China Yuan Weakens as BIS Says Foreign Exchange Markets have Systematically Failed

Friday, overseas stocks got hammered. The popular reason was that with recent polls suggesting that UK’s Brexit was suddenly in a commanding 10 point lead against Bremain, markets have viewed this as a surge in uncertainty.

By sector, the decline in US stocks was led by the energy (XLE -2.16%) and the financial industry (XLF -1.24%). While the S&P 500 was down (-.92%, year to date), the S&P Bank Index ($BIX) was slammed 1.74% (-2.6% week on week and -9.3% year to date). The NYSE Broker Dealer ($XBD) was hit -2.11% -3.63% w-o-w, -10.73% y-t-d)

The Stoxx Europe 600 Bank index plummeted 3.7% (-4.8% wow, -23.48% ytd) to approach a two month low. Deutsche Bank crashed 5.8% (-7.74% wow, -35% ytd). The FTSE Italia All Share Bank Index plunged 5.03% (down 5.85% wow, 43% ytd) now nears the 2012 lows. Now even before the Brexit poll announcement, Japan’s Topix Bank ETF dropped 1.31% (-3.2% wow and -29.44% ytd)

So while it may be true that Brexit (political risk) could have been a factor, there must be something else that must have been affecting financial stocks.

That other major factor must have been the Chinese yuan.

Last May 28, I wrote that the USD-yuan was making strides to hit its previous highs. While the Chinese went into a 5 day holiday to celebrate the Golden Week Spring Festival and because of this, the onshore yuan CNY was last traded to reflect on a rebound mostly in reaction to the weak US payroll data of the other week, the offshore yuan got clobbered.

By Friday, the offshore yuan (CNH) suffered its biggest weakly decline since March (Bloomberg). Importantly, the CNH appears to have outpaced the CNY which like in August and January incited a global asset convulsion.

And if you haven’t noticed, the strains on the China’s yuan have appeared like clockwork—every SIX months.

And why shouldn’t this happen? The January yuan (deflationary) strain has prompted the Chinese government to unleash a staggering USD 1 Trillion of Total Social Financing (lowest window)! And the magnitude of credit expansion perked up domestic liquidity which subsequently caused food inflation even when the general measure of inflation the CPI barely budged.

From the supply side alone, the flood of credit by itself should be indicative that the yuan is southbound or headed lower! 

Additionally, with the inundation of credit, the public went into a speculative binge. They revved up speculations in commodities such as iron ore and steel rebars—which eventually collapsed. Moreover, Chinese property prices have gone berserk.

So it is likely that such developments may have prompted those in the know to escalate capital flight.

Chinese May imports reported a minimal .4%. But that’s most likely because imports from Hong Kong skyrocketed by a nosebleed 242%!!! Much of these imports have likely been about over-invoicing of imported goods which serves as a way to go around capital controls to send capital abroad.

China’s reserves have most likely been propped up by derivatives, (forex swaps and futures contracts). And with such derivative tools being short term in nature, borrowed dollars will again need to be paid back or rolled over. So the 6 months cycle could have signified expiring contracts.

So even when Chinese reserves dropped by only $28 billion in May to just $3.19 trillion to its lowest level since 2011, current pressures reveal that China’s “dollar” strain may have been vastly understated.

Again China’s currency ailment could be a symptom or a manifestation of the escalating pressure on the US dollar “shortages” through wholesale finance, in particular fx swaps and forward contracts.

In a recent speech by Bank for International Settlement’s, Economic Adviser and Head of Research, Hyun Song Shin, Mr Hyun opined that a critical measure of the foreign exchange markets have broken down or in his words a “widespread failure”.

Such systematic failure which has become pronounced in the last 18 months have been seen through the Covered Interest Rate Parity (CIP)

Covered Interest Rate Parity is “a condition where the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium” (Investopedia)

In short, the relationship between interest rates and currency values has been rendered dysfunctional.

