FxWirePro: Extended impact of CNY on capital outflow – USD/CNY trade strategies

Although China's capital account is closed, several illicit channels of capital outflows have made the capital account rather leaky. Leaky capital account estimates outflows and policy implications, the capital outflows from China could rise from the current 8-10% of GDP, driven by slowing growth, financial market volatility, policy uncertainty and currency overvaluation. In an adverse scenario, total outflows on the capital account could rise to a significant - 15% of GDP. Since these outflows are much larger than current account inflows of 5% of GDP, they will pressure China's FX reserves and/or the CNY exchange rate.

The valuation models from Barclays, it suggests that the CNY is about 5-10% overvalued and with China's growth prospects deteriorating, if China absorbs the balance of these outflows (USD1trn) completely by selling reserves and meeting hedging demand (in forward markets), this implies a drawdown of 28% of the current reserve portfolio. We believe this is a significant amount, especially if authorities are unable to slow capital outflows. We expect a weaker CNY over the medium term and significant jump risk for USDCNY as sustained intervention of such a size is unlikely given the uncertainty of success.

We see risks of capital outflows and CNY depreciation pressure persisting. We think a 10% fall in the CNY versus the USD is needed to stabilize the REER and capital outflows. It is recommended a long USDCNH 6-month forward trade and maintain our USDCNH call spread.

Forecasts (USD/CNY)
Spot - 6.37, Q4'15 - 6.80, Q1'16 - 6.90, Q2'16 - 6.95, Q3'16 - 7.00

Outright Forward
Q4'15 - 5.4%, Q1'16 - 6.0%, Q2'16 - 6.2%, Q3'15 - 6.3%.