No easy option

China's yuan plan looks too clever by half

This article has been modified. Please see the correction at the end.

China's currency has lost one per cent of its value against the US dollar in just over a week. One explanation is that it's all part of a scheme by the central bank to pour boiling oil on currency speculators betting that the yuan will stay stronger for longer. If that's the case, the plan looks too clever by half.

Over the long term, a gradually rising yuan is good for China. It encourages productive investment and allows residents to consume more imports. The downside is that speculators ride the currency's coat-tails. That may create short term inflows which make it difficult for the central bank to manage prices. Banks reported a whopping 448 billion yuan ($73 billion) of net inflows in January.

Two fundamental factors drive such speculation: the rising price of the yuan and the fact that interest rates are higher in China than outside. But what makes speculation easy is the lack of volatility. China's relatively stable yuan makes it cheaper to borrow in offshore markets and invest onshore. Investors can also sell options that allow buyers to swap dollars for yuan in the future at a fixed rate. In options parlance, they are "short volatility". The chief protagonists of both trades have been exporters and Chinese companies, banks say.

If volatility rises, those trades look less attractive. That's happening now: the implied volatility of three-month options linked to the offshore yuan has roughly doubled in a week. In theory, the central bank has deterred speculators, but without changing the long-term value of the yuan or relative interest rates.

The danger is that the markets might stop believing that the long-term direction of the yuan is up. Then, long-term investors too will be deterred. Higher volatility and a weaker yuan will leave those who have bet heavily a stronger currency with big losses. As they sell, the yuan could fall further.

The most puzzling thing is that the real winners are hedge funds who were betting on more volatility in China, in many cases because they have a bearish view on the economy's prospects. The central bank risks not only losing control of all-important currency expectations, but rewarding exactly the wrong bunch of people.

CLARIFICATION
The sentence "Banks reported a whopping 794 billion yuan ($130 billion) of inflows in January." has been replaced with "Banks reported a whopping 448 billion yuan ($73 billion) of net inflows in January." We apologise for the error.