China Default Swaps Climb Most Among BRICs on Inflation

Dollar Should Gain on Good U.S. Data, China Fears .Article Stock Quotes Comments (1) more in Markets Main ».EmailPrintSave This ↓ More.
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The dollar stands to gain as the U.S. economic picture shows signs of brightening, while some expect China may act to slow its rapid growth.

With the Federal Reserve's $600 billion bond-purchase program as a backdrop, the dollar is likely to react in the coming week to any suggestion that the U.S. central bank might alter its views about the trajectory of the economy's recovery.

Meanwhile, a higher-than-expected reading of Chinese inflation—it grew in November at its fastest clip since July 2008—raises the specter that China may have to take additional measures to tighten monetary policy to ward against prices spiraling higher.

"Tighter policy in China still has an element of risk aversion in the markets," said Jessica Hoversen, fixed-income and foreign-exchange analyst at MF Global in Chicago. "Short-term, I think it could be dollar favorable," she said, especially in light of worries over euro-zone sovereign debt and as the U.S. economy begins to show signs of picking up steam.

Currencies such as the Australian and New Zealand dollars that are particularly closely tied to Chinese growth could dip against the greenback if investors "start hearing rumors China will hike rates more aggressively," Ms. Hoversen said.

China's consumer price index rose 5.1% in November, the fastest rise since July 2008, government data showed Saturday, up from the previous month's 4.4% rise and above the 4.7% median forecast of economists.

But China could be unlikely to raise key rates soon, the state-run China Securities Journal said in a Saturday front-page article, given that developed nations' so-called quantitative easing programs—such as the Fed's bond buys—are driving more cash to emerging markets as investors chase higher returns. A higher key rate could encourage such moves.

The dollar could benefit in the short term from speculation that China could slow growth. Too-fast China growth could eventually lead to China making progress on unshackling the Chinese yuan to the dollar, allowing the Chinese currency to rise. A move on the yuan could benefit other emerging-market Asian currencies.

"China's CPI numbers might just save the Fed's bacon," said Geoffrey Yu, currency strategist at UBS in London of the China consumer price index figures. "Right now [the Fed is] having a torrid time, with QE, plus higher yields, plus [a] stronger dollar, which is a toxic combination," he said.

"What can change things is how China wants to fight inflation," Mr. Yu said, with Chinese authorities realizing "importing U.S. monetary policy is absurd" and perhaps moving to allow the yuan to appreciate against its defacto peg against the U.S. dollar.

The divergence in rapid Chinese growth compared to the inching ahead of the world's more established economies "is dramatic and increasing," said Jens Nordvig, head of G-10 foreign-exchange strategy at Nomura Securities in New York. "The logical response is significant [yuan] appreciation. "

"In the absence of greater currency flexibility in China, we will be facing ever-increasing global tension around currency issues and global capital flows, and, ultimately, trade barriers," Mr. Nordvig said.

The prospect of such things only brightens the prospects for the U.S. dollar, which benefits when investors flee riskier assets for the perceived safety of the greenback.

Also benefiting the dollar in recent days has been a stream of mostly better-than-expected U.S. data. Virtually all analysts expect the Fed to keep rates at historically low levels when the Federal Open Market Committee announces its decision Tuesday.

Traders will closely parse the Fed's statement for clues on the economy's health and the future of the central bank's hotly debated quantitative-easing program. The narrative for much of the trading week focused on optimism over the U.S. economy, which sent both the dollar and bond yields higher.

"If the Fed takes the view that there is significant upward revision to growth, then you have to discount the idea of further quantitative-easing measures, or expect they may stop short of $600 billion," in planned asset purchases, said Michael Woolfolk, senior currency strategist at Bank of New York Mellon. "That is going to be positive for the dollar."

An additional positive factor for the dollar is the prospect that President Obama and Congress can strike an agreement to extend the Bush-era tax cuts.

Late Friday afternoon, the euro traded near $1.3228 from $1.3243 late Thursday. The dollar bought 83.94 yen from 83.70, while the euro changed hands at 111.04 yen from 110.84. The U.K. pound was at $1.5810 from $1.5766. The dollar was at 0.9803 Swiss franc from 0.9834.

—Javier E. David contributed to this article.


China Default Swaps Climb Most Among BRICs on Inflation
By Bloomberg News - Dec 12, 2010 8:00 AM PT
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Business ExchangeBuzz up!DiggPrint Email . Chinese President Hu Jintao. Photographer: Toshiyuki Aizawa/Bloomberg
Investor perceptions of China’s credit are worsening at the fastest pace among the largest emerging markets on concern policy makers will slam the brakes on economic growth to curb inflation.

The cost to insure against default on Chinese government debt in the past month advanced 13.5 basis points, more than in any of the so-called BRIC markets, according to CMA prices. Brazil’s similar five-year contracts increased 10 basis points, while those for Russia climbed 4 basis points. Bond risk for the State Bank of India, the benchmark for the nation’s sovereign risk in the absence of sovereign dollar securities, rose 1 basis point. The derivatives are used to speculate on market performance as well as hedge against non-payment.

