The Chinese currency, Renminbi or Yuan (both denote the official currency of China) has fallen by close to 1.5% against the USD since beginning January 2014. The USD/CNY, which is the market symbol for the pair, has fallen from levels of CNY 6.0552 to the USD to CNY 6.1501 as of 3rd March 2014. The Yuan had strengthened by around 3% in calendar year 2013 before it fell by 1.5% over the last two months.
Markets are talking about a forced devaluation of the Yuan by China’s central bank, the PBOC (People’s Bank of China). The reason PBOC is forcing the Yuan value down is the lack of competitiveness of its currency against other major export nations such as Japan. The Japanese Yen has weakened by over 10% against the USD over the last one year. The Indian Rupee has fallen by 14% against the USD over the last one year.
The Yuan is a managed currency and the PBOC pegs it against the USD. It allows the currency to trade in a tight band and hence it leaves the currency open for interest rate arbitrageurs. FII’s were busy borrowing money in USD at Libor that is at less than 0.5% and investing in Chinese government bonds that are yielding over 3% across maturities thereby earning a spread of 2.5% and above. The fact the Yuan was appreciating gave FII’s currency gains as well.
PBOC was giving free gains to FIIs given its peg. The move by the PBOC to depreciate the Yuan by buying USD is making the FIIs nervous as arbitrage gains are wiped out by currency losses. FIIs will think twice before putting on any arbitrage trades.
The Indian Rupee (INR) will benefit from the Yuan depreciation move by the PBOC. The INR is looking stable at levels of Rs 62 to the USD given that current account deficit is down over 40% for fiscal 2013-14. FIIs have bought in the first two months of calendar year 2014, USD 4 billion worth of treasury bills and short maturity corporate bonds that are yielding over 9% and 9.6% respectively. Given stable outlook for INR, FIIs are not hedging their currency risk. Spread between Libor and bond yields in India is over 8.5%.
FIIs who are nervous about the PBOC intervention to depreciate the Yuan would look at diverting the flows to India. Stable outlook for INR coupled with high interest rates will prompt arbitrage flows leading to the INR strengthening against the USD. INR appreciation will further encourage arbitrage flows, a self fulfilling cycle that could take up the value of the INR by a good margin.
