Dec 11, 2015

Chinese Currency Update: Derivatives Impact and FX Market Outlook

The IMF recently announced that it would add the Chinese Yuan to the basket of currencies that make up its lending reserve. This blog Udi Sela VP of Partner Solutions and Jim Jockle, CMO discuss the implications behind this decision. Udi explains how this decision might be a move by the IMF to further legitimize China’s currency and what it might mean for the larger markets if China is willing to lessen control over its exchange rate and financial system.

Weigh in and continue the conversation on Twitter @nxanalytics, LinkedIn, or in the comments section.

Video Transcript:

Jim Jockle (Host): Hi, welcome to Numerix video blog, I'm your host Jim Jockle. This week China has joined the world's elite currency club with the IMF announcing that starting in October that the Yuan will join the likes of the dollar and the pound. Joining me today to discuss implications of this announcement as well as a forward look as to implications of this announcement as well as a forward look for implications for the derivatives market when this takes effect, is our regular FX Expert, Udi Sela, Udi how are you sir?

Udi Sela (Guest): Excellent, thank you Jim.

Jockle: So, the first question I really want to jump into is, really, how does this announcement further legitimize China’s currency?

Sela: Well clearly, this is another step in opening the Chinese market for international players and investors in various ways. Basically they now mean the Chinese Yuan will be part of the SDR and that basically means that it (the Yuan) could become a reserve currency for central banks. So clearly this change could augment the demand. It also means that people will start, or would be able to start, using the Chinese Yuan as an investment vehicle. You can think for instance of international bonds, held by international investors denominated in Yuan, not necessarily issued in China. You can think of a  two way activity, of more volatility. I think it’s an exciting development and it will really reflect the increasing weight of China in the international Trade and you can even see in the SDR that the proportion of the Chinese Yuan will be higher than the of the Euro. So basically we definitely see, the impact of the growth of the Chinese market.

Jockle: So one of the questions is the timing of this announcement. Over the last few months we’ve seen the devaluation of the Yuan as a proactive measure by the Chinese, we’ve seen a lot of stock market volatility. What insight can you give around this timing?

Sela: Well first of all we need to take the devaluation with a pinch of salt. The Yuan moved about 2-3%, so that’s not a really high volatility. Typically the volatility of the Chinese Yuan is around 2%, it was a little but higher, but not much more so it’s still perhaps 25% of the volatility of the international market. Now, indeed, the timing is very interesting. The IMF is trying to get the Chinese regime towards a more liberalized market because we saw that over the years the Chinese Yuan was actually undervalued to support to Chinese exports. The Yuan was allowed to floated within a 2% band. And basically what happened was the Yuan actually weakened instead of being overvalued. So in a sense it enables the Chinese Yuan to find its real weight and its real market price which is not determined by the government. So I think this is really the message that the IMF wanted to deliver. Because you cannot say that the currency is not being fully liberalized. So I think if they want to encourage the Chinese government there (in liberalizing the markets)

Jockle: So specifically taking a step in talking a little bit more on the derivative side of things, what can we expect in terms of over the next few months? I mean obviously you know we can start seeing different and new pairs coming into the market for FX trading. What is it going to take to get there?

Sela: So I think that at the end of the day, the more the Yuan is being allowed to fluctuate, it will be subject to natural economic forces. What we see in general in the world, probably two countries, the US and the UK where the economic situation enables the starting the cycle of rate hiking. While with the rest of the world where we see a different phase and a reversed cycle; actually the economies are still weak and the central banks still try to stimulate activity by lowering the interest rate. So China is definitely slowing down and I think it belongs more to this pattern of weakening currencies. I think it’s a very good timing because on one hand you can see central banks starting to invest in the Chinese Yuan and generating demand. At the same time economic forces driving the Yuan lower because of the economic cycle and again we know that China's GDP globally will be 7%, perhaps more like 6%. So I think the bottom line is really volatility, which is always good for market trading.

Jockle: And implications within the region? I mean obviously you know, Taiwan, Hong Kong have been gateways to China for years. Is it possible we’re going to start seeing out flows of monies from China, as compared to the benefits of liberalization and in flows of cash?

Sela: I think one of the biggest economical partners of China is Japan, so we can definitely start seeing the huge Japanese asset managers investing in Chinese denominated bonds. Perhaps even Japan will start issuing bonds, which are denominated in Yuan. Because we know that now a huge part of the government bond sector (in Japan) that is already held by the central bank and they keep on going with the quantitative easing by buying government bonds and soon they will own all of the market, so maybe there will be another way to generate more inventory. If the Chinese Yuan will be allowed to weaken, that’s probably not great for the Asian exporters because they would less local currencies for the sales that they produced in China, and it actually could give China a competitive advantage over countries such as Vietnam or other countries of the region. And we still look that the commodities keep on weakening. So again that’s the reasoning for the slowdown of the economy.

Jockle: Well Udi, I want to thank you so much. And this is something we obviously want to keep our eyes on. I’m sure they’ll be some changes in market dynamics over the next few months, especially as we roll into the New Year, and it’ll be interesting to see sensitivity as it relates to if and when the US starts raising its rates now that we will have a little bit more transparency onto the Yuan. So, definitely more to talk about in the near term and I want to thank you so much for joining me today, Udi, for sharing your insights.  And of course we want to talk about the topics that you want to talk about, so please follow us along on LinkedIn or on Twitter @nxanalytics. Thank you very much and thank you very much Udi.

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