How Fake Exports Caused The Yuan Rally

Includes: BOM
by: Matthew Cowie

Chinese exporters on the brink of bankruptcy have turned to currency arbitrage to stay alive, distorting Chinese trade data and the Chinese banking system.

This weekend, the Ministry of Commerce admitted trade figures overstated Chinese exports, where they had reported 14% growth for the first four months of 2013, y/o/y, they now report growth was really 9.2% when hot money is removed (link).

Separately, we learned exactly what is behind the inflow of U.S. dollars: currency arbitrage. Firms are taking advantage of the lower Mainland USD-CNY exchange rate to earn much needed profits, now that the real estate sector is closed off. Here's an example of what's happening: an exporter will "sell" $100 million worth of goods to Hong Kong and exchange the $100 million for 620 million yuan (based on a 6.20 exchange rate). Since the exchange rate in Hong Kong is 6.18, they can clear 2 million yuan in profit. Additionally, thanks to yuan settlement, they can do the settlement in yuan and don't need to move dollars back to Hong Kong (link).

April's trade data was the most distorted, and many analysts speculated it was fake invoices for the purpose of obtaining tax credits. However, arbitrage makes the most sense because it explains the massive distortion in the Chinese exchange rate.

Over 10 trading days in April, the yuan advanced 5x as much as all of 2012 (a gain of 749 basis points versus 146 in 2012). This generated a stampede into the arbitrage trade because it was becoming more profitable (the mainland exchange rate is always playing catch-up to the offshore rate during sustained trends) and because low margin exporters were facing the prospect of bankruptcy.

Low margin exporters have been in trouble since 2010, when the yuan began rising again and QE2 (and other central bank money printing) sent raw material prices higher. Meanwhile, economic weakness in Europe, Japan and the U.S. have been keeping demand soft. Previously, firms turned to real estate (a strategy not isolated to low margin export firms), but with the government closing off this avenue, firms turned to currency arbitrage.

This isn't the first time we've seen it either. There was a mirror image decline in the yuan in 2011. At that time, the yuan was falling as dollars were being drained from the Chinese banking system because the Mainland yuan price was higher than the Hong Kong price.

The trend is easily seen in this chart of the FX loans-to-deposit ratio in the Chinese banking system.

Back in 2008, dollars were drained from the Chinese banking system as they were across the global economy, to repay U.S. dollar debts. Chinese businesses bet on the steady appreciation of the yuan by borrowing in USD and the Chinese government halted the yuan exchange rate to prevent a decline, restarting appreciation in 2010. In 2011, we saw dollars drain once more, thanks to an economic slowdown and arbitrage opportunities in Hong Kong. This was the time when factory owners were fleeing their debts and the yuan traded limit down for half of December 2011.

And while most of the pundits out there will talk of the death of the U.S. dollar and the rise of the yuan, the reality is that most yuan trading at this point has been currency arbitrage, in both directions. For more information, see Yu Yongding's paper, "Revisiting the Internationalization of the Yuan."

The reality is that the opening of the yuan to this point has created the conditions for economically destructive volatility in the yuan exchange rate. If the current yuan rally were to continue, China would begin to see a wave of bankruptcies across the low margin export sector. The move higher in the yuan is particularly out of line when one considers the environment. The yen is depreciating rapidly, the South Koreans last week decided to cut rates, Australia cut rates, and the euro looks weak, possibly forming a head & shoulders pattern that if completed, would have a target below the 2010 low. Since the yuan remains highly correlated to the U.S. dollar, it is already appreciating and does not need the added appreciation courtesy of currency arbitrage!

The government's response to the problem is two-fold. First, it will investigate exporters for invoice discrepancies, second it will restrict banks FX LTD ratio. As the chart above shows, the ratio was about 170% at the end of March, but the State Administration of Foreign Exchange (NYSE:SAFE) will restrict this ratio to 75% for Chinese banks and 100% for foreign banks (link). At the depth of the financial crisis in 2008, the ratio never reached 110%, so it's unclear how the government will achieve this smoothly.


First, we knew Chinese trade data was overstated, but now we know the method of the trade distortion is bearish for the Chinese economy. Not just bearish because the real trade numbers are lower, bearish because internal inflation plus a rising yuan exchange rate is hitting exporters on both ends. Faked invoices used to obtain tax credits would distort trade data too, but changes in the exchange rate impact the broader economy, coming at the worst possible time and moving in precisely the wrong direction.

Second, yuan exchange rate volatility has arrived. We saw a decline in the yuan in late 2011 that raised alarm bells (in the financial sector) and once again we see alarm bells (in the export sector) over the rise in the yuan. Even if both moves are not significant in the long-run, it is significant that the currency is not as stable as it was. These moves make the widening of the trading band concrete: a wider band plus several limit up or limit down days in a row can move the yuan substantially. There is now talk of the band widening to 2%, (link) were that to happen, a 5-day 10% move in the yuan is quite possible.

Third, the greater risk for China is an economic slowdown and outflow of U.S. dollars, along with a need for a QE type policy that would devalue the yuan. This topic isn't ignored in China, and I covered it here: Could China's $3.2 Trillion Forex Reserves Be Gone In 5 Years?

In sum, over the short term, we need to see if the government is able to stem the yuan appreciation by cutting off the currency arbitrage in the export sector. Longer-term, the yuan is going to be more volatile. Since I believe a U.S. dollar rally is only beginning and appreciation in the yuan is not what the overcapacity-laden Chinese economy needs, volatility to the downside is the greater risk. (The Chinese government agrees: Yuan appreciation nears limit: experts)

Investments implication: no matter how China slows, via the planned rebalancing or through a more serious slowdown, the greatest impact will be on industrial metals. Commodity producers and commodity exporting countries and their currencies (such as Australia and Brazil) will be at risk. Though it is extremely thinly traded, I like PowerShares DB Base Metals Double Short ETN (NYSEARCA:BOM).

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BOM over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.