Is the Chinese dragon really asleep?

Capital controls continue

The Chinese yuan (CNY) appears to have been stable over the last couple of months, giving the impression that capital outflows have stabilised. But while the Chinese dragon seems to be asleep, there is more going on than meets the eye. The side effects of government intervention are increasingly apparent in the Hong Kong dollar (HKD) market, which offers an interesting way for investors to seek to protect against the risk of another round of market stress stemming from potential CNY depreciation.


Capital outflows from China have been driven by expectations of currency weakness. Erik has written previously about these pressures. To stabilise outflows, Chinese authorities had to tighten capital controls, introduce a trade-weighted basket to divert attention from the US dollar peg and intervene heavily in the offshore market. And while the yuan has been stable against the US dollar, it is now depreciating against the trade-weighted basket.

Bouts of yuan weakness can be very negative for global risk assets

In Hong Kong, the Chinese capital controls are also starting to bite. The Hong Kong dollar is pegged to the US dollar through a currency board system. This means that every Hong Kong dollar in circulation is backed by an equivalent number of US dollars owned by the Hong Kong Monetary Authority (HKMA). Given equivalent interest rates, that should make investors reasonably indifferent between holding US dollar assets and Hong Kong dollar assets. However, Chinese banks in Hong Kong have a political incentive to reduce their overall US dollar exposure as part of the efforts to reduce capital outflows. This is creating an unusually large amount of demand to sell US dollars (synthetically) versus the Hong Kong dollar using currency derivatives to hedge existing US dollar holdings. As a consequence, forward exchange rates remain stubbornly below the low/strong end of its 7.75-7.85 band.

As a result of this imbalance, investors can potentially earn a small premium (0.7% per annum) by taking the other side of this trade (i.e. selling Hong Kong dollars via currency forwards). The 0.7% premium is made up of two components: 0.5% comes from the difference between Hong Kong and US interest rates, while the additional 0.2% comes from the so-called cross currency basis. In a frictionless market, this cross currency basis would be driven to zero by arbitrage flows. However, in reality, regulatory frictions inhibit those flows. Toda there is a premium over and above straightforward interest rate differentials due to the distortions described above.

While the yuan has been stable against the US dollar, it is now depreciating against a trade-weighted basket

Why might multi-asset investors be interested in this type of position? On a standalone basis, it is a positive carry trade to bet on the weakening of a currency that is trading at the strong end of its 30-year-old pegged range. Such a position could incur an immediate mark-to-market loss, but ultimately could make a small profit unless the peg breaks on the low/strong end of its band. Given the currency board system, a break of the peg is more likely to be driven by large macro imbalances (which do currently exist) or by political choice, but not through capital flows. This, combined with the longevity of the pegged regime, makes it incomparable in our view to the currency floor in Switzerland that was abandoned early 2015.


More importantly, however,  it also acts as a proxy hedge for episodes of stress in the Chinese yuan. As demonstrated in January 2016, the Hong Kong dollar tends to weaken during episodes of yuan weakness/volatility. In turn, those bouts of yuan weakness can be very negative for global risk assets. Having a short Hong Kong dollar position could therefore be especially appealing.