Yuan Gains Traction as Asia Funding Currency as Yen Carry Trade Wobbles

The Chinese yuan is drawing fresh attention as a funding currency for global carry trades as expectations build for a Bank of Japan rate increase, lifting the yen.

Bloomberg reported on September 9 that strategists at major financial firms including Citigroup, Maybank, Societe Generale and BBVA have recently highlighted the yuan as a potential alternative to the yen in carry trades.

A carry trade is a strategy in which investors borrow in a low-interest-rate currency and invest in higher-yielding currencies or assets. The yen has long been a leading funding currency because Japan kept rates low. But that calculus has begun to shift. The yen has climbed about 4% this month, hurting returns on carry trades financed in the Japanese currency.

China, by contrast, has kept interest rates relatively low compared with other major economies. Even as global bond yields rise sharply, China's funding costs have remained stable and yuan volatility subdued, creating favorable conditions for carry trades.

"Relatively low interest rates and a stable yuan could make the currency more attractive as a carry-trade funding currency," Fiona Lim, a senior strategist at Maybank, said.

The performance gap has already started to show. A strategy that borrows offshore yuan and invests in eight emerging-market currencies returned 1.5% over the past three months, according to data compiled by Bloomberg. The same strategy funded in yen posted a 1% loss.

Citigroup said in a report earlier this month that offshore yuan has become more attractive as a funding currency as carry returns relative to volatility improve. Rising government bond yields in the U.S., Japan and the U.K., together with the People's Bank of China's relatively accommodative policy stance, have widened rate differentials and supported yuan carry trades.

Derivatives markets are also showing signs of change. Average daily trading volume in dollar-offshore yuan put options rose more than 60% from the previous month between September 1 and September 8, according to the Depository Trust & Clearing Corporation. The increase suggests stronger demand for hedges against further yuan gains and growing interest in yuan-based carry trades.

Still, the yuan may be hard-pressed to fully replace the yen. The yuan is not a freely convertible currency, and liquidity in long-term funding markets remains more limited than for the yen.

"We need to watch whether offshore yuan can replace the yen as Asia's main carry-trade funding currency," Dariusz Kowalczyk, head of Asia cross-asset strategy at BBVA, said.

If the BOJ raises rates this month, funding costs for the yen and the yuan could converge. Any additional BOJ increases could leave offshore yuan funding cheaper than yen funding.