Second Verse, Same as the First, a Little Bit Louder and a Little Bit Worse
China surprised the financial markets on August 11, 2015 by devaluing their currency, the Renminbi (CNY), the equivalent of 2% versus the U.S. Dollar (USD). This is the largest daily move in the CNY in over 10 years and likely the first in a series of devaluations by the Chinese government. Since 2014, the Chinese had pegged their currency to the strengthening USD and watched it appreciate against many of the world’s currencies just as the USD was doing. Over the past year for example, the USD and CNY appreciated 20%, 25% and 12% against the euro, yen and South Korean won respectively. It just so happens that these currencies are the ones used by 3 of Chinas largest trade partners. Thus, maintaining a peg to the USD eroded export growth as China’s products became more expensive for countries other than the U.S to import. Conversely, in China the rising CNY brought further deflationary pressure as goods imported from countries that use currencies other than the USD became less expensive. Now, in an effort to level the global trade playing field, China has decided that the economic harm produced by pegging to the dollar outweighs the benefits produced by a strong domestic currency.
In December 2014 the Bank for International Settlements (BIS) warned of the growing risks associated with the global carry trade. They estimated that since 2000 the amount of such trades quadrupled in size to $9 trillion and grew 5.5x faster than global growth over the same period. The massive amount of these trades outstanding dwarfs anything seen in the past, leading the BIS to repeatedly warn of potential financial repercussions if these trades suddenly and simultaneously unwound. The Asian currency crisis of 1997, for instance, was greatly magnified due to the unwinding of an estimated $300-$500 billion of these types of carry trades.
The carry trade that is so concerning to the BIS involves borrowing USD (typically on a leveraged basis) and investing those funds in a foreign country. This trade possesses all of the risks of a typical investment but it also layers on substantial currency risk as the borrower/investor must first convert the borrowed dollars to the currency of the country where the investment takes place. By default a USD short is created when the currency is converted.
It is estimated that carry trades involving USD loans invested in China could represent a quarter to a third of the BIS estimated $9 trillion global carry trade. The popularity of this trade grew steadily since 2006 as strong Chinese economic growth and an appreciating CNY versus the USD made this trade lucrative on both the investment front but also from a currency perspective. The graph below shows the CNY appreciation from 2006-2013 (green arrow), the pegging of CNY to the USD in 2014-2015 (blue arrow) and last night’s 2% devaluation (circled yellow).
As mentioned earlier this devaluation is likely not a one-time event but rather the beginning of an ongoing and persistent depreciation of the CNY versus the USD. The embedded USD short position within the carry trades will begin to result in losses and margin calls as the USD appreciates versus the CNY, thus forcing investors to liquidate some of their positions. These trades, which took years to amass, could unwind abruptly and exert an influence of historic magnitude on markets and economies.
The Asian currency crisis of 1997 could prove to be a worthy example of the effects to be felt from a massive unwind of carry trades of this sort, albeit of a much lesser magnitude. Therefore, caution is urged and investorsshould prudently monitor their positions and risk tolerances. During the Asian crisis of 1997 and 1998 the following effects were felt:
- South Korean Won declined 34% against the USD
- Thai Baht declined 40% against the USD
- South Korean Gross National Product (GNP) declined 34%
- The USD index rose 13% versus a basket of other major world currencies
- The S&P 500 fell 15% in 1997, rallied, and then dropped another 20% in 1998
- The Japanese Nikkei index declined 36%
- South Korean share prices declined 58%
- The 30 year US bond yield fell from 7.0% to 4.2%
- Crude oil prices declined 62%
- The Asian crisis contributed to the Russian default in 1998. This in turn led to the collapse of Long Term Capital which required a $3.625 billion bailout organized by the Federal Reserve as well as a 1% reduction in the Federal Funds Rate to contain the fallout.