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On 13th August New York time, the US Trade Representative's Office announced delaying till 15th December the 10% tariffs on about half of the USD300bn of Chinese goods, that were originally scheduled to come into effect 1 September.

Though the tariff delay should increase Beijing's interest in sending a delegation to Washington for another round of trade talks in September, we do not think a trade deal will be reached anytime soon. We reiterate our view that China is adopting "better-late-than-early" strategy and will continue to let the trade talks drag on till at least year 2020.

In our view, the more back-and-forth by Trump, the more volatile the USD/CNH is going to be. However, that won't reverse the depreciation trend of the RMB.
We saw a rangebound market followed by a deeper downward correction after USD/CNH set its new high of 7.1400 on 6 August. Nobody should be surprised by such a development if they make reference to what happened after PBOC changed the FX regime on 11 August 2015.

Experience learnt in the aftermath of the FX regime change on 11 August 2015 suggests a gradual rather than a one-off currency depreciation is far more acceptable to the Chinese leaders if devaluation (or depreciation) of the RMB is needed. This is particularly true this time around because:

  1. foreign inflows to onshore RMB bonds, which may be scared away if the RMB depreciates in a drastic manner, now play a more important role than 4 years ago in replenishing China's FX reserves; and
  2. a disastrous debt crisis could arise if the RMB depreciates fast enough to make domestic borrowers with huge foreign currency liabilities fail to hedge their FX exposures effectively.

 

Recall, RMB depreciated 13% against USD during the 16-month period starting from 11 August 2015. During those 16 months, there were 3 consolidation (or stabilization) periods with the shortest one lasting 3 months and the longest one lasting 5 months (chart 1), enabling many market participants to have sufficient time to have their FX exposures properly hedged if they wanted to.

We expect PBOC this time around will again let the RMB FX stabilize from time to time by intervention. If what we expect materializes, market participants in general should be still able to conduct hedging against RMB depreciation risk effectively.

China Insight 0820  

 

Unlike 4 years ago, hedging RMB depreciation risk is far more affordable this time around, thanks to the cheapness of USD/CNH FX swaps.

Take the 12-month tenor as an example (chart 2), its price has been locked in a 400-700 range (against 2000 on average in 2016) since the spot rate surged thru the 7.0000 level, far lower than the 1000 level registered in April last year when CNH was trading at 6.2000-6.3000 (the strongest level since 11 Aug 2015) against USD.

Assume a transaction is done at the mid-point of 400-700 range, we work out a 12-month forward price of 7.0750 (based on the spot rate 7.0200). This forward price looks reasonably good if we assume further RMB depreciation will bring USD/CNH spot up to 7.3000 or 7.5000 in 6-12 months.

Bear in mind, capital outflows still being very effectively curbed is one of the main reasons for the prevailing cheapness of the FX swaps. However, in the case massive outflows arise again, PBOC may have no choice but to tighten the liquidity, which as a result will drive the FX swaps upward and make hedging FX risk via going long USD/CNH forwards far more expensive.

China Insight 0820 

 

In regards to FX options, the USD/CNH implied vol curve has been inverted since USD/CNH surged thru the 7.00 level on 2 August. This type of vol curve inversion did occur a couple of times in the 16-month period starting from 11 August 2015 (chart 3), none of which however did sustain more than 4 weeks.

China Insight 0820 

Failure of the curve inversion to be sustainable to certain extent was due to realized vols being well-capped by frequent PBOC intervention. We think this market pattern will repeat this time around. In our view, calendar spreads consisting of short positions in short-dated vols (e.g. 3-month) and long positions in long-dated vols (e.g. 12-month) are typically the preferred strategy in this market scenario.

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