Inflation accelerated to 5.1 percent in November, the fastest in 28 months, adding pressure on the central bank to raise interest rates, threatening expansion that’s averaged more than 10 percent in the past five years. The government pledged to focus on stabilizing prices and maintaining “relatively fast” growth after President Hu Jintao and Premier Wen Jiabao attended an annual economic policy meeting in Beijing on the weekend.

“If you look at China risk in the last two or three weeks we’ve seen a fairly pronounced reversal in trends evident for the last six months,” said John Woods, the Asia chief investment strategist at the private banking unit of Citigroup Inc. “China’s golden era of low inflationary growth, underpinned by compliant domestic savers and enthusiastic external consumers, could well be at an end.”

Reserve Ratio

Policy makers increased banks’ reserve-ratio requirements by 50 basis points, or 0.50 percentage point, on Dec. 10 -- the third time in five weeks -- in a bid to cool lending. They raised interest rates in October for the first time since 2007.

Inflation for the first 11 months was 3.2 percent, more than the government’s full-year target of 3 percent, a statistics bureau report showed on Dec. 11. Producer prices climbed 6.1 percent in November, more than any of 28 economists surveyed by Bloomberg News had estimated.

The spread between China’s dollar bonds over Treasuries as measured by a JPMorgan index widened to 150 basis points at the end of November, its highest level since May 2009, from 87 basis points on Nov. 1, indicating investors are more concerned about deteriorating credit quality. It was at 119 on Dec. 10.

Cooling the Economy

Five-year default swap contracts on the nation’s bonds rose to 71.5 basis points, from a two-year low of 52 basis points on Oct. 13, according to data compiled by CMA. Timothy Ash, an analyst at Royal Bank of Scotland Group Plc, predicted this month that the swaps may trade as high as 150 basis points next year and recommended investors buy them as a hedge.

“China is trying to cool things down and manage a deflation of the bubble,” Ash said in a phone interview from London. “If that fails then that’s how CDS gets driven up, because concern will be that the sovereign balance sheet will have to bear the costs of restructuring banks.”

The net amount of protection bought and sold on Chinese government debt with credit swaps has doubled over the last year, according to the Depository Trust & Clearing Corp., which runs a central repository for the market. The net notional value of swaps on China has risen to $4.6 billion as of Dec. 3, from $2.3 billion a year earlier, the DTCC data show.

Food Prices

Credit-default swaps typically decline as investor confidence improves and rise as it deteriorates. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a government or company fail to adhere to debt agreements.

China’s inflation mostly stems from food, not a broad-based increase in all products, Donald Straszheim, International Strategy & Investment Group’s head of China research, said in an e-mail. The biggest risks to China are from Europe, the U.S. and Japan, he said.

“The insurance ought to be bought on the prime mover, not on one of the down-the-line casualties like China,” he said.

Nick Chamie, global head of emerging markets research at RBC Capital Markets, said buying a basket of credit default swaps on Latin American bonds where China is a major buyer of commodities is a good strategy for investors.

Yuan Gains

The yuan had its biggest weekly gain in almost a month last week on speculation China’s central bank will raise rates to temper inflation after a report showed export growth beat economists’ estimates. The currency advanced 0.12 percent for the week to 6.6556 per dollar. Twelve-month non-deliverable forwards fell 0.1 percent in the week to 6.5105, reflecting bets the yuan will gain 2.2 percent in a year.

The one-year swap rate, the fixed cost needed to receive the floating seven-day repurchase rate, rose three basis points in the week to 3.14 percent. The benchmark 10-year yuan government bond yield was little changed at 3.85 percent, after jumping 5 basis points on Dec. 10. Exports increased 35 percent in November to $153.3 billion from a year earlier, compared with 22.9 percent in October, the customs bureau reported on Dec. 10.

The state-run Xinhua News Agency, which reported on the outcome of the so-called Central Economic Work Conference, didn’t give any specific targets for growth, inflation or lending. The comments alluded to the risks from the record lending that jump-started the Chinese economy during the financial crisis, including concern that banks will be saddled with bad loans to local-government financing vehicles.

China will step up management of local-government debt and prevent officials “blindly” starting new projects as the next national five-year plan begins, Xinhua reported. Officials will also seek to better manage liquidity, the news agency said.

Yields on China’s $1 billion of 4.75 percent due October 2013 notes rose nine basis points to 1.624 percent this month, RBS prices show. Brazil’s $1.25 billion 10.25 percent notes due June 2013 yield 1.6 percent, according to Bloomberg data, while Russia’s $2 billion 3.625 percent due April 2015 yield 3.3 percent, according to RBS.

“The potential of a slowdown in China following a sharp policy response to inflationary trends is arguably the greatest risk to the global economy at the moment,” said Daniel Arbess, who manages the $2.4 billion Xerion fund for Perella Weinberg Partners in New York, in an e-mailed comment.