MARKET SIGNALS-Shorting China plays may have staying power
(Adds link to PDF: r.reuters.com/fys52s)
* Some investors seek China crisis "tail risk" hedges
* Positions taken in yuan options, China CDS and bank shares
* Short-selling of Chinese bank H-shares running high
* China H-share forward valuation falls towards post-Lehman low
By Eric Burroughs and Kevin Plumberg
HONG KONG/SINGAPORE, July 8 (Reuters) - China is almost certain to weather the economic and fiscal challenges it faces, but some investors are taking no chances.
In the past month, hedge funds and portfolio managers have sought relatively cheap insurance against any risk that a slowdown in the world's second-largest economy or the troubles tied to local government debt spark a broader crisis.
China's huge economic clout and the potentially far-reaching ramifications of any crisis on the mainland, however remote the risk, have spurred a variety of hedges: buying sovereign CDS default protection and yuan put options on top of short-selling bank shares listed in Hong Kong.
Traders say the positions are more about medium-term investors fortifying their portfolios and less about fast-money hedge funds wagering that a China crisis is around the corner.
The flurry of China-related hedging -- which happened even before the accounting scandals of U.S.-listed Chinese companies -- also underscores the problems investors face with an economy of such size that has closed capital markets: there are not enough ways to tweak exposures to such an important part of global economy.
Some market players called these China plays "Black Swan" trades after the book by Nassim Nicholas Taleb on how markets tend to underprice low probability risks.
While some of the plays are at risk of a sudden unwind, such as the relatively large short-selling of bank shares, the worries surrounding China and the current popularity for seeking "tail risk" hedges may mean these positions have staying power.
At the same time, robust earnings by Chinese companies and already low valuations -- almost record lows on H-shares -- mean that it takes some conviction to believe in a deep equity selloff from here.
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Following are charts explaining the different bets and their impact on markets so far:
YUAN 'DISASTER INSURANCE'
Chart on dollar/yuan risk reversals and implied volatility:
If there is any market that has always seemed like a sure bet, it's the yuan. The intense pressure on China to allow greater appreciation, coupled with China's own desire to wean itself off exports and contain inflation, has led to a steady yuan rise to record highs against the dollar.
Yet some market players have been buying dollar/yuan call options -- a position than gains if the yuan were to drop -- in very long-term tenors of one year or two years with strikes around 8.0.
The call options are very far out of the money to make them cheap and their value less vulnerable to day-to-day swings in the spot rate.
Traders have described the option positions as one form of inexpensive insurance against a worst-case scenario for China, such as a "hard landing" in the economy.
The buying of dollar/yuan calls has made waves. Risk reversals, which reflected the relative pricing of puts versus calls, are now flat in these long-term options after having previously favoured puts on the expected yuan appreciation.
The positions have even spilled into dollar/yuan non-deliverable forwards , causing an unusual rise in one-year NDFs -- typically the most popular contract for betting on yuan appreciation -- even as the spot rate hit record lows on the mainland last month.
"This is an extremely cheap hedge against the Asia portfolio," said one head of institutional FX and rate sales at a European bank in Hong Kong. "Overall USD/China positioning is very light, but people who are dedicated China traders look to be buying disaster insurance."
CHINA CDS SPREADS WIDEN
Chart on Bank of China and China's sovereign CDS spreads:
Chart on China CDS and net notional volume:
Another preferred means of hedging such risk is buying default protection in CDS because there are so few means available for "shorting" China, with its domestic markets closed and the offshore yuan market only in its infancy.
Some portfolio managers have bought CDS protection as a hedge against "Dim Sum" bond holdings -- bonds sold in the Hong Kong offshore yuan market. Others have used the CDS more broadly as a macro hedge against China-related risks, rather than betting on an actual default.
Spreads on both China's sovereign CDS and the big banks with CDS outstanding have widened sharply, causing a rise in the market-implied default probability even as broad measures of default probability -- such as from credit analytics company Kamakura -- have not budged.
At 87 basis points, China's sovereign CDS spreads are near the widest levels in a year and about 20 bps wider in the past month. Such a spread means it costs just $8,700 to insure $1 million of debt.
Just last year, China's sovereign CDS spread shrank to as little as 7 basis points above the United States' CDS spreads, a trend that was seen as heralding China's growing economic clout and healthier fiscal outlook, and as investors sought a means to buy China exposure.
China-related CDS positions have increased as spreads have widened, showing that more market players are taking out protection.
Net notional volumes outstanding on China sovereign CDS has jumped to $7.5 billion, data from the Deposit & Trust Clearing Corp shows, up from $5.8 billion two months ago and $4.7 billion at the start of the year.
BEATING UP THE BANKS
Chart on short-selling in China Construction Bank:
Short-sellers have pounded the shares of the big state-owned Chinese banks over the past month, especially on expectations that the banks may need to take write-downs and even raise capital as the first reports on the local government debt problem emerged.
The selling pressure remained this week after Singapore's Temasek sold a sizable chunk of its holdings in Bank of China and China Construction Bank and Moody's warned that Beijing may have underestimated the local debt outstanding by $540 billion.
Traders say short-selling of bank shares is often done with a medium-term view to hedge a portfolio, unlike short-selling in other sectors, such as Chinese automakers, which tends to reflect near-term bets on where the stocks are heading.
Banks are a favourite target for the broader market because of the sheer amount of outstanding bank shares, making financials such a sizable chunk of the Hong Kong market -- nearly 70 percent of the H-share China Enterprises Index .
The jump in short-selling in bank shares may just sow the seeds for a powerful short-covering rally in coming weeks unless investors have more reasons to worry about a big hit from non-performing loans or the economic outlook.
In the past month, CCB's shares saw short-selling reach 20-25 percent of total daily turnover on a few days compared with average levels near 1-5 percent in April and May. Short activity in the stock has died down a bit late this week.
BUT VALUATIONS ALREADY LOW
Chart on MSCI China and China share valuations:
Chart on MSCI China sector performance:
One of the biggest factors working against short sellers is that equity valuations are already low.
The MSCI China index, the usual benchmark of fund managers with China-focused portfolios, is trading at 10 times its forward 12-months earnings multiple, the lowest in two years, according
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