Crossing China’s Big Red Currency Line

Crossing China’s Big Red Currency Line
ALEX FRANGOS
March 20, 2014 1:32 a.m. ET
China’s currency slide continues, crossing a level that traders worry will trigger turmoil for investors. Heard on the Street columnists Alex Frangos, Abheek Bhattacharya and Aaron Back debate what Beijing is aiming to do by letting its currency move sharply lower.
The big red currency has crossed a big red line. It might not be so scary on the other side.

A year of steady appreciation in the yuan has gone poof in a few weeks, with the Chinese unit now crossing the 6.20-per-dollar threshold. Market players have warned that breaching that level would trigger collateral calls on investment products that could unleash even more instability in the currency. Those products were sold when the yuan was stronger than 6.20—with herd-like consensus that it could only go in one direction.
The structured products in question were mostly sold to Chinese export businesses to hedge against dollar earnings. The risk is that some used leverage, making these bets less about hedging and more about speculating.
It is hard to pinpoint exactly how big a threat this poses. Morgan Stanley MS +1.70%estimated the size of this market at $350 billion. It has since revised that to $150 billion. The products expire over two years, meaning there won’t be some giant collective payment due. Others, such as Deutsche Bank, DBK.XE -0.80% say the risks are actually concentrated at weaker yuan levels, such as 6.25. And given that the slide began several weeks ago, some investors have already moved to close out positions and hedge risks.
The volatility adds to jitters about the Chinese economy. Housing prices in February rose at the weakest pace in months, while a loan default by developer Zhejiang Xingrun Real Estate has raised fears that the long-awaited popping of a real-estate bubble is getting closer. Foreign-exchange purchases by Chinese banks dropped sharply in February, indicating speculative inflows are drying up.
Beijing’s currency managers remain very much in charge, however. It’s precisely this type of market pain that they are after to flush out speculators. Policy makers bristle at so-called hot money inflows because they make managing domestic liquidity and money supply more difficult.
The central bank has pushed its yuan “reference rate” to a weaker level each day. This week it also widened the permissible trading band around that rate from 1% to 2% on either side, to signal that even more volatility will be permitted. On Wednesday, the yuan weakened more than 1% past the reference rate for the first time. This shows the band widening wasn’t just a theoretical exercise.
Beijing is betting that even if the yuan products in question blow up, it won’t cause broad harm to the economy. If authorities become concerned, the central bank could swoop in at any time to drive the yuan higher again.
China has no problem watching currency speculators writhe in pain. That’s the point.