Future(s) of the Yuan

Submitted by Daniel M. Harrison on September 28, 2007 - 1:03pm.

An interesting comment from Adrian Foster, head of Market Strategy for Kleinwort in Beijing in today's research note:

China: won't allow FX options or derivatives until the CNY [Chinese Yuan] is more flexible, according to SAFE's [State Administration of Foreign Exchange] deputy international director (Wang Yungui). "Derivatives are possible only when there are two sides in a trade. That's why we need the yuan's rate to be more flexible."

This is the point I have been making in previous posts about sub-prime - when there is no buy-side in a derivatives category, then the category is essentially worthless, no matter what the price movement (it's also why you should stay out of housing derivatives right now, despite the huge marketing effort behind them). Given the recent performance of mortgage-backs then, to the lay investor Wang's comments look credible.

The problem is, liquidity very, very rarely dries up in the case of global currencies -- and if it does so, then it is for a very short period of time. The Argentine peso and the Thai Baht in the 1990's are two exceptions to the rule, but China is in a different "volume" league (which is Wang's argument in the first place) in terms of global currency buying and selling. Rather, the yuan is more akin to Japan in the early 90's: even during the credit crunch back then, there was still a substantial market for the yen -- albeit a negative one.

More likely the reason Wang is defensive about derivatives on the yuan is that if China makes an international futures/options market on her currency, then the next logical step is to unpeg it vs. the dollar. That would mean that the current cozy relationship she enjoys exporting cheaply across the world would fall overnight, as the yuan naturally appreciated against international currencies. It's a sly PR move, made at a precipitous time, and it'll fool most domestic traders, which is presumably the intention.

Posted in | Daniel M. Harrison's blog »

Tatyana Shumsky said:
September 28, 2007 - 2:22pm

Given that the Yuan is pegged to a basket, a Yuan derivative’s risk profile would have the same limitations as the floating basket.

Basically, by pegging the Yuan to a USD weighed basket, the Chinese government made sure the currency trades within particular bounds. Unlike a straight peg that keeps a fixed exchange rate, the basket system offers some flexibility. However, that flexibility is bound by the movements of currencies inside the basket.

If you offer a derivative on the Yuan, aren’t you just offering a derivative on the movement of the basket? In which case your upside and downside fall within the margins dictated by the government. Is that margin wide enough to offer investors worthwhile returns? Would there be a market for this product, given its limitations?

More importantly, a derivative market dependent on the Yuan’s exchange rate is at the mercy of the Chinese government, who can unpeg or change regulations that will affect the value of outstanding contracts.