After years of an artificially undervalued Chinese yuan, most investors were shocked when it started falling against the dollar two weeks ago (David Einhorn shorted the yuan before it started falling, but it was a contrarian position). Now, many smaller investors may get caught in a position they assumed was almost risk-free.

Yuan

Unhedged, long CNY products popular with small/mid-sized investors

“A more rapid decline could leave small/mid-sized corporate and private banking clients exposed to un-hedged positions (typically long CNH/short USD) via structured products,” write Citi analysts Ronit Ghose and Rahul Bajaj, who don’t think large banks are at risk because they generally have better risk management policies (hedging, use of collateral) in place than small or mid-sized investors.

If the yuan continues to fall or has higher volatility, large banks could lose markets income as investors become less willing to buy the products that were built on the assumption of a flat/rising yuan, though they may be able to create new structured products that take advantage of the yuan’s volatility if that happens.

Ghose and Bajaj argue that Chinese officials’ involvement in the onshore CNY market also limits how far the currency will be allowed to fall.

Falling yuan boosts liquidity and pressures repo rates

There have been some reports that the falling yuan was engineered as a first step toward liberalization as China tries to push its currency as a real alternative to the dollar or euro for international trade. The idea is that a temporarily weakened yuan would scare off some of the speculators who might drive the yuan up during liberalization.

If that was the intention, it looks like China’s plan might work out, but it has come at the cost of high liquidity.

Since foreign investors have been selling their yuan for dollars, there has been an influx of cash while China is trying to keep interest rates relatively high to cool the economy down gradually and avoid a crash. The weighted average of the seven-day repo has fallen from 3.84% to 2.83%, renewing concerns that banks will make risky loans and increase the country’s overall leveraging when the government is trying to move in the other direction.

“It’s matter of prioritizing. Hot-money inflows are a greater threat now. Once it’s gone, they can go back to guide interbank rates higher again. They are willing to live with this apparent contradiction but they would say it’s expected to be transitory,” said ING economist Tim Condon, economist at ING, reports Shen Hong for The Wall Street Journal.