomberg.
The collapse of the yen carry trade following the BoJ’s July 31 decision affected the yuan, at least initially. The yen rose 6.8 percent in the week to August 5, while the yuan gained 1.7 percent. Gains in the funding currency for a carry trade can wipe out potential gains.
Important differences
There are a number of key differences between carry trades in yuan and yen. The yuan is not fully convertible because the authorities limit the inflow and outflow of foreign currency to strengthen their control over the economy. This automatically reduces the size of carry trades in yuan compared to those in yen.
Second, while yen-funded deals are invested in a wide range of overseas destinations, the bulk of deals using borrowed yuan are held in dollars by Chinese exporters and multinationals, which only became profitable in 2022 after Federal Reserve interest rate hikes pushed U.S. borrowing costs above Chinese ones.
According to Macquarie, Chinese exporters and multinational companies have accumulated more than $500 billion worth of dollar holdings since 2022.
There are a number of reasons why investors are interested in the yuan carry trade, says Wee Khoon Chong, a senior strategist for Asia-Pacific markets at the Bank of China (BNY) in Hong Kong.
“The continued high liquidity of the offshore yuan may simply make it too difficult for market participants to resist the temptation to enter carry trades again once market volatility subsides,” he said.
Still, the overall volume of yuan-funded carry trades is likely to be limited because the People’s Bank of China has sufficient tools to prevent what it sees as an excessive buildup of speculative positions, Wee wrote in a client note this month.
“Will offshore yuan shorts build up again? Sure, why not?” he said. “There will always be some opportunistic market participants, but we don’t expect them to emerge in any significant volume.”
Trading recommendations
Many financial firms are telling their clients that issuing yuan bonds will continue to be a profitable method of financing carry positions.
Citigroup Inc. recently advised investors to bet on the Mexican peso and Brazilian real against the yuan and yen in the options market, according to a research report by strategists including Dirk Willer in New York.
Goldman Sachs Group Inc. and Nomura Holdings Inc. also recommend that investors short the yuan against a trade-weighted basket of other currencies as China’s macroeconomic headwinds are large and the U.S. dollar is weaker.
