Why the Yuan Must Devalue: $700 Billion in Short-Term Loans Betting on Yuan Appreciation & Rate Arbitrage; One-Third of Reserves Is Hot Money

This post headline is a translation of the iFeng headline, a top story in the finance section. The article is originally from 岭峰资本. I've cleaned up the Google translation.

This year only three trading days, the offshore US dollar against the RMB exchange rate to appreciate 2.35 percent, more than two-year RMB deposits of interest. Last August 10 to today, the US dollar against the RMB exchange rate appreciation of 5.6% in the bank, while the same period the Shanghai Composite Index fell 10%. Devaluation trend has been very obvious. Why the RMB will depreciate?

To understand why the RMB will depreciate, we must first find out why the past ten years, the continued appreciation of the yuan. Over the years, China's rapid economic development, investment opportunities are everywhere, a lot of foreign capital inflows, pushing up its currency. On the other hand, China has become the world's factory, rapid export growth, the trade surplus more and more, also pushing up the exchange rate. From 2009 onwards, an important factor in an unknown supported the rise in the RMB exchange rate, currently also the factors that determine the renminbi exchange rate depreciation is a very determined event.

A few years ago, I was reading a shipbuilding enterprise's annual report and found significant abnormalities. The company's financial investment accounted for more than 60% of profits, exceeding the company's shipbuilding business. The balance sheet had more than 10 billion yuan of investment in a large number of domestic financial trust products supported by a large number of foreign US dollar loans. The company used RMB collateral domestically to obtain a full amount of US dollar letter of credit, the equivalent of financial leverage. The parent company's overseas subsidiaries relied on the guaranteed letter of credit in US dollars from teh domestic banks to obtain short-term US dollar trade loans from foreign banks. Then the overseas subsidiaries found various ways to move the capital into China, allowing the parent company to earn profits from domestic investments.

Six-month USD business loan interest was approximately 3%, and if the domestic investment financial trust products yield a 10% return, coupled with the appreciation of the yuan against the dollar, and then multiplied by leverage, corporate earnings are (7% + revaluation) x leverage. Even assuming conservative 2X leverage, the RMB from 2010 to 2013 appreciated around 1.4% to 5.0% each year, the company's rate of return would have been at least 20% or more. Such a rate of return during an increasingly difficult time for industry is very impressive. No wonder the company's executives believe this new business was low-risk, high-return, and vigorously expanded. These industrial bosses do not understand finance, really do not understand the financial risk, but the first taste of financial leverage arbitrage was sweet. Once the tasted blood, working hard at the industrial business to earn a small profit was soon disdained.

This is just a single business. I checked the Bank for International Settlements statistics, these arbitrage funds are higher than one trillion US dollars. More dangerous is that nearly 70% of this one trillion in arbitrage funds is backed by short-term loans of less than one year that must be constantly rolled over.

More than one trillion US dollars is not a small number, it's about one-third of forex reserves. That is to say about one-third of reserves is hot money arbitrage, at the first sign of trouble it will leave. The returns in the real economy are less and less, large inflows of foreign capital are gone, simply relying on the trade surplus has been unable to offset the pressure of capital outflows, the RMB exchange rate begins to depreciate. The more than one trillion US dollars in arbitrage funds is facing extinction. First, since the Federal Reserve raised interest rates, interest on overseas dollar loans rose. Second, domestic investment products offer ever lower rates of return. The key is that yuan devaluation reverses the arbitrage, the leverage becomes leveraged losses. As a result of the trend reversing, arbitrageurs must flee. This situation recently happened in the A-shares market. Speculators wantonly used high leverage financing, pushing the stock market higher, get high returns several times over, but in the stock market decline they collectively stampeded away.

If the trend reversal is slow and orderly and speculative arbitrage funds can gradually exit, devaluation pressure may be smaller. However, the law of financial markets is to rush. In the book "Financial Alchemy", Soros wrote, "Even more important, when a change in trend is recognized, the volume of speculative transactions is likely to undergo a dramatic, not to say catastrophic, increase. While a trend persists, speculative flows are incremental; but a reversal involves not only the current flow but also the accumulated stock of speculative capital. The long the trend has persisted, the larger the accumulation. There are, of course, mitigating circumstances. One is that market participants are like to recognize a change in trend only gradually. The other is that authorities are bound to be aware of the danger and do something to prevent a crash." For the moment, arbitrageurs had already recognized the change in trend and after the central bank made various efforts that shows they have no will nor the ability to maintain the stability of the RMB exchange rate at the present level.

What is a real opportunity? When market participants act involuntarily, when they have to do something, it is the real opportunity. Soros said reflexivity is this case. During a bubble, participants act cannot help but join in, to not participate will cost you the opportunity to make big money, if you do not participate someone else will take your place. When the bubble bursts, if you do not run, others will run, if you do not run you will be trampled to death. The current exchange rate, if you do not exchange at it, others will, think that there is more than one trillion US dollars in arbitrage funds that need to swap, right now the price is really very favorable. These arbitrage funds, faced with extinction, have to buy dollars, the are "desperate for money." And overseas banks are not philanthropists, always have an umbrella in the rain, will call back the dollar loans. As a result, devaluation trend over the next few years is very clear.

Why the RMB will depreciate? In addition to economic factors, the most important thing is more than one trillion US dollars of reverse arbitrage funds. Speculators enjoyed a feast in previous years, with easy access to the highly leveraged profits, pushing up the currency. Today, speculators flee in panic, let the currency depreciate, let all hold RMB assets holders pay the bill.

iFeng: 人民币为何贬值：超万亿美元套利资金流出