Hedge funds’ ten-year wait for Chinese yuan crash nears payday

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(Bloomberg) — For the better part of a decade, an American hedge fund manager who has never even set foot in China is patiently betting that the yuan will cause a massive collapse, so deep that its value could be cut in half .

Since 2014, Kevin Smith of Crescat Capital has invested up to 10% of his $136 million macro fund in options bets against the currency. Sometimes he lost money. Sometimes it paid off, even though the major devaluation he was looking for never happened.

But Smith says it might be his time.

China’s once booming housing market is cracking. Economy is collapsing under Covid lockdowns. And the People’s Bank of China has cut interest rates just as central banks around the world have raised them, giving investors even more incentive to transfer money overseas.

Together, these forces have caused the yuan to fall more than 8% against the US dollar this year. That puts it on course for the biggest annual decline since 1994 – and Smith said that may just be the start.

“China is going through a financial crisis today, I think it’s much more serious than even the global financial crisis in the United States,” Denver-based Smith, 58, said in an interview. “For us, the game is in the money.”

Warnings of an impending collapse of the Chinese currency are not new. Bearish investors have been warning for years that Chinese banks have lent far too much money, including to fund a real estate frenzy. They predict this will lead to a wave of bad loans so large that Beijing will have to print money to bail out the banks, which will lead to a devaluation of the currency.

The argument seems appropriate. China’s housing market is running out of steam, threatening to saturate banks with mountains of non-performing loans. Meanwhile, Beijing’s draconian zero-Covid policies have led to continued lockdowns that put China on track for one of its slowest periods of growth in modern history. In the second quarter, China’s economy shrank 2.6% from the previous three months, marking the first contraction since early 2020 when the pandemic began.

In response, the PBOC is easing monetary policy, dampening the yuan’s appeal by widening the interest rate differential in China and elsewhere. Foreign investors withdrew a record amount this year from the Chinese bond market.

Yet Smith is still in the minority. China’s large savings, high mortgage payments and tight government control of banks mean that China is “unlikely to experience a typical debt or financial crisis with an uncontrolled credit crunch, large-scale bank failure scale and substantial depreciation,” said economists at UBS Group AG led by Wang. Tao wrote in a report earlier this month.

In fact, the yuan’s decline this year is more a reflection of a stronger dollar than a weaker Chinese currency, with the country’s record trade surplus offsetting capital outflows. Against a basket of currencies, the yuan was little changed, and analysts polled by Bloomberg expect the yuan to be stable around 6.9 to the dollar by the end of the year.

Smith’s belief in the yuan has never wavered since he started betting against it eight years ago. China’s startling devaluation in 2015 helped the fund gain 16% that year. Since then there have been ups and downs, but overall he said the bet has made money.

This year, he contributed to the fund’s 38% gain through August, as well as its bearish bets against large-cap growth stocks and its long positions in the energy sector. The gain extended the fund’s return since its inception in 2006 to 655%, beating the S&P 500’s 343% gain, but with higher volatility.

“We still haven’t seen what we can do in this trade,” Smith said. “Maybe it’s coming now.”

©2022 Bloomberg LP

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