Investors convinced China's currency is once again a one-way bet upward should think again: signs of slowing economic growth could cut short the yuan's rally.
Investors and companies have been pouring funds into China in recent months, helping send the yuan to a series of record highs.
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But with evidence of a slowdown mounting, investors thinking of joining the rush into yuan would do well to remember 2011 and 2012, when fears of a Chinese hard landing sent the yuan, or renminbi, tumbling.
"Does this herald a return to the old status quo of one-way FX appreciation? Our medium-term answer is 'no,'" Paul Mackel, head of Asian FX research for HSBC in Hong Kong, wrote in an April 14 note to clients. The latest inflows, he wrote, were driven by financial inflows, including speculators betting the yuan will rise. "These expectations could reverse in the future should the domestic and external environments change."
A Reuters analysis of official data indicates that $181 billion in so-called "hot money" portfolio investment flows entered China in the first three months of 2013.
And that estimate may understate the true figure, since it doesn't include those inflows that many economists suspect have been disguised as trade payments.
The inflows have helped push the yuan up 1.1 percent since April. Though hardly dramatic by the standards of freely floating currencies, most analysts began the year forecasting gains of only 1 to 2 percent in 2013.
China's foreign exchange regulator responded earlier this week with new rules aimed at plugging holes in China's capital controls that punters have exploited to bet on appreciation.
The new rules spooked China's currency market: yuan traded outside China, or offshore yuan, suffered their worst one-day drop in 15 months on May 6, while yuan traded in China's more regulated currency market, or onshore yuan, fell by the most since December. But the currency quickly recovered to scale new highs on May 8 and May 9.
China's problems with hot money put it among the many emerging economies coping with the frustrations of rapid capital inflows from the United States and Europe, where central banks have pushed interest rates to record lows in an effort to revive growth, sending domestic investors in search of higher returns abroad. That has sparked concerns of a global "currency war," with central banks cutting interest rates to help keep their own currencies from rising.
In the past week, central banks in Australia and South Korea surprised markets with rate cuts, and New Zealand's central bank said it had been selling its own currency to stem its rise.
While the yuan's own exchange rate was once fixed, in 2005 China began letting its value fluctuate around a set rate. With its trade surplus ballooning and its foreign exchange earnings soaring, the question was not whether the yuan would rise or fall, but how quickly authorities would let the currency rise.
In late 2011, as fears that China's credit-boom would burst and send the economy into a sharp "hard landing," the market got its first taste of downside risk.
Even the most pessimistic forecast would have left China growing at a rate most countries would envy, but the fear of a sharp Chinese slowdown was enough to spook investors and cause a sharp drop in a seemingly unshakeable market.
Chinese companies that had sold dollars short during years when the yuan was a one-way bet rushed to buy them back, helping to speed the yuan's decline. Onshore yuan fell 1.3 percent through the first seven months of 2012, the currency's first bout of sustained declines since China's modern foreign-exchange trading system was launched in 1994.
The yuan's tumble appeared for a time to have cured the market of its faith in the yuan's perpetual ascent. But in August 2012, the market shifted again. As fears of a euro zone break-up eased and China launched a mini-stimulus program to revive growth, investors' taste for yuan returned.
When the yuan began rising anew in the fourth quarter of 2012, companies that had accumulated large dollar holdings earlier in the year scrambled to sell them, accelerating the yuan's climb. By late November, when confidence in the recovery peaked, China's onshore foreign exchange market ground to a virtual halt, as dollar bids disappeared from the market, forcing the central bank to step in to buy dollars itself.
The central bank was still buying dollars in the early months of 2013. Balance of payments data shows that it bought $157 billion in the first quarter, the most since the fourth quarter of 2010.
"Non-FDI capital flows have returned to China on improved global risk sentiment and signs of stabilization on the Chinese economy," Wang Tao, head of China economic research at UBS in Beijing, wrote in late April, using an abbreviation for foreign direct investment.
Currency traders say China-based companies have also been "over-hedging" their dollar holdings by buying forward contracts for yuan, fuelling the yuan's rise. A Reuters analysis of yuan purchases by companies shows that China-based importers and exporters are now buying yuan at the fastest pace since 2010.
But even as Chinese companies and global investors lay ever-bigger bets on the yuan's rise, worries about China's economy are stirring, threatening a 2011-style correction. GDP grew at 7.7 percent in the first quarter, down from 7.9 percent in the last three months of 2012 and well below analysts' expectations of 8.0 percent. Industrial output and fixed-asset investment also disappointed.
Purchasing managers' indexes, which gauge economic activity, also suggest China's manufacturing and service sectors were still weak in April.
If such indicators continue to disappoint, a 2011-style correction may not be far behind. The latest regulations, which target fake trade invoicing used to convert excess dollars to yuan, are also likely to bring reported export growth down to levels economists view as more realistic, given weak external demand.
That could sap confidence in China's economy and its yuan.
"It's going to be quite difficult for the renminbi spot exchange rate to appreciate much in the short-term. We think the recent moves have slightly overshot,' said Robert Minnikin, senior foreign exchange strategist at Standard Chartered in Hong Kong. "The data is not super strong," he said. "If anything, there's a risk that we could see a bounce in dollar-CNY."
(Editing by Wayne Arnold)