Written by Winnie Zhou and Summer Chen
SHANGHAI/HONG KONG (Reuters) – A sell-off in global markets triggered by the unwinding of yen-funded carry trades has put the spotlight on China’s yuan, also widely used as a cheap funding currency.
Although August saw the yuan rise sharply by 2% against the dollar, traders say the yuan carry trade is strong and unlikely to unravel anytime soon.
What is yuan trade?
In traditional trading, investors borrow low-yielding currencies such as the Japanese yen and Swiss franc to invest in higher-yielding assets, mostly currencies, but also to finance leveraged trades in stocks.
The yuan interest trade is similar to the local currency interest trade, but with some limitations because the currency is not fully convertible.
A large proportion of yuan trading involves Chinese exporters depositing their money in dollars. In another version, foreigners borrow yuan to invest in mainland markets. A third type of yuan trading involves using cheap bonds denominated in dollars and other currencies.
How did the yuan trade develop?
Until 2022, when the US Federal Reserve began aggressively raising interest rates and Beijing moved to ease monetary policy to help the struggling economy, Chinese interest rates had been higher for years than their US counterparts.
With dollar returns rising, Chinese exporters have found they can earn up to 5% a year if they hold their earnings in dollars, compared to the paltry returns on yuan time deposits.
Excessive dollar hoarding by exporters has been a major factor behind the yuan’s depreciation since April 2022.
The depreciation of the yuan meant that foreigners were able to trade dollar-yuan swaps onshore, which resulted in a significant spread on these deals. Foreign investors could borrow cheap yuan from abroad and convert it into US dollars or other currencies to invest in stocks and bonds. Investors would benefit from the exchange rates as the yuan fell in value, as well as the usual returns on assets.
What is the volume of yuan trade?
The total volume of yuan trade is difficult to measure, analysts say, but it is smaller than global trade financed in yen, since the yen is a more liquid and open global currency.
Macquarie estimates that Chinese exporters and multinationals have accumulated more than $500 billion in foreign exchange reserves since 2022.
Foreign companies have also begun sending more of their profits out of China rather than reinvesting in the country.
Meanwhile, foreign holdings of bonds have increased by 920 billion yuan ($128.12 billion) since the end of 2022 to a record high in June, official data showed. This is evidence of what traders call the reverse yuan trade, where foreign investors profit by lending U.S. dollars and borrowing yuan through currency-protected swaps and then buying yuan bonds.
Could the Chinese Yuan Become the Next Trade to Decline?
The recent decline in the once popular yen carry trade after Japan raised interest rates has sent the yuan higher and raised questions about the viability of the yen carry trade.
UBS said offshore short positions in the yuan fell due to the currency’s peg to the yen.
Domestic interest trading may decline if Chinese yields rise and dollar and yuan interest rates converge.
“The yuan trade will ease once domestic demand in China improves. Then it depends on when stimulus policy becomes decisive enough,” said Larry Hu, chief China economist at Macquarie.
(1 USD = 7.1809 Chinese Yuan)