China's Reserves Depleting as Options Indicate Yuan Decline Seen

Cash outflows from China are accelerating amid an increase in trades of high-strike options betting that the yuan will weaken beyond the psychological barrier of 7 per dollar.

China has swung from inflows of more than $100 billion a month to outflows of a similar magnitude in the past two years. China’s foreign-exchange reserves as a percentage of M2 money in circulation has steadily decreased since the 2008 financial crisis, when the ratio reached a local high. Looking at reserves relative to money supply shows the proportion of the money in circulation that can be absorbed by the reserves if these were to leave the country.

Investment flows and policies were among the themes being discussed at the World Economic Forum meeting in Davos, Switzerland, end of January.

The series above shows the ratio of reserves to M2 money in circulation has declined from 28 percent in 2008 to 16 percent, indicating China’s significantly weakened its position to counter outflows.

This depletion of foreign reserves may be one of the factors leading to the increased market activity for foreign-exchange high-strike options. The Depository Trust & Clearing Corporation is reporting $189.05 billion of USD Call/CNY Puts with a strike rate at or above the psychological barrier of 7 with expiry dates from January 2016 to the end of 2017.

The chart above indicates that the market is expecting the yuan to weaken throughout the year.