For an overview. A currency’s forward rate and the current “spot” rate provides for the implied interest rate on the US dollar. Thus the difference between Libor and FX swap-implied dollar interest rate is called “cross-currency basis”

And when the implied interest rate from the fx dollar swap is above Libor, then the borrower of dollars will be paying more than the rates at the open market.

The systemic failure or breakdown occurs when cross currency basis have consistently been in negative, or when the fx swap dollar borrowers are, as noted above, paying above the market rates.

Negative cross currency basis occurred during the Great Recession. Today it has been happening for the 18 months even “during the period of relative calm”

But such correlational breakdown has been anchored on a strong US dollar which is a symptom of tighter credit conditions. 

Mr Hyun*

The breakdown of covered interest parity is a symptom of tighter dollar credit conditions putting a squeeze on accumulated dollar liabilities built up during the previous period of easy dollar credit 

*Hyun Song Shin Global liquidity and procyclicality World Bank conference, “The state of economics, the state of the world” Washington DC, 8 June 2016 Bank for International Settlements

Ironically, the CIP breakdown has not been seen only in emerging markets but in the yen, Swiss franc and the euro. Yes negative rates economies!

And these accumulated dollar liabilities or “ dollar shorts” emanate from three aspects of the US dollar’s currency reserve and cross border transaction role: namely, trade finance, invoicing currency and funding currency.

As trade finance currency, hedging activities are usually channeled through US denominated bank credit.

As invoicing currency, borrowing and lending occurs on the currency from which trade has been denominated in. For instance, exporters who trade in US dollars tend to borrow US dollars to finance operations and real assets.

As funding currency, globalization of financial markets means that a significant number of financial- institutions (such as pensions) or investors invest or take advantage of trade or speculative arbitrages around the world. In doing so, they convert foreign currency to domestic currency where investments are made. This leads to currency mismatches which these institutions or investors apply hedge positions. And the hedging counterparty is typically a bank. And as consequence, the bank will likely resort to mitigating its currency risk exposure by borrowing dollars. In this way, dollar claims are counterbalanced by dollar debts.

In other words, dollar liabilities built the period of easy dollar credit are equivalent to dollar "shorts".

So when credit conditions tighten, the race to meet dollar obligations are magnified, hence fx borrowers to pay above market rates to cover dollar “short” positions or dollar liabilities. This leads to the systemic CIP failure. Thus the recent rise of the US dollar, which has been accompanied by the negative cross currency basis, means that global conditions have been tightening.

I might add that such correlational breakdown have also been tied with ZIRP, NIRP and QE which provided the “period of easy dollar credit” and the incentives to hedge and leverage up in USD.

Aside from the above mentioned strains, China’s weakening currency could be in part,  brought about dollar shorts and also in part from a stampede to meet such obligations.

The BIS’ latest outlook on China’s external credit conditions provides some clues [Bank for International SettlementsHighlights of the BIS international statistics (June 6, 2016)] "Cross-border bank credit to emerging market economies (EMEs) was down by $159 billion during Q4 2015, or 8% in the year to end-December 2015 – the sharpest year-on-year contraction since 2009” And this was largely due to China where “ The $114 billion decline in cross-border lending to China was the second quarterly drop in a row, and it pushed the annual growth rate down to –25%.”

Furthermore, “The $114 billion decline in cross-border lending to China was the second quarterly drop in a row, and it pushed the annual growth rate down to –25%.”

And for potential supply of dollar shorts “New data published by China confirm that banks on the mainland are becoming an increasingly important source of international bank credit. They are an especially important source of US dollar credit: their cross-border dollar assets totalled $529 billion at end-December 2015."

So if there is anything, the bank selloffs and yuan’s weakening are symptoms of the ongoing tightening credit conditions around the world.

And tightening credit conditions should extrapolate to a weaker economy and narrowing access to credit. This subsequently implies greater credit risk which should transpose into greater systemic fragility.

Is it a wonder now why George Soros made a huge bet on a market crash and called for a sell on Asia?