The Chinese yuan spiked against the US dollar on Monday in moves that were similar to the Japanese yen carry trade unwind.
The markets appear to have stabilized after melting down on Monday, but there's a new worry on the horizon in the form of the Chinese yuan.
Monday's massive market selloff — the worst on the Nikkei since Black Monday 1987 — was in part triggered by the unwinding of Japanese yen carry trades.
"The next carry trade unwind could be the yuan," Khoon Goh, the head of Asia Research at ANZ, told CNBC on Wednesday, pointing out that the offshore yuan already jumped against the dollar earlier on Monday as a kneejerk reaction to the yen carry trade unravel.
The carry trade strategy involves borrowing Japan's longstanding ultra-low interest rate environment to fund higher-yielding assets elsewhere. The Bank of Japan's rate hike last week, however, jolted the market, forcing investors who borrowed to fund their carry trades to liquidate their positions, setting off the global market rout.
Now, analysts and investors are jittery about the same happening in the Chinese yuan.
China is in a low interest-rate environment as authorities are trying to boost the country's flagging economy.
Citibank strategists expressed such concerns in a client note, Bloomberg reported on Wednesday. They wrote there are "positioning worries in the funding side of the carry trade, and in particular the yuan." Business Insider was not immediately able to reach Citi for comment.
ANZ's Goh said Chinese exporters have been holding onto large amounts of dollar earnings that they had been unwilling to convert due to higher rates in the US. However, they may soon be doing so as the Fed readies to cut rates — which could create "big moves" in the markets.
The US dollar is trading around 7.17 to the offshore yuan now after falling to below 7.1 on Monday amid the market mayhem.
However, analysts don't seem to think the fallout from the yuan carry trade would be as tumultuous as the action in the yen.
Vishnu Varathan, the chief economist of Asia excluding Japan at Mizuho Bank, wrote in a note on Thursday that the yuan isn't the "next big shoe" to drop.
That is a "somewhat misguided view," given that the yen — unlike the yuan — is a deeply liquid and global currency, added Varathan. In contrast, China still guides the Chinese currency's movements.
China also has different problems than Japan.
While the yen's weakness is due to Japan's low interest rates, the yuan's weakness is mainly due to China's "structural economic headwinds and daunting geo-political threats," wrote Varathan.
China is navigating a painful economic transition from a low-value manufacturing juggernaut to its push into the hot "new three" industries of electric vehicles, lithium batteries, and solar cells. However, it's facing rising geopolitical tensions, including high import tariffs from the US and the EU on such high-value industries.
This means that these geopolitical risks have to fade for the yuan to strengthen and cause an impactful unraveling of the carry trade like that for the yen earlier this week, he added.
Goldman Sachs' analysts share these sentiments. In a note on Wednesday, they wrote that weak Chinese growth fundamentals mean any yuan rally should be limited.
"Still-elevated carry returns, weak domestic demand in China, and our expectation of continued monetary policy easing by the PBOC are likely to drive dollar-yuan back higher," the Goldman Sachs analysts wrote.
JPMorgan estimated on Wednesday that about three-quarters of global carry trades have been unwounded so far, per Bloomberg.
China's economy hasn't been able to take off convincingly since the country exited nearly three years of pandemic restrictions, so it's more likely that the People's Bank of China still needs to cut rates, wrote Varathan.
Therefore, the yuan's risk is — unlike the yen — one of depreciation rather than appreciation, and a yuan meltdown could trigger risk-off sentiment in the wider market, added the economist.
"While excessive volatility either way is not desirable, we fear abrupt CNY meltdown more than we do sudden CNY strength," wrote Varathan, referring to the yuan.
Japan's benchmark Nikkei 225 index was down 0.2% at 2:32 p.m. local time on Thursday.
South Korea's Kospi was down 0.7% while Taiwan's Taiex was down 2%.
Hong Kong's Hang Seng Index was 0.7% higher at midday and China's CSI 300 was up 0.3%.
