Selling the Chinese Short: Interest Revives in Chinese Index

The last time there was so much short interest in the Chinese Index CSOP FTSE China A50 ETF, China’s economy went into a $5 trillion-dollar rout. 

Are the short sellers on to something this time around, or will they lose big when China recovers?

The Surge in Short Interest Has Been Staggering

A surge of five-hundred percent, to be exact, bringing it to a high not seen since last year in April. 

As of May 25^th of this year, it was up to 6.1 percent from a mere 1.3 percent at the end of this April. 

At the same time, bearish sentiment was felt in the iShares China Large-Cap ETF, which jumped to bearish bets on 18% of its outstanding shares.

The Current Performance of the CSOP FTSE China A50 ETF

As you can clearly see, the index’s steepest drop was back at the beginning of the year, and it has even seen a nice upward trend in recent days. 

Nothing in its numbers indicates that it’s in any danger of a sudden crash. 

If anything, it looks to be heading for another small peak.

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So Why the Confidence that Chinese Shares will Crash?

Simply put, it’s the Yuan. 

Investors believe the Yuan will continue to devalue, and that will pull down the market. 

Observe the following chart:

The numbers on the left are the number of yuan exchanged per United States Dollar, and as you can tell, they have generally been climbing all through April and May. 

This represents a weakening of the yuan, probably exacerbated by the strengthening of the dollar in the face of potential rate hikes from the Fed. 

This is most likely what short-interest investors are noticing, and hoping to profit from.

Traders are betting on the yuan to devalue further, especially if the Fed follows through on its threat to raise interest rates. 

More specifically, they are betting that there will be selling in China if the yuan softens.  

And there is a consensus that market forces will force the yuan down, one way or another.

Where the Yuan Currently Sits

The yuan has lost 1.6% this month and was at 6.58 per dollar as of Tuesday. 

This number is very close to the five-year low that it hit in January. 

Meanwhile, the dollar was trading at an almost ten-week high.

CNBC Believes that China Has Only Three Options for the Yuan at This Point

• Defending the currency with its foreign currency reserves, thus preventing further devaluation

• Biting the bullet and creating one very large devaluation that will garner upward pressure from foreign traders (who currently think the yuan is overvalued)

• The gentle slide to a more reasonable market value, bolstered by reserves to soften the fall

Yu Hongding of the Chinese Academy of Social Sciences Warns Against the Third Option

He says that the second option is the only real option and that the yuan needs to devalue by 15pc. 

He observes that the government is intervening to create a gentle slide is creating exactly the sort of climate that we are now observing—one where speculators thrive.

Speculators, Meanwhile, Have Caused Recent Flash Crashes

• Late in May, there was a flash crash of nearly 10% when an investor on the CSI 300 index ordered 398 contracts at once

• Since they filed one at a time, in order, it prompted a huge sell-off.

• Fortunately, the drop lasted barely more than a minute, but it was most certainly rattling.

Foreign Speculators are Also Getting in on the Act

Brett McGonegal of Capital Link International Holdings Ltd. thinks that hedgers are using the CSOP FTSE China A50 ETF to access China long enough to profit from its predicted downturn. 

This would be the cause of the record-level short interest in the index.

Even Though the Yuan is Devaluing, the Shanghai Composite is Good

In fact, it’s 30-day volatility has not been so low since December of 2014.

Investors are Likely Assuming that Domestic Equities, Called A Shares, Will Drop

Sam Chi Yung of South China Financial Holdings Ltd. believes this is the case. 

He says that investors are counting on A shares to plummet, as the yuan falling would have an effect on the value of domestic Chinese shares.

Conclusion

While the devaluation of the yuan is likely to continue due to market forces if nothing else—after all, China cannot continue to prop it up forever—it remains to be seen whether there will be a significant economic crash as a result. 

If the short interest levels are any judge, however, a number of people will make a lot of money if there is.