Last week, USDCNY began to accelerate lower and break across the “real pain” threshold that we have been discussing for many of the world’s so-called “hedgers” who have been riding the one-way strengthening trend of the CNY for years and piled in with leveraged trades on what had been a one-way bet. The collapse this week, to levels not seen since pre-BoJ QQE and pre-Fed QE3 appeared to trigger an avalanche of unwinds or hedges of the exposures we have been worrying about. As the chart below shows, billions of dollars of upside calls on USDCNY were purchased on Friday with serious size out to 6.65 strikes (levels not seen since 2009) by the end of 2014.
The losses are mounting, as we explained in great detail here…
Simply put, if the CNY keeps going (whether by PBOC hand or a break of the virtuous cycle above), then things get ugly fast…
How Much Is at Stake?
In their previous note, MS estimated that US$350 billion of TRF have been sold since the beginning of 2013. When we dig deeper, we think it is reasonable to assume that most of what was sold in 2013 has been knocked out (at the lower knock-outs), given the price action seen in 2013.
Given that, and given what business we’ve done in 2014 calendar year to date, we think a reasonable estimate is that US$150 billion of product remains.
Taking that as a base case, we can then estimate the size of potential losses to holders of these products if USD/CNH keeps trading higher.
In round numbers, we estimate that for every 0.1 move in USD/CNH above the average EKI (which we have assumed here is 6.20), corporates will lose US$200 million a month. The real pain comes if USD/CNH stays above this level, as these losses will accrue every month until the contract expires. Given contracts are 24 months in tenor, this implies around US$4.8 billion in total losses for every 0.1 above the average EKI.
And clearly the hedging of those losses is underway en masse… (the size of the circles is the notinal being hedged – we have highlighted a few for context) as it is clear, hedgers are concerned that CNY would weaken to 6.65 or beyond by the end of the year
(h/t @moved_average )
The escalation of the unwind in recent days suggests the vicious circle is beginning.
Finally, putting aside speculative trader P&L losses, many of which are said to be of Japanese origin and thus will hardly enjoy much or any PBOC sympathies, here is CLSA’s Russel Napier on what the long-tern fate of the Renminbi will be:
“Mercantilist alchemy transmutes China’s external surpluses into foreign exchange reserves and renminbi. But with capital outflows from China at record highs, those surpluses are only maintained due to its citizens’ foreign-currency borrowing. Bank-reserve and M2 growth are already near historical lows and are driving tighter monetary policy. This will lead to severe credit-quality issues and force the authorities to accept a credit crunch or opt for a major devaluation of the renminbi. They will do the latter; and despite five years of QE, the world will get deflation anyway.”