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Playing The Yuan
By Paul Amery | 23 June, 2010 17:29 (GMT)   

The firm’s announcement of its inaugural emerging market currency trackers came on the first trading day after China said that it would be relaxing its exchange rate regime – good timing indeed.

The new emerging market currency ETCs come with a steeper price tag than the developed market equivalents launched a few months ago. The yuan and rupee versions charge 59 basis points in annual management fees and 85 bps in annualised daily spread (which reflects the cost of currency transactions), adding up to nearly a percent and a half in annual charges. By comparison, ETF Securities’ developed market currency ETCs charge an all-in 99 basis points (again, management fee plus spread). The difference is unsurprising – the emerging market currency products are new in Europe, and so ETF Securities can charge a premium rate for them.

However, given that an investor will have to pay brokerage commissions and the ETC bid-offer spread on top of these annual charges when buying or selling currency ETCs, and since most expectations for the yuan’s movement against the dollar are for a few percent in appreciation per annum, the question remains as to how much of any currency return will be left for the investor.

Having said that, and with all due respect to China’s economic performance, we are talking emerging market currencies here, so anything might happen. It’s worth pointing out that the consensus view of yuan appreciation has its opponents: Société Générale’s Albert Edwards is on record as expecting the country to move into current account deficit this year and to have to devalue its currency, while Edward Chancellor of fund manager GMO makes the case for an imploding real estate bubble.

It seems broadly accepted that Chinese interest rates have been held too low to prevent excessive property speculation, so perhaps we might see more in the way of currency fluctuations than the Chinese authorities are currently planning.

But the question of interest rates brings me on to the key difficulty in evaluating emerging market ETCs. For a developed market currency, forward currency rates reflect any interest rate differential between the two currencies concerned. That’s not the case in emerging markets, where the existence of capital controls may mean that there’s no obvious relationship between currency forward rates and interest rate differentials.

The classic case was in Russia in 1996-98, when forward FX rates were set by local banks according to the central bank’s pre-announced currency corridor, which factored in an annual depreciation of around 15% in the rouble versus the dollar. As Russian t-bills were paying over 100% in interest, it was possible to buy them, sell the currency forward and lock in a huge dollar return. All worked fine until...well, that’s another story.

In China’s case, before the yuan/dollar rate was actually fixed in late 2008, forward rates were consistently pricing in much more yuan appreciation than actually took place. Again, there were no obvious linkages between the forward rates and the interest rate differential between the yuan and the dollar at the time (12 month CHIBOR was around 4% and 12 month dollar LIBOR around 3%, implying that forward rates should have reflected a 1% devaluation in the yuan over the coming year, rather than the 10%-plus appreciation priced in by actual market forwards). The chart below, taken from a paper by Yi David Wang of Stanford University, illustrates the prevailing market quotes from that time.

Yuan_spot_and_forward_2

Those who bought yuan non-deliverable forwards (NDFs) in mid-2008 to speculate on the currency’s further appreciation lost out, in other words.

This, to me, is the trickiest part of dealing with emerging market currencies. ETF Securities’ yuan ETC gets its exposure by rolling three-month NDFs, so understanding how those forward rates are derived, or to what extent they reflect how investors have already positioned themselves, seems the most important issue for any potential investor. Currently, yuan forward rates build in an expectation of a 3% or so appreciation over the next year, so any ETC investor will need to see more than a 4.5% rise in the spot rate over the year (factoring in the product’s fees as well) to make a profit from the long yuan ETC. Alternatively, you could buy the short version, of course.

Our regular contributor Cris Sholto Heaton will be writing in more detail next week about Asian currency regimes and I look forward to reading his thoughts on how Western investors should best approach this asset class.

 

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