Scramble To Hedge Dollar Bull Will Fuel Rally in 2015, Yuan Bear Market Is Fissile Material

The next phase of the dollar bull market will come when unhedged U.S. dollar debtors realize they need to hedge.

UBS Raises Flag on China’s $1 Trillion Overseas Debt Pile
Daiwa Capital Markets has a $1 trillion estimate for carry-trade inflows since 2008, bets on the difference between yields in China and overseas.

...“This could get very uncomfortable very quickly,” he said in a Dec. 12 interview. “I boil it down to its basics. You’ve borrowed unhedged and leveraged: you’re at risk.”

Andrews says the mechanics of what’s happening are this: mainland companies deposit 20 percent to get a letter of credit from an onshore lender. They take that document to get a low-interest dollar loan from a Hong Kong bank, which treats it like a no-risk check fully backed by the guarantor.

The companies flip those dollars back to the mainland, where they use them as collateral to get even more letters of credit, leveraging even further, said Andrews. That money is then used to invest in China’s high-yield and often risky trust products or in the booming stock market. The profits are then used to pay off dollar borrowings.
A credit bubble based on the "guaranteed" appreciation of the yuan versus the U.S. dollar is a recipe for disaster. Borrowers are short the U.S. dollar and even if their loans aren't called, they may decide to hedge against losses in the currency market.

If the Fed increases interest rates, there will be a flow out of yuan and into dollars. Exporters will hoard dollars and we could see a replay of what happened in 2012 when the PBOC couldn't buy a buck.

Here is a quote from 2012 from the post Chinese Hoard Dollars:
China's largest privately run shoemaker, Aokang, exports 40 million pairs of shoes to the United States and Europe each year. Previously, the firm would swap U.S. dollars for yuan on the same day they were received, but now, "[We] keep as much as possible, we even wish we could keep all of it."
Imagine the explosive bull market in Chinese stocks this year being replayed in the currency market in 2015.

Andrews says the similarities between pre-Asian financial crisis Thailand and China today are limited. The amount involved is still small relative to China’s $9.2 trillion gross domestic product. The nation’s overall loan to deposit ratio is healthy and China has foreign-exchange reserves that peaked at $4 trillion in June, he said.

Chen Long, Beijing-based China economist at research consultancy Gavekal Dragonomics, said China’s overseas debt has been growing in line with the economy and banks are healthy enough to absorb any changes in interest rates or currencies.

“The renminbi is controlled by the People’s Bank of China and no one has enough resources to bet against the PBOC’s foreign-exchange reserves,” he said.
This thinking is why I'm worried that the risk is even greater than in 1997. Not for China, but for the global financial system. A currency/financial crisis can erupt when too many people are on one side of the trade. While no "one" has the resources to bet against the PBOC's FX reserves, 1.4 billion Chinese have the ability to deplete China's FX reserves several times over because money creation has far exceeded the accumulation of reserves. All renminbi in circulation has a claim on China's dollar reserves and if claims start to be called, the reserves will decline. Each time reserves have declined (or failed to grow) the yuan has weakened. A weaker yuan can quickly change market perceptions in China. The drop in late 2011 and early 2012 caused exporters to say of U.S. dollars, "[We] keep as much as possible, we even wish we could keep all of it."

If the psychology in the yuan market tips to bearish, watch out.

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