Yuan Carry Trade

by | May 18, 2009 | Multi Currency Investing

In a moment we’ll look at a Brazilian currency sandwich. First, here is  what a reader sent me about a yuan carry trade (Chinese currency sandwich):


I’d not heard of this anywhere else, but received this from one of my ex clients who has been pretty accurate in his information.  If true, I thought it might be of great interest to you.

Here is what he sent:

Institutional investors have talked a lot about the so-called “yen carry trade” over the past couple of years. But that’s really just been a warm-up act for a much bigger story.

I’m talking about the “yuan carry trade.”

You’re hearing about it here first. But I promise that you’ll soon be hearing about it virtually everywhere.

Let me explain.

China’s New Profit Catalyst

Most investors are aware of China’s massive profit potential. But what they may not understand is this: Before all that potential can be transformed into actual profits, this Asian giant needs to develop a modern, fully functional financial system. That obviously can’t happen overnight, and China’s been smart – and avoided making major mistakes – by not rushing things.

In fact, despite some stinging criticism from the West, Beijing has held its companies and its financial markets in check to ensure an orderly development. It’s even left some protectionist measures in place to make sure that opportunistic foreign firms don’t overrun its markets.

Naturally, there’s been a near-term cost. It’s held some China-based companies back, making them less competitive in such developed markets as the United States and Europe. Chinese firms were severely limited in their access to funding, meaning they were also limited in their ability to capitalize on business opportunities in these overseas markets.

But I could see that the long-term profit potential for these companies was huge – and I’ve repeatedly said so to the audiences that I’ve spoken to at events all around the world, I’ve told listeners and readers that the day would come when these companies were able to raise enough investment capital at home to finance their forays abroad.

The day that occurred, I’ve said, is the day when the real fireworks would begin.

Beijing finally lit the fuse.

By announcing the launch of a new market for dollar-denominated bonds that are issued by non-financial firms, China has now taken a major step toward modernizing its capital markets. The move hasn’t made much of a splash here in the United States. But I was in China, heading my annual investment tour of that country, when the announcement was made. And believe me when I tell you that China’s company executives, investors and government officials fully understand the implications of what’s just been done.

The move is very shrewd,  for it brings about the confluence of highly complimentary trends.

• For China-based companies that want to invest abroad, or that want to buy foreign companies, product lines, or other assets, these new dollar-denominated bonds will make it possible to do these deals more easily, and at a much lower cost.

• Beijing had already launched an official campaign that urges “Corporate China” to acquire overseas companies and assets. But there had to be a liberalization of the financial system for this to happen. So back in August, in fact, for the first time in 11 years, China’s government eased rules governing its foreign-exchange systems.

• These new regulations permit companies to retain foreign-exchange income offshore, if they want, and thus helped pave the way for the new bond market because it stokes potential demand for dollar-denominated investments.

• And that comes at a perfect time for – up until now – the ongoing global financial crisis, which has made Chinese investors wary of buying foreign-currency bonds that were issued outside China. But these dollar-denominated bonds will be created inside China, effectively short-circuiting that worry.

Given what we know about China’s global natural-resource-acquisition ambitions, the first entrants into this new market will likely be one or more of China’s huge natural-resource concerns that are presently scouring the globe, creating captive supplies of the very commodities that will be necessary to ensure China’s future growth. My experience here suggests that high-tech and infrastructure companies will follow almost immediately. Many of those firms may head straight for Taiwan, thanks to newly inked agreements that make it easier for Mainland China companies to invest across the Taiwan Straits for the first time in decades. After that, these firms will direct their appetites for acquisitions elsewhere around the world.

Just how big could this new dollar-denominated financing market turn out to be?

At a time when Western debt markets remain mired in muck, it’s too soon to tell for certain. But Bank of China Ltd. analyst Shi Lei estimates that non-financial Chinese firms may issue as much as $30 billion during the next two quarters alone.

That amount tallies closely with China’s estimated $23 billion pipeline of outbound mergers-and-acquisitions deals that have been announced this year, but not yet consummated – especially if you factor in the $9.7 billion worth of deals that were announced in the past three years, but that are still pending, Thomson Reuters reports.

Could New Financing Deals Accelerate the U.S. Recovery?

Many Americans will clearly view a big uptick in investments from China with significant fear – especially if they remember the late 1980s Japanese shopping spree that sent ownership of Rockefeller Center, Columbia Records, Universal Studios and the Pebble Beach Golf Course back to Tokyo.

