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At China’s Foreign Exchange Trading Center: This week announced revisions to the currency composition and weights in its CFETS trade-weighted index, effective January 1, 2017. In the new basket, the number of currencies is expanded from 13 to 24 with the weights adjusted accordingly.
The weights of the currencies in the old basket generally were revised down (except CHF): USD from 0.264 to 0.224, EUR from 0.2139 to 0.1630, and JPY from 0.1468 to 0.1153.The 11 newly added currencies together represent 21.09% of the new basket, led by KRW at 0.1077, the fourth-largest weight in the new basket.
The CFETS also announced that the basket will be revised annually, and the index will be re-based every year accordingly (using the old index on the last trading day as the base for the new index the following year). The criteria for currency selection will be based on the availability of direct bilateral quotes in the CFETS market, and the weights calculated based on trade weights of each trading partner (taking into account the processing exports/imports effect) in the previous year.
The revision of the CFETS index signaled that the PBOC will likely maintain the current CNY fixing regime, which is jointly determined by the USDCNY closing spots on the previous day and trade-weighted indexes (CFETS, BIS, and SDR baskets). In other words, the likelihood of a regime shift to a one-off devaluation or free-float looks very small in the near term.
How will the revision affect CNY dynamics? In the new basket, the weight of USD was reduced by 4%-pts. In theory, if USD strength persists, maintaining a stable TWI will imply a bigger devaluation of CNY against the USD than in the old basket.
In practice, the difference could be negligible. First, as HKD, AED, and SAR are pegged to the USD, the weight of USD-bloc currencies is revised down by less (from 0.3295 to 0.3054). Second, it also depends on whether USD strength is driven by the relative weakness of other reserve currencies or EM currencies and their relative weights.
Notably, the KRW is included in this new basket and its weight of 10.77% is the fourth highest in a basket after USD, EUR, and JPY. As such, the performance of the KRW will have a relatively large impact on the moves of the new CFETS TWI. Our back tests indicate that the weak KRW performance was one of the main reasons why the new CFETS TWI declined more slowly than the old one in 1H of this year; though overall the CFETS indices are quite similar under the old and new baskets in the past two years (Figure 1).
CNH Option strategies on hedging grounds:
Buy USDCNH 1y topside seagull, strikes 6.90/7.20/7.50, zero cost (indicative, spot ref: 6.85), the structure is a standard 1y call spread strikes 7.20/7.50 fully financed by selling a put strike 6.90, exposed to a maximum USDCNH appreciation of 4.2% at expiry.
