Yuan surge may trigger fresh volatility

Bloomberg

China's yuan may soar if a scenario similar to the unwinding of the yen carry trade plays out, a prominent economist has warned, a dislocation that could bring fresh volatility to markets.

As the world's second-biggest economy ran massive trade surpluses in recent years and local interest rates fell below those in the US, Chinese exporters began to hoard dollars in anticipation that the yuan would weaken. Some investors also borrowed in yuan to invest in higher-yielding assets abroad, a strategy known as the carry trade.

But a shift in sentiment in favor of the yuan could prompt exporters and speculators to unload dollars and send the Chinese currency surging, said Guan Tao, global chief economist at Bank of China International.

"If people see a signal that the yuan could strengthen by 3 percent to 4 percent, they won't be interested in holding the dollar and profiting from the yield gap," said Guan, who previously worked for China's foreign-exchange regulator, the State Administration of Foreign Exchange.

Currently, the market has priced in a yield gap of 3 percent to 4 percent between the currencies of China and the US based on the one-year contract for the dollar-onshore yuan swap.

The yuan has already strengthened over 1 percent since the beginning of this month, after angst surrounding the risk of a US recession prompted traders to walk away from carry trades in which they borrow the likes of yen and yuan and buy higher-yielding currencies.