CHINA MONEY-China's weak currency disappoints carry trade hunters

HONG KONG, June 30 Mon Jun 30, 2014 2:12am EDT

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HONG KONG, June 30 (Reuters) - Investors who bet on an appreciating yuan this year, especially carry trade enthusiasts, have met with dismal returns.

The first half of 2014 has been an forgettable one for the Chinese currency, so far Asia's worst performer.

Borrowing in an equal-weighted basket of the Japanese yen , Swiss franc and the U.S. dollar and investing the proceeds in the Chinese yuan, would have handed investors a negative return of 3.4 percent in the first six months of 2014, a Thomson Reuters analysis shows.

Carry trades -- borrowing in lower-yielding currencies and investing in higher-yielding ones -- is a strategy pursued by investors especially in times of low market volatility.

The renminbi's underperformance stands out even more starkly if seen through the lens of the Sharpe ratio, which takes into account percentage returns of the currency minus risk-free rate returns adjusted for currency standard deviation or swings.

Using that metric, the Chinese currency has notched up a ratio of minus 2.2, the worst six-month performance since the second half of 2010, according to Thomson Reuters data. In comparison, on a Sharpe-ratio basis, the renminbi posted a rate of return of 2.8 in the corresponding period of last year.

That is because while currency market volatility in general has been subdued for much of this year, the renminbi's moves have been unusually volatile thanks to the People's Bank of China's stance towards the currency.

"The underperformance of the yuan in the first half has been led by the central bank's policies to stamp out hot money inflows into the market," said Dominic Bunning, a senior currency strategist at HSBC in Hong Kong.

"Now that policy has largely succeeded, we expect a return to a path of modest appreciation in the second half," said Bunning, who expects the yuan to strengthen to 6.14 by the end of 2014.

That performance changes only marginally, with the overall trend to remain intact, even if one of the borrowing currencies is substituted with other low-yielding currencies such as the euro.

In at least two different phases in February and April, it brought U.S. dollars aggressively via its agent banks in the currency markets and fixed the daily midpoint -- around which the currency is allowed to trade -- sharply weaker against the dollar, according to traders.

It also widened the currency trading band to 2 percent in March from a previous 1 percent, giving it greater flexibility to carry out its currency market policies.

The change in the PBOC's stance towards the currency is not without reason.

China's economic growth was at its slowest in 18 months in the first quarter at 7.4 percent from a year earlier, and a growing number of economists believe Beijing would find it difficult to meet a target of 7.5 percent for the full year.

Some hedge funds are betting that a weaker currency would help make Chinese exports more competitive, thus putting a floor under slowing growth.

It would also deter speculative capital flows into the country and reduce the headache for the country's foreign exchange regulator who faces a growing mismatch between its assets and liabilities.

But the renminbi's pronounced weakness in the first half has started to make some investors cautiously optimistic about a rebound in the currency in the second half. On Monday, the yuan stood at 6.2070 per dollar, just below its strongest level in more than two months.

Investor sentiment on most emerging Asian currencies improved over the last two weeks, with the first bullish bets seen on China's yuan in four months as the currency showed signs of stabilising, a Reuters poll showed.

With China embarking on a wave of reforms in recent weeks aimed at simplifying the movement of funds across borders, market watchers believe the central bank is satisfied with the level of the currency for now, another sign of likely slower gains (Editing by Jacqueline Wong)

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