Yuan May Soar as Carry Trade Unwinds, Top China Economist Warns

The Chinese currency risks surging 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 Ltd.

“If people see a signal that the yuan could strengthen by 3% to 4%, 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.

“The carry trade positions will be closed, and it could happen fast,” he said.

Such an unraveling would have echoes of the recent blow-up of yen-centered carry trades — but with a twist.

Unlike financial investors who’ve piled into short yen positions, the yuan carry trade largely involves exporters and multinationals, according to Macquarie Group Ltd., which estimates they’ve amassed over $500 billion in dollar holdings since 2022.

Just over two years ago, the Federal Reserve embarked on its most aggressive tightening cycle in a generation. The Fed is now edging closer to cutting rates from a two-decade high, with expectations building that US policymakers are likely to start lowering borrowing costs in September.

Currently, the market has priced in a yield gap of 3%-4% 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% 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.

The latest round of appreciation offered a welcome respite to the People’s Bank of China following its year-long battle to defend the yuan. Policymakers could now have more room to cut interest rates and support the domestic economy.

Chinese regulators are likely to tolerate some appreciation of the yuan, according to Guan, who added that the country’s exports are less sensitive to currency moves than changes in external demand.

Guan, a long-time advocate of allowing the yuan to be more flexible, said China should prioritize promoting domestic inflation and growth over maintaining a stable currency.

He’s attended former Premier Li Keqiang’s economic seminar in 2022, a regular meeting where some of the country’s most prominent economists are consulted, as well as sessions with government ministries more recently.

Despite the rising pressure of capital outflows over the past year, authorities haven’t resorted to administrative measures to tighten controls that prevent money from leaving, Guan said.

The approach marks a departure from the strategy employed in 2015, when regulators stiffened restrictions on the movement of money in the aftermath of the yuan’s shock devaluation and a huge exodus of capital that followed.