This is different. In fact, I think the new rules are likely to create entirely new funding sources that will boost international trade and that could actually accelerate the U.S. economy’s recovery from the global financial crisis. In fact, it’s entirely possible that this new form of financing will help facilitate a post-recovery golden age of expansion led by such as-yet unsaturated markets as China.

Call it the “Mother of All Carry Trades” – only this time it will be yuan-based, instead of yen-based.

A carry trade is an investing strategy in which an investor takes advantage of interest rate differences between two countries. He’ll borrow money in a country where rates are low and invest it in another market where rates are higher, profiting from the difference. The rate disparities are often caused by the respective central banks; one may be trying to combat inflation with high rates even as another is trying to nurture economic growth by reducing rates.

There are no actual examples to point to, yet, since the market isn’t yet up and running, but we can draw some inferences based on who’s filed to issue this dollar-denominated debt, and look at who’s likely to file in the months to come.

I replied to this reader:

At first glance this seems a terrible idea.  When I have time. I’ll look in more detail but here are my initial thoughts.

The yuan is undervalued and the US dollar in a position where it will be highly inflated.  If you borrow the yuan and invest the loan in US dollars, you are wiped out when the yuan appreciates against the greenback. If the person is saying borrow the US dollar and invest in yuan… this may make sense… if yuan investments pay more than dollar investments.

I have continued to think about this and the idea of borrowing Chinese yuan to invest in US dollars still does not make sense to me.

This is what one would call a yuan dollar carry… Or I would call it a yuan dollar currency sandwich, to borrow yuan and invest the loan in US dollars… a really bad idea for now.

However what this writer might be suggesting is that interest rates for dollar denominated bonds issued in China might pay higher than the loan costs of dollars.

Now that might make sense. I’ll try to find out more and will keep you advised.

A Make Sense Multi Currency Sandwich

For those who would like to take risk now, (I am not ready to do this), a US dollar Brazilian real (plural is reais) carry makes sense for three reasons.

The first reason is the interest rate differential commonly called positive carry.

You can borrow US dollars at Jyske Bank now for 3.375%.

Brazilian bonds pay 10%.

If you invest $100,000 in Brazilian bonds, you earn $10,000 a year income.  Use those bonds as collateral to borrow $100,000.  Invest this US dollar loan in more Brazilian bonds. Your interest cost is $3,375, your income $10,000.

This increases your total income to $16,625 a year or 16.625% per annum.

The second reason this sandwich makes sense is that there is  a chance for foreign exchange profit IF the Brazilian real appreciates versus the greenback. The chart below from finance.yahoo.com shows that this is a trend.


This chart shows that from 2004 until July 2008 the real steadily appreciated versus the dollar.  The dollar enjoyed a dramatic surge mid 2008 but now appears to be leveling off.  If the dollar real parity returns to the early 2008 levels, a substantial forex profit would be made.  See a link to updates on this chart at finance.yahoo.com

Third, the fundamentals of Brazil’s economy look good long term which could cause the value of the bonds to rise as well.

Here are excerpts from Jyske Bank’s Global Economic Analysis of yesterday.  The emphasis in bold is mine.

Negative growth is also seen in a number of western countries and in Latin American countries, but the difference between ’the other countries’ and Central and Eastern Europe is that the Central and Eastern European countries do not have the same latitude to pursue a relaxed monetary and fiscal policy as they have in the other countries.

Therefore, an improvement in growth also seems to be longer in coming in this region. The region will be an interesting investment case again, but it will be some months yet.

Therefore, we still prefer Latin American bonds in general to bonds from Central and Eastern Europe.


Our favourite 12.50% Brazil 2016 and other BRL- denominated bonds have performed well.  Following several initiatives rendering bonds/bond funds relatively more attractive than deposits, demand for BRL-denominated
bonds has increased.
It is presumably a temporary effect on the bonds.

But whether this is the case or not, Brazil is still among our favourite countries in the emerging- market universe, and we still recommend long – term bonds in Brazil.

Although interest rates have fallen quite a lot in Brazil, investor still gets a yield to maturity of approx. 10% on our favourite bond Brazil 12.50% 2016.

Furthermore, we expect that the development of BRL (against  EUR and DKK) will be stable to positive over the next months.

