V is for (RMB) Volatility
The widespread influence of Chinese volatility
In our most recent note, we discussed the growing influence of Chinese economic and market developments on markets world-wide (including Australia). In Chart 1 we witness the elevated correlation between the S&P500 and Shanghai A shares from late 2014 onward, as well as similarly high correlations between Shanghai A shares and the ASX since mid-2015.
This week, we focus on a related phenomenon – that of market volatility, which has also proven rather infectious across global markets. Excessive volatility is fingered by many investors – Australian institutional investors in particular – as one reason to steer clear of Chinese markets. But is this approach merited?
Faces of market volatility
China’s capital and foreign exchange controls manifest differently across markets. For example, realized Chinese stock volatility, particularly of domestically traded Shanghai A shares, has surged compared to that of the S&P (as demonstrated by the well-monitored VIX index, see Chart 1). The volatility divide between Chinese and US indices intensifies in times of greater overall stock volatility such as the recent Chinese market rout (see Chart 2). Part of this is due to Chinese capital controls (and the outsize influence of Chinese retail investors), as we might see were we to compare the historical volatility of Shanghai A shares with that of Hong Kong listed H shares.
Chart 1: CBOE VIX Index vs Shanghai ‘A’ Share historical vol
At the same time, while China’s tightly controlled exchange rate experienced a large move in comparison with its tightly-managed daily range, even compared to the implied volatility of freely-floating liquid major currency pairs (such as EURUSD, USDJPY and AUDUSD), implied CNY forex volatility is extremely low (see Chart 2). For example, AUDUSD, a typically volatile developed market currency pair, sees a much greater range of movement than USDCNY during periods of risk aversion.
Chart 2: CNY volatility vs Forex majors (Source: Thomson Reuters Eikon)
Policy outlook is of paramount importance
It is however possible that “market volatility” is a symptom of a deeper-seated fear responsible for lackluster Australian institutional interest in China. Australian investors may fear that volatility in Chinese stocks and non-linear moves in forex and surrounding lack of policy transparency mask hidden weakness in Chinese output or worse, irredeemable policy mistakes.
Indeed, we witness quite a diversity of opinions surrounding the rise and precipitous fall of Chinese stocks. The unanticipated nature of, what in the context of RMB appreciation since 2005 is a small move toward devaluation, was received only by some as a necessary measure to combat an extreme shift in market sentiment, while others inferred a desperate, yet inadequate, attempt to repair rapidly eroding policy credibility.
Panic or hedge? What the rest of the market thinks matters
The problem with non-linear moves such as that seen in the RMB, while less significant against the backdrop of multi-year historical trends, may have been associated by the “panic” contingent with unquantifiable risk, enemy of the institutional investor.
If instead (as the “hedge” contingent holds) this move is a step toward normalization in CNY volatility to the level of other freely-floating currencies (not signal of Chinese policy Armageddon), the scenario is altogether different. In this case, so long as we have an idea of the ultimate outcome, we might set up hedges against interim temporary volatility. Helpfully, we do have means of measuring “normal” volatility in forex majors, as we show in Chart 4. Next, the question becomes one of adequately hedging future flare-ups of volatility without having to flee the market wholesale. It goes without saying that as currency volatility normalizes, the earlier the better to establish hedges (the cost of which will only increase as volatility trends higher).
What if it’s ‘Panic’?
Even if we were to fall prey to extreme pessimism over Chinese policy credibility, ignoring the problem will not make it go away. As we pointed out before, Chinese market moves are growing drivers for moves in other, larger markets as rising correlation between ‘A’ shares and other markets implies (see Chart 1). Even in forex markets, we might witness the (smaller) boost to volatility in FX majors in response to the RMB movement (Chart 4). Assuming Chinese policymakers are committed to continuing RMB internationalization and capital account liberalization, there may be no reversing the increasing influence of Chinese policy, currency and asset moves on the rest of the world. It may not be reasonable to assume that the best response to Chinese equity and currency volatility is simply to shut off the lights and go home.
Hedge: global investors are still in it for the long-term
There are indicators that demonstrate that panic is not widespread in the market and that Chinese policymakers have not completely exhausted their credibility with market participants. Rather, quite a few market participants view even the sudden CNY devaluation is a temporary market adjustment rather than a catalyst for a string of periodic (though unpredictable) forced currency devaluations. Evidence of these calmer sentiments is be demonstrated in CNY options pricing. We elaborate:
One way in which we might measure market sentiment toward directional currency moves and volatility is by examining risk reversals in the relevant currency pair. Risk reversals measure the premium paid to purchase or sell out-of-the-money calls versus out-of-the-money puts. Many times, market participants watch short-term moves in risk reversals for signals of saturation – unless a permanent shift in currency volatility and direction is prevalent, risk reversals tend to fall subject to the dynamics of regular supply and demand in the options market, and snap back from extremes.
As we see in the below Eikon Chart (Chart 3), USDRMB 25-delta risk reversals continue to hover near post-2013 highs (biased toward RMB puts/USD calls) but have failed to break conclusively higher. As such, although the bias remains toward foreseeing RMB declines, an exceptional surge in volatility is not the prevailing view in the market.
Chart 3: USDCNY spot (upper) 3m volatility and CNY 3m Risk Reversals (lower)
(Source: Thomson Reuters Eikon)
Rather than panicking, we may conclude that the cost of hedging sudden RMB declines is steeper than before, yet still a traded strategy; those who have the most to lose by sudden declines might avail themselves of functional market mechanisms to hedge, rather than fleeing in panic. These are viable strategies for Australian (as well as global) market players to cope with the transition to China’s “new normal”.