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There has been the dual piece of news about China over the past weekend. One is that the US formally launched a trade investigation on China’s intellectual property practices, under so-called “Section 301”, which could take one year to decide whether to impose tariffs on Chinese products. The other is that China has formalized its policies on overseas investment and implemented a sector approach. For instance, investment in property and sports is restricted, while the government encourages investment related to “Belt and Road” initiatives.
From a balance of payments (BOP) perspective the US’ punitive tariff, if there is any, will likely narrow China’s current account surplus. China’s controls on overseas investment, on the other side, indicate that China does not want to see a big capital and financial account deficit. Certainly, if the current account surplus shrinks significantly, China might have to further control its outward investment. Balancing these factors, it appears that China will have to continue to carefully manage its BOP going forward.
In currency space, the PBoC set the USDCNY fixing rate at 6.6709 this morning, again surprising the market on the downside. One of the most important developments over the past few months, according to many corporates and funds, is the narrowing spread between USDCNY and USDCNH forwards. Taking one-year tenor as an example, the USDCNH forward is around 400pips higher than USDCNY forward.
Lower vol/skew and CNH stronger than forwards:
Assuming tail risks have been effectively curtailed, volatility and risk reversals should stay low, all else equal. Investors are unlikely to be willing to pay up for protection against severely reduced capital outflows and FX depreciation risks.
Furthermore, CNH is unlikely to underperform the forwards this year unless the dollar starts strengthening. Indeed, CNH has remained closely linked to the EUR/DXY this year and the counter-cyclical adjustment factor has not caused any notable changes to our fixing model performance.
Despite this baseline assumption, we like owning some topside exposure in USDCNH as a protection against an EUR correction, a hedge against a short dollar/long carry portfolio and an earlier slowdown in Chinese growth. Investors’ interested in carry could consider long CNHTWD. Courtesy: Societe Generale.
