Foreign Currency

China Swap Market Goes Into Overdrive as Traders Seek FX Bypass


(Bloomberg) — Trading has surged to a nine-year high in China’s onshore swaps market, an increasingly popular one-stop-currency-shop for everyone from foreign to local to state banks and corporates, all happy to bypass traditional FX venues.

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Attractive rates for those with dollars to lend, strong demand for the US currency in China’s banking system and even shadow intervention from officials keeping the yuan in check are some of the suggested reasons that have driven one measure of client activity to the highest since 2015.

Swaps are becoming more common tools to manage currency positions, with a market share now of 10%, according to Bloomberg calculations, compared to about 75% for old school buying and selling via so-called spot trading.

A key factor behind the growth has been investors taking advantage of low interest rates on the yuan relative to the dollar after the stark divergence of monetary policies between the world’s two largest economies. A gauge measuring funding costs in the Chinese currency has sunk to the lowest since 2008 in the swaps market, making it highly profitable to borrow in yuan with dollars.

For example, an investor lending their greenbacks for yuan for one year using swaps would enjoy a return of 3.4%, with the chance to put the proceeds to work elsewhere, according to calculations by Bloomberg.

Alongside the lure of returns, swaps also offer cheaper ways for investors to bet on currency moves without giving up core positions, as they are derivatives. That makes them one possible way China can manage volatility in the yuan without spooking the market by dipping into its foreign-exchange reserves.

“I would look for a higher proportion taken by FX derivatives in the long run in China,” said Lemon Zhang, macro & currency strategist at Barclays Bank Plc, citing the nation’s relatively low share compared to developed markets. I see “improvement on both variety of market participants and products.”

State Banks

Large state banks have been heavily active of late. They traded $1.2 billion a day of one-year swaps on average in the first seven sessions of 2024, according to traders who asked not to be identified as they were not authorized to comment publicly. That’s about eight times the daily average volume seen in the first quarter of 2023 and is part of a surge that started in November, they said.

For Ju Wang, head of greater China FX & rates strategy at BNP Paribas, that could be down to the banks acting as proxies for officials trying to stabilize the yuan without exhausting the government’s FX reserves. The Chinese currency strengthened from near a 16-year low toward the end of 2023 alongside swap market activity, before slipping back about 1% this year.

“It could be intervention,” she said.

China’s forex reserves finished the year higher in 2023 at about $3.2 trillion, suggesting authorities refrained from direct intervention despite their battle to rein in yuan weakness. The People’s Bank of China resorted to using more indirect measures such as guiding the yuan higher with its daily reference rate, fine-tuning required foreign exchange reserve ratios at lenders and squeezing offshore liquidity to discourage short-sellers.

Natural Growth

Still, others are doubtful of the intervention explanation, saying the growth in swaps could be just be the lenders trading for themselves or clients, rather than acting as a central bank proxy.

The PBOC didn’t respond to a request for comment sent by Bloomberg this week.

Yuan funding is currently very cheap and some firms may borrow and then swap the proceeds for dollars, rather than directly borrow the US currency, said Le Xia, chief Asia economist at Banco Bilbao Vizcaya Argentaria SA. In recent months there was also less of a need for currency intervention after the dollar retreated on bets of US interest-rate cuts, he said.

Demand for trading onshore swaps has also picked among dollar-based bond investors.

Lending dollars in exchange for yuan via swaps and then investing in some onshore Chinese bonds has become a more lucrative trade than outright buying and holding US debt, according to Bloomberg calculations. Such swap-based trades helped boost China bond inflows in late 2023.

China Bond Inflow Extends on Lucrative Swaps, PBOC Easing Hope

“Thanks to lower swap points, their FX hedged investment in China, especially in bonds, could generate a better return,” said Kiyong Seong, lead Asia macro strategist at Societe Generale.

One-year dollar-yuan swap points in China’s onshore market remain deeply negative at about minus 2400 pips and hit minus 2744 pips in September, the lowest since the global financial crisis.

Corporates have also been active for operational purposes, in part because swaps won’t cause them to reduce the amount of dollars they hold.

“They can borrow onshore to give bonuses, pay bills, rather than converting their dollar holdings,” Barclay’s Zhang said. “Corporates and foreign investors are enjoying the tailwinds from FX swap points.”

Watch Yield Differentials

With the yuan trading close to a two-month low and persisting concerns on China growth, some market watchers see robust swap trading extending in the near term. The wide gap between US and China rates is key, which hinges on bets on when and how quickly the Federal Reserve will pivot to cuts, they said.

“This dynamic will most likely to hold in the first half of 2024 given still very wide dollar-yuan rate differential,” said Becky Liu, Head of China Macro Strategy at Standard Chartered Bank. “But it should fade in subsequent quarters when their rate differential narrows.”

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