Hedge Funds Versus Nascent (Communist) Superpower

January 31st, 2016 9:26 am | by John Jansen |

Via the WSJ:
By Juliet Chung and
Carolyn Cui
Jan. 31, 2016 5:30 a.m. ET

Some of the biggest names in the hedge-fund industry are piling up bets against China’s currency, setting up a showdown between Wall Street and the leaders of the world’s second-largest economy.

Kyle Bass’s Hayman Capital Management has sold off the bulk of its investments in stocks, commodities and bonds so it can focus on shorting Asian currencies, including the yuan and the Hong Kong dollar.

It is the biggest concentrated wager that the Dallas-based firm has made since its profitable bet years ago against the U.S. housing market. About 85% of Hayman Capital’s portfolio is now invested in trades that are expected to pay off if the yuan and Hong Kong dollar depreciate over the next three years—a bet with billions of dollars on the line, including borrowed money.

“When you talk about orders of magnitude, this is much larger than the subprime crisis,” said Mr. Bass, who believes the yuan could fall as much as 40% in that period.

Billionaire trader Stanley Druckenmiller and hedge-fund manager David Tepper have staked out positions of their own against the currency, also known as the renminbi, according to people familiar with the matter. David Einhorn’s Greenlight Capital Inc. holds options on the yuan depreciating.

The funds’ bets come at a time of enormous sensitivity for China’s leaders. The government is struggling on multiple fronts to manage a soft landing for the economy, deal with a heavily indebted banking system and navigate the transition to consumer-led growth.

Expectations for a weaker yuan have led to an exodus of capital by Chinese residents and foreign investors. Though it still boasts the largest holding of foreign reserves at $3.3 trillion, China has experienced huge outflows in recent months. Hedge funds are gambling that China will let its currency weaken further in a bid to halt a flood of money leaving the country and jump-start economic growth.

The effort is a lot riskier, though, than taking on a currency whose value is set by the market. China’s state-run economy gives the government a number of levers to pull and tremendous resources at its disposal. Earlier this year, state institutions bought up so much yuan in the Hong Kong market where foreigners place most of their bets that overnight borrowing costs shot up to 66%, making it difficult to finance short positions and sending the yuan up sharply.

The situation grew more tense after billionaire investor George Soros predicted at the World Economic Forum gathering in Davos, Switzerland, recently that “a hard landing is practically unavoidable” for China’s economy. He said he is betting against commodity-producing countries and Asian currencies as a result.

Days later, a commentary appeared in China’s state-run Xinhua News Agency warning that “radical speculators” trying to short sell, or bet against, the Chinese currency would “suffer huge losses” as the Chinese monetary authority takes “effective measures to stabilize the value of the yuan.”

A spokesman for Soros Fund Management, Mr. Soros’s family office, declined to comment on the firm’s currency positions.

The show of force has scared off some fund managers from adding to their wagers. Some traders have scaled back or even exited from their short bets, saying they have little appetite to go up against the Chinese government. Some say they are looking with new interest at shorting the currencies of other Asian countries that they expect would fall if the yuan keeps depreciating.

The standoff harks back to big battles such as Soros’s bet against the British pound a quarter-century ago. In 1997, Malaysia’s prime minister blamed Mr. Soros for a run on the ringgit during the Asian financial crisis. Mr. Druckenmiller, then chief investment officer for Soros Fund Management, said at the time that while the main Soros hedge fund had earlier shorted the ringgit, it bought the currency during the crisis, cushioning its fall.

Hayman Capital began betting against the yuan last year after studying China’s banking system and being stunned at its rapid expansion of debt. The firm’s analysis suggested that past-due loans, which currently stand at about 2% of the total, would rise sharply and eventually require an injection by the central government of trillions of dollars of yuan to recapitalize the banks. An expansion of the Chinese central bank’s balance sheet would lead its currency to weaken, just as the dollar depreciated when the Federal Reserve bailed out U.S. banks during the financial crisis.

Broader market bets against the yuan began growing last August, when the People’s Bank of China unexpectedly devalued the currency by 2% against the U.S. dollar. The move fueled speculation that Beijing eventually would have to decouple the yuan from the strengthening dollar and follow other countries to weaken its currency as a way to buoy growth.

Mr. Druckenmiller, who now invests his own wealth, and one of his former protégés, Zach Schreiber, who runs the roughly $10 billion hedge-fund firm PointState Capital LP, also have had sizable shorts against the renminbi since last year, people familiar with the matter said.

The wager helped PointState gain about 15% last year, said a person familiar with the firm, and has contributed to gains of more than 5% through mid-January.

Traders who remain bearish now are shorting China’s currency in several ways, say people familiar with the trades. Some are betting that the gap between the currency’s onshore exchange rate and more market-sensitive offshore rate will diverge further. Early in January, the spread hit a record of 0.1367 before government intervention narrowed it sharply.

Two days before China devalued its currency last August, William Ackman’s Pershing Square Capital Management LP began to put on a “large notional short position in the Chinese yuan through the purchase of puts and put spreads” to hedge against “unanticipated weakness in the Chinese economy,” according to Mr. Ackman’s annual investor letter, disclosed this past week.

But, demonstrating how difficult it can be to profit from such bets, Mr. Ackman said in the letter the wager had generated only a modest profit for Pershing Square and had been insufficient to offset the firm’s larger losses, as China continued to defend the exchange rate.

Mr. Ackman wrote that he continued to hold the position because of its importance as a hedge.

Other firms that have profited from shorting China’s currency include the $2 billion Scoggin Capital Management and Carlyle Group LP’s Emerging Sovereign Group, according to people familiar with the matter.

For 2016, ESG’s short-China fund, Nexus, was up more than 20% partway through January, according to people familiar with the fund, thanks in part to a large short position against the yuan. Much of Nexus’s position is made up of options, one of the people said.

It was unclear how much exposure Greenlight and Mr. Tepper’s Appaloosa Management LP have, though Mr. Tepper was outspoken last year in calling the yuan overvalued.

Since August, China has been imposing various rules to stabilize the exchange rate and stem the outflows, including a 20% reserve requirement applied to onshore yuan-derivative trades. That move makes it more expensive for funds to keep shorting the currency through swaps.

Chinese officials have indicated they aren’t seeking to devalue the yuan in order to gain advantage over their trading partners, citing the need to avoid a damaging spiral of competitive devaluations as others follow suit. The country still has room to stimulate its economy through fiscal policies, economists say.

Write to Juliet Chung at juliet.chung@wsj.com and Carolyn Cui at carolyn.cui@wsj.com


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