Trading China is one of the more specific challenges. For much of the past decade, the importance of China in macro portfolios has been growing – you need look no further than the growing link between’s China’s growth and world commodity prices or the effect China’s accumulation of more than $2 trillion has had on currency markets. Since the start of the financial crisis, however, China has become a far more central driver of macro portfolios. Two dynamics have driven this. First, China’s economy is today simply too big to ignore. Indeed, sometime in the middle of this year China surpassed Japan to become the world’s second largest economy in US dollar terms. At the beginning of the global recovery in 2009 many investors made the mistake of underestimating China’s capacity to play a leading role in the market’s turn. These days few investors make that mistake. Today, focus on China’s economic cycle is nearly as intense as that of the US cycle.
Another post crisis dynamic, perhaps a more important one, is that China’s growth is racing ahead at a time when growth in much of the developed world remains anaemic. Here, there are doubters as well. Many argue China simply cannot sustain its pace of growth without supporting demand from developed economies. Others say China’s markets are the next in a long line of financial market bubbles. We are unconvinced on both counts. Since the start of the recovery, China’s trade balance fell by nearly 50% yet its economic growth remained close to 10%. Behind this trend is a slow but important shift toward more domestic-led growth. Given China’s strong structural position – its huge FX reserves, little fiscal overhang, reasonably healthy banks and household balance sheets – we see little reason for the transition toward more domestic growth to slow. As for concerns about a China bubble, one statistic worth remembering is that while China’s aggregate economy is now larger than Japan’s, per capita GDP in China is less than 1/8th of Japan’s (just under $5000 per capita compared with over $40,000 in Japan). China structural emergence is still very much in its infancy.
To us, the obvious question then is not whether you trade China in a macro portfolio, but how you do it. The answer is harder than it ought to be. Most fixed income macro investors have focused on trading a China view in FX markets – by buying the Chinese yuan directly. It is easy see why. China’s persistently strong growth and massive FX reserve accumulation, coupled with growing pressures by policy makers in the developed world for more FX flexibility has led many macro investors to believe a significant yuan appreciation is imminent. The trouble is that same view has been around for some time. Today, it is a little over five years since China announced a modest yuan revaluation against the US dollar and a commitment to more FX flexibility. At the time, it was viewed as a watershed event. Since then, the yuan has gained a little under 20% against the US dollar in spot foreign exchange markets – a modest, respectable gain.
Unfortunately, macro investors can’t trade USD/CNY spot as the yuan is not fully convertible. Instead, investors trade the non-deliverable forward, an instrument with two significant disadvantages. The first is liquidity. While liquidity in CNY NDFs has improved markedly in recent years it still pales in comparison to that of major currencies. In any given day, we estimate USD/CNY NDF turnover to be around $6 billion. According to the Bank for International Settlements, turnover in EUR/USD is closer to $1 trillion. The second problem is the supply-demand dynamics of the USD/CNY NDF market means most time investors are paying away interest-rate carry on their investment. Figure 1 illustrates the problem. While USD/CNY spot has moved nearly 20% since the yuan was first revalued in 2005, the total return on a buy-and-hold USD/CNY NDF position is actually negative (Fig.1). In other words, trading a positive China view via CNY NDFs is a classic story of being right on a macro view but badly wrong on the instrument to trade it.
The good news is the magnitude of China’s growth and its relative outperformance is drastically changing the behaviour of the global economy and financial markets – and perhaps making it easier to trade a macro view on China. Here are a few statistics to ponder. In 2000, just ahead of China’s recent period of rapid growth, exports to China as a percentage of the total GDP for Chile were close to zero. China simply did not matter to Chile – or the rest of South America for that matter. Today, that number is close to 10%. In other words, 10% of Chile’s annual income is derived from exports to China. In Singapore, the same number has jumped from around 5% in 2000 to over 15% today. In Australia, it is from virtually zero to more than 5%. Across the globe, the pace and nature of China’s strong growth and the economy’s sheer size are transforming other economies.
A similar transformation is happening in financial markets. As China’s economy has grown in importance, those financial markets tied to Chinese growth have become more and more correlated to Chinese markets. Fig.2 looks at the first principal component of daily returns for yuan NDFs and basket of currencies whose countries have a high ratio of exports to China as a percent of GDP. For some time, the interconnectedness between China’s market and those markets fundamentally linked to it has been growing. But the inter-linkages have surged since the financial crisis and have remained strong ever since. What this means is currencies like the Australian dollar, Chilean peso and Malaysian ringgit are increasingly tracking China’s markets – a natural outcome when their economic cycles and terms of trade (for large commodity producers) are increasingly driven by China’s growth.
Why does this matter? We think it matters for two reasons. First, the change in market correlations driven by China’s growth underscores the growing need for macro investors to have a view on China’s cycle and polices. Second, these correlation shifts actually make trading that view on China a lot easier than purely via CNY NDF trades.
Nomura’s C10 Index is an attempt at trading a macro view on China through the rise in fundamental correlations. The concept is a simple one – rather than buy China directly, you buy the countries that make what China buys. Fig.3 looks at the top 15 countries (with liquid currencies) with respect to exports to China as a percentage of GDP. It is an interesting mix. There are the obvious countries such as other Asian countries, who export semi-finished and increasingly finished manufacturing goods to China. Then, there are the commodity producers feeding either China’s manufacturing machine (like Australia and Chile) or the mouths of a growing population of Chinese middle class (like Brazil and New Zealand). Just to underscore the rising importance of domestic middle class spending in China, even Switzerland – the world’s luxury goods maker - makes it to the top 15.
The construction of Nomura’s C10 index is relatively simple. We select the 10 countries with the highest proportion of exports to China as a percent of GDP. We exclude illiquid currencies, fixed exchange rate regimes and major currencies (i.e., the US dollar, yen and euro). We then make a modest adjustment to weights based on the level of a country’s interest rates – allowing us to build a basket that unlike the CNY NDF can earn positive carry. Finally, we set a volatility target for the index so that we can adjust the size of our investment based on the underlying volatility in global currency markets.
Table 1 shows returns from 2001 to present for Nomura’s C10 index compared with other investments, including the CNY NDF. A few points are worth highlighting. First, Nomura’s C10 Index has clearly been a better option for trading China’s growth than the CNY NDF. Compared with the small negative returns of the NDF, the C10 index has gained around 8% per year. To be fair, if Chinese policymakers did begin a significant policy of exchange rate appreciation, NDF returns should turn more positive. But we reckon the C10 index would also gain. The C10 index is also a better instrument than other China proxies, such as outright equity purchase or long-only commodity funds – the C10 index outperforms on both a total return and risk-adjusted-return basis. To be fair, the C10 max draw down is over 13%. But given it is a “beta” index, this number seems manageable compared with draw-downs of more than 70% in equities and commodities during the financial crisis.
Jim McCormick is Head of Nomura’s Fixed Income Research Division for Europe, Middle East and Africa. He also leads Nomura’s macro Strategy Research Group. The group provides comprehensive advice to clients, identifying global market themes and cross-asset/cross-currency trading opportunities using Nomura’s fixed income product platform.