The temporary interest in Brazilian bonds suggests a “get ready but don’t buy yet” situation.  If demand slackens then yields may rise a bit.

An excerpt from the Economist Economic Unit enforces the idea of Brazilian bonds when it says:

The Economist Intelligence Unit expects the global financial crisis to have a strong negative impact on Brazil’s economic activity in the first half of the outlook period. We expect real GDP to contract by 1.5% in 2009, before it recovers modestly to 2.7% in 2010. The 4.1% average annual growth projected for 2011-13 is weaker than the 4.5% average of 2004-08. We anticipate severe credit rationing in 2009, which will weigh on private consumption and investment, but expect that the contraction in domestic demand will lead to lower inflation. We assume that policy continuity will facilitate a modest recovery from 2010 onward, in tandem with trends in the global economy. Brazil’s reduced external vulnerability should help the domestic economy to cope with the global economic downturn. But we expect a weaker exchange rate in 2009-13. The current account slipped into deficit in 2008 and will remain in the red in 2009-13.

Brazil is Latin America’s largest market, the world’s fifth-most populous country and the world’s tenth-largest economy in GDP terms. Above-average GDP growth in 2010-13 will allow real incomes to rise over the forecast period, albeit at a more moderate pace than that seen in recent years. Income inequality will continue to decline on the back of income support programmes, but will remain high. Nonetheless, Brazil will become an increasingly attractive market.

If the EIU assessment is correct,  an improving economy and low inflation will push down interest rates beyond 2010.

This would add capital profits on the longer bonds.

Let’s look at what this means on a five year basis. Assume for a moment that you held a Brazilian bond sandwich ($100,000 invested and $100,000 borrowed) for the next five years. You earn 15% per annum to begin.

Let’s assume that the Brazilian real appreciate 10%  versus the US dollar and that the bonds appreciate 1o%. The bonds become worth $240,000. You pay off the loan of $100,000 and have $140,000 plus the $83,125 of interest you have gained over five years.  That is a total return of $123,000 of income and gain returned on $100,000 invested or 24.6%  per annum return.

The reason I am not increasing my position in Brazilian bonds in these volatile times (I have these bonds in my portfolio already) is:

#1: The Brazilian real could drop versus the US dollar if the economy takes another downturn.

Fundamentally the Brazilian real looks very strong versus the dollar. Here is a review of  some basic factors that affect a currency’s long term strength (as of May 14, 2009).

US     Brazil
Trade Balance  ($ billions)              -730     +27
Current Account % of GDP            –  3.3     -1.2
Budget Balance % of GDP              -13.1     -2.0
Growth of GDP qtr. 1 2009 %          -2.6     +1.3
Industrial Production Growth %    -12.6    -10.0
Consumer Price Rise  %                   -0.2      5.0
Unemployment rate %                      8.1       9.0

These figures suggest long term strengthening of the real versus the dollar, but short term moods of the market could cause another dollar surge.

Do not get caught out over borrowing in the short term so that you lose a position due to a margin call.  Review your liquidity and liquidity timing carefully with your adviser or manager.

Be sure to calculate a potential profit and draw down projection.  To remember how to make these projections read Chapter 14 of International Currencies Made EZ

#2: Bonds could default.  Brazil’s economy may be less resilient than that of the US.

#3: Dollar interest rates could rise.  This would increase the cost of the loan.

#4: Brazilian real interest rates could rise (causing the bond value to fall).  The higher inflation numbers sen in the statistics above suggest this.

#5: Current interest in Brazilian bonds may reduce their value short term so it may be a bad time to buy right now.

However, for those with a speculative portfolio, this US dollar – Brazilian real sandwich is worth discussing with your portfolio manager or adviser now.

If you are using Jyske Bank, and are a non US citizen or resident, or a US citizen living abroad, you can simply have the bank purchase Brazilian bonds and lend you the funds (within the bank’s loan to asset restrictions).   Non US citizens contact Rene Mathys for more details at mathys@jbpb.dk

US citizens contact Thomas Fischer at fischer@jgam.com

If you are a US citizen resident in the US and have an advisory account with JGAM, they may not be able to buy Brazilian bonds for you.  They could  buy the US traded ETF “The WisdomTree Dreyfus Brazilian Real Fund.” (BZF)

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You can see updates on the US dollar- Brazilian real yahoo.finance.com chart here.

You can read the entire Economist Brazil Briefing here.