China Has Yet to Shock the World

This post is a bit of continuation of Prepare for Currency Chaos, why I expect things will be more volatile than generally expected.

ZeroHedge: A Shocked Wall Street Reacts To China's "Surprising" Devaluation

Sean Callow, Sydney-based FX strategist at Westpac:

Today’s fixing was a big surprise, and impression is that upside risks to USD/CNY have grown
Allowing the yuan to trend lower against the dollar this year is consistent with the need to loosen domestic financial conditions to support growth
PBOC may not tolerate widening CNY-CNH spread for long since it will encourage capital outflows

Tommy Xie, Singapore-based economist at OCBC:

PBOC’s actions are conflicting: there was suspected intervention yesterday and sentiment stabilized, but it set such a low fixing today
PBOC may be taking dollar demand into consideration: usually at the start of a new year, retailers’ and corporates’ foreign-exchange requirements are higher
Central bank may be using the fixing to convey a message to the market that it doesn’t want the RMB index to be too strong

Zhou Hao, Singapore-based senior economist at Commerzbank:

Lowered-than-expected yuan fixing today shows authorities will tolerate more weakness for the time being
Will help loosen monetary conditions; still, risk of capital outflows could increase concurrently
Increasing outflow pressures may rule out excessive drop in yuan

Liu Dongliang, Shenzhen-based senior analyst at China Merchants Bank:

Yuan depreciation this week aims to stabilize the yuan index amid a stronger dollar environment
Expects 5%-10% depreciation by end of the year, though this depends on the pace of PBOC’s intervention and health of macroeconomy

ZH is correct, there's nothing surprising about what is happening with the yuan. Even if you don't think it is likely, a significant devaluation in the yuan is probable enough to warrant a speculative bet at the right price and it would be prudent to be hedging against this risk if you're exposed to it. A surprise here is the the timing. The Swiss National Bank suddenly ending its peg with the euro in January 2015 was a surprise on that day, but the act itself was not a surprise. It was forecast.

we venture that the SNB will sooner or later be forced to permit the franc to appreciate and thus to enrich the holders of low-priced, three-year call options on the Swiss/euro exchange rate. It's a long shot, to be sure--the options are cheap for a reason--but we judge that the prospective reward is worth the obvious risk.

A similar move is possible in China. Even without devaluation risk, the market is pointing towards depreciation.

In the ZH yuan article is this chart:

Whenever the spread is in the green there, when offshore yuan (CNH) is weaker than onshore (CNY), there is a incentive to pull USD out of the Mainland. There's also incentive for Chinese U.S. dollar earners (exporters) to hold their U.S. dollars outside of the China. We often think of currency outflows, but there is also a lack of inflows. A great way to avoid capital controls is to never fall under their control. Why sell your USD earnings for 6.5 yuan in Mainland China, when you can sell them for 6.7 yuan in Hong Kong? Or simply sit on them and wait for the yuan to drop further before exchanging your dollars.

The arbitrage opportunity between CNY and CNH is difficult to close due to capital controls. Nearly everyone views CNH as the real price for yuan because it is a market price and capital controls make it difficult for to arbitrage the price. The recent crackdown on banks is a way to keep them from earning risk free profit at the expense of the nation's FX reserves, which is possible because currency policy has left the vault door wide open. This is a good temporary policy if the trend is transitory, but lower CNH hardens depreciation expectations. The policy itself could backfire if the arbitrage opportunity doesn't close.

China devalued the yuan one day in 1994. From the viewpoint of policymakers, it worked. The calculation is different today due to the size of China's economy. Perhaps they will avoid a big move because of perceived political risk, perhaps they won't.

Conclusion

The big banks may be putting out optimistic yuan forecasts because they fear reprisals from Chinese officials, but I don't see significant depreciation expectation in the market (looking at CNH futures). Between the talk of orderly decline and "surprise" at a 2% move, this looks like the "consensus" view. Bearish yuan outlooks are growing, but maybe not a lot of money is being put behind those words or "the market" is ignoring them. HK futures are pricing in depreciation of about 4.3% in CNH out to March 2017. That is less than 7% depreciation in CNY.

Apparently the options market is heating up: Options Traders See Yuan Collapse Continuing In "Dangerous Situation For Policy-Makers"

Contract prices indicate a 79 percent probability that the currency will weaken this year and 33 percent odds that it will drop beyond 7 per dollar, a level last seen in 2008, according to Bloomberg calculations. That’s up from 15 percent at the start of December and comes as the central bank shows signs of reining in its support for the exchange rate in the face of rising intervention costs and sliding exports.

“We’ve seen explosive growth in demand for options betting the yuan will weaken as clients seek protection against further depreciation," said Frank Zhang, Shanghai-based head of foreign-exchange trading at China Merchants Bank Co., which trades yuan options. "The situation won’t get better until market sentiment stabilizes in the spot market, which isn’t going to happen in the next few months."

Stability in the currency regime is over. Shifts from stability to volatility are not stable transitions, they are chaotic. Don't be surprised by what happens.