What looks like a debt crisis in China is thus likely to morph into a currency crisis.

Russell Napier, Macro Strategist, ‘The Toronto Star’, October 6th

Don’t bet on appreciation or depreciation in the yuan.  (People who) always gamble will definitely lose.

Pan Gongsheng, Head of State Administration of Foreign Exchange (SAFE), June 2021

Risk is high these days in global forex and commodities markets, so please pay attention to controlling risks.

Statement from ICBC, China’s largest bank, October 2021

The Evergrande crisis is focusing investor attention on the possibility of systemic risks building in Chinese financial markets.  It also appears to be focusing the attention of Chinese government regulators, who have begun taking action to clamp down on possible sources of risk throughout the financial system. 

Having recently banned crypto currency trading, Chinese authorities are now eyeing the FX markets as a potential source of systemic risk.  This is unsurprising.   The build-up of private sector debt in China is worrying, and the proportion of income used to service debt in China now sits at 20% of GDP, one of the highest levels in the world.  This means that the chances of a Chinese financial crisis are growing, and as Russell Napier wrote in the Toronto Star last week: ‘The monetary medicine necessary to combat a financial crisis, usually in the form of lower interest rates and the creation of much more money, are not ultimately compatible with a stable exchange rate.’

The Chinese government knows this, of course, and has begun to take action to try and protect the domestic economy from FX volatility.  Some of their actions seem sensible, like ensuring that the domestic corporate sector understands the importance of currency hedging.  Beginning earlier this year, China’s financial regulators launched a campaign to encourage more corporate FX hedging, which included ensuring commercial banks were educating their clients on FX risks and hedging strategies. 

Other actions are more controversial and, in some cases, just plain odd.  For example, Chinese banks and brokers seem to have stopped publishing yuan forecasts at the behest of regulators.  Banks are also clamping down on retail trading.  Last week, ICBC, China’s largest bank, announced that it has suspended new account openings for retail FX trading, and it will also be stopping the initiation of new trading positions from November. 

According to a recent report from Reuters, regulators are pressuring Chinese banks to provide faster pricing to customers, reduce spreads, and lower the turnover of interbank trade.  This seems to be an attempt to transfer risk away from the corporate sector and towards the banks themselves, presumably because regulators feel that they will have better oversight and control of risks which are sitting on the bank’s own books.   

From the perspective of investors with yuan exposure, these developments are concerning for three reasons:

  1. It implies that Chinese regulators are becoming concerned about systemic risks associated with the FX markets;
  2. Forcing banks to warehouse more FX risk for less profit will likely have the opposite effect to that intended – FX volatility will go up as banks refuse to step in should the yuan begin to fall; and
  3. The availability of FX hedging instruments may decline, restricting the ability of investors to manage risk effectively.  As the Zerohedge website put it recently (in their characteristically excitable tone): ‘first price forecasts are banned, then retail trading, soon all institutional exposure to FX and commodities will be taboo too, leaving companies unable to hedge exposure and really setting off a chain of dominoes that will end with catastrophic consequences…’

China is the third largest market for private equity investment today, after the US and the UK.  Traditionally, many foreign investors in China, including dollar-based private equity managers, have benefited from a strong and stable yuan to underpin these investments.  Changes in the macro environment, notably the divergence of monetary policy bias between China and the G10 economies, mean that this tailwind is under threat.  As the Chinese FX markets themselves are also undergoing rapid change, and traditional hedging strategies may become harder or more expensive to execute, the art of FX risk management will become ever more crucial in supporting China -focused investment strategies.