Watching the ongoing Greek saga unfold is enough to make a blind man grimace. Capital controls which could be seen coming down the track like a freight train are but one more notch on the disaster stick called European Monetary Union.
Why talk of Greek debt negotiationsis even taking place at all is the height of absurdity. It’s akin to discussing how large an area of the desert should be dedicated to growing lettuces. The answer which no Eurocrat is prepared to acknowledge is, “Who cares? Nobody should be so daft as to grow lettuces in the desert”.
Let’s all be honest, shall we. What we’re talking about here is foreign aid. It’s not about debt repayments. Nobody is getting repaid. Anyone still clinging to that hope is simultaneously still waiting for Santa to come down the chimney, the Easter bunny to show up and for “liberating” forces to find weapons of mass destruction in Iraq.
Let’s just table debt talks, call them what they are, which is foreign aid, and move this thing along. The problem with acknowledging the ugly truth is that German banks would then have to write down those “assets” on their balance sheets: “Jeez, it’d just be so much easier if we could keep them at par value and ensure we pick up that bonus at year end. And so we must endure more saga and carry on this game of pretense”.
While I could spend time on Greece, what I’m more interested in is what few are paying attention to while this Greek saga unfolds.
That is what is going on with the Chinese yuan.
We’ve recently made the argument for a weakening yuan. My friend Brad and I both went up against the yuan late last year.
That, ladies and gentlemen, is our current bias. We’re currently short. It’s important to establish one’s bias early on in order to attempt to understand any argument, so now you have ours. Often fund managers are selling a product which leads them into making decisions which have more to do with an agenda than with sufficient critical thought.
Let me say therefore that we have an opinion right now. But since we are not selling any product, hopefully we can keep our minds open.
Let’s see where we get to and then I’m going to show you why we have a decent crack at making money without having an opinion either way.
By many accounts the yuan is one of (if not THE) most overvalued currencies in the world right now. But there are just as many well thought arguments arguing the opposite saying that it is indeed undervalued.
Both sides have credible and well thought out ideas so let me attempt to summarise the most credible I’ve found.
Why the Yuan will Rise
Chinese policy makers are unlikely to let anything take place which rocks the yuan exchange rate boat.
The yuan fell to 6.28 in early March of this year before the PBOC stepped in and threw $33 billion at the “problem”, reversing the decline and sending it back up to where it trades today around 6.21. They have around $4 trillion in reserves so if, like us, you’re a speculator looking at firepower this is well worth looking at. Clearly the monetary authority is prepared to dip into their vast currency reserves to offset capital outflows and stabilize the yuan.
The IMF discussions around including the yuan into the SDR basket of reserve currencies (currently the dollar, euro, yen and pound) is something which China has long been courting. Right now, the yuan has posted it’s biggest monthly advance since December 2011, on the heels of or in anticipation of inclusion in the SDR basket by the IMF.
Amongst other things, what is required is for the yuan to be “fairly valued”. Wild swings in the yuan – whether up or down – would kill their chances of joining the hallowed ground of the other terrible units of payment.
In order to meet their criteria it’s essential that the yuan remain stable. Another IMF criteria is that the currency is “freely usable”. In other words, free floating. I’ll come back to this in a minute as I think it’s something overlooked by many observers.
Why the Yuan will Fall
On the other side of this argument is the fact that China’s economy is slowing and is facing increased competition from regional players, such as Japan, who are playing the currency card, devaluing their currencies and sucking up export market share.
A weaker exchange rate would help boost exports and while China is certainly moving towards a domestic consumer supported economy, they are not there yet and manufacturing and exporting to the developed world is still their “bread and butter”.
Remember I mentioned that part of the IMF criteria is that the currency float freely?
Well, many believe – and perhaps correctly – that when (or if) the yuan is added and floats freely there will be an almighty rush INTO the yuan. I’ve seen few who believe that this wouldn’t at least in the short-term allow the opposite to happen.
Consider for a moment that most Chinese have been going to great lengths to get OUT of the yuan. Does it not make sense that when they are allowed to do so there will not be a decent amount of them quite excited with the prospect of moving out of yuan?
In the simplest of terms the question boils down to the following…
Upon inclusion into the IMF and a subsequent floating of the yuan, does capital flow into the yuan or out of it?
The problem with China is that nobody knows the real numbers. Nobody!
What are the insiders doing? They’re shoveling their money out of the country so fast it’s going to catch fire from the friction. This is what the insiders are doing. That doesn’t mean that suckers won’t come in the other way and we get a strong yuan rally. It’s certainly possible and maybe it’s even probable.
Fortunately, the market is gifting us an opportunity right now and we don’t have to make that decision.
I just got off the phone with Brad who told me about me the below pricing of an at the money call option on the yuan (or the offshore yuan, to be more specific). Currently, you’re paying 2.5% premium for a 12-month call option.
Now, take a look at the below chart. You’ll see that buying a 12-month at the money put we’re paying just 0.3%. You can buy 100,000 USD/CNH puts for 12 months at the money and it’ll cost you a mere $300!
To break even on the first trade we need the currency pair to move by 2.5% in our favour within 12 months and on the second trade we need the pair to move by just 0.3% to break even. Pardon me for saying so but that is almost as insane as the Eurocrats discussing Greek debt.
Buying both is what traders term a “straddle” but don’t get hung up on terminology. The point is that for a 2.8% premium (2.5% + 0.3%) we can hold both positions. We don’t much care which way it moves but simply that it MOVES!
What could make it move? Well, inclusion at the hallowed table of disreputable currencies currently making up SDRs or of course non-inclusion.
Either of these events have the potential to create capital flows one way or the other causing the USD/CNH pair to move substantially more than a mere 2.8%.
I’d suggest we’re likely to see MORE not LESS volatility over the next 12 months and the current lack of volatility being priced into the market is just the sort of golden gift which Brad looks for.
“Eppur si muove (And yet it moves).” – Galielo Galilei
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