China's Yuan Could Rival Yen in Carry Trades

This strategy traditionally involves borrowing in currencies with low interest rates, such as the Japanese yen, to invest in assets that offer higher yields.

For a carry trade to be successful, stable exchange rates are crucial, as currency fluctuations can significantly impact returns.

The yen recently reached a seven-month high against the US dollar, driven by market expectations of potential additional monetary tightening from the Bank of Japan.

Such volatility and currency appreciation can severely erode the returns from carry trades, prompting capital repatriation as investors anticipate higher Japanese interest rates.

Claudio Piron, head of Asia foreign exchange and rates at Bank of America, identifies higher volatility as the primary risk for carry trade participants. This heightened volatility is compelling investors to actively seek alternatives to the Japanese yen for their funding needs.

Among the currencies currently being considered as potential alternatives are the Swiss franc and the Canadian dollar, both of which offer different risk-reward profiles.

Japan is now moving away from its historically ultra-loose monetary policy, resembling China's economic situation of two decades ago.

Conversely, China is currently experiencing challenges such as weak household borrowing and a downturn in its property sector, mirroring Japan's economic conditions from 20 years prior. These shifts have profound implications for global financial markets and currency strategies.

The country's one-year loan prime rate has remained stable at 3% for a 15th consecutive month, offering a predictable low-cost borrowing environment.

The offshore yuan market has expanded significantly, leading to a notable increase in the issuance of CNH-denominated bonds by international companies seeking funding.

Despite its attractive interest rates, China's restricted capital account and managed currency regime present key limitations for the yuan as a global funding currency. The openness of China's capital account is considerably more restricted compared to that of Japan, impacting the free flow of funds.

China maintains strict controls over cross-border capital movements, and its onshore yuan is managed through a daily reference rate set by the People's Bank of China (PBOC), with trading generally limited to a 2% band on either side of this midpoint.

In 2026, the yuan appreciated by 4.3%, reaching a four-year high, which can make it less attractive for borrowing.

While a strengthening yuan may appeal to investors who believe Chinese authorities are comfortable with gradual gains, rapid appreciation makes the currency significantly more expensive to repay, deterring carry traders who prioritize stable or depreciating funding currencies.

The Renminbi's daily fixing mechanism provides policymakers with a powerful tool for guiding market expectations, influencing the currency's trajectory. Bank of America projects the dollar-renminbi exchange rate to reach 6.6 by year-end, reflecting anticipated policy and market dynamics.

Currency markets are closely monitoring an upcoming high-level meeting between the US and China, scheduled for September 24th, for any signs of easing trade-related tensions that could impact currency valuations.

Seasonal conversion of dollar earnings by Chinese exporters creates additional yuan demand, influencing its availability and cost.

Other currencies are also being considered: the Singapore dollar offers predictability through its exchange rate management, the Canadian dollar is liquid but carries volatility risks due to its commodity linkage, and the Swiss franc remains a traditional low-yielding alternative, though its market depth might not match the yen's.

The Japanese currency achieved its dominant position in carry trades due to a unique combination of factors: deep financial markets, enormous liquidity, consistently low borrowing costs, and decades of very low interest rates. These attributes are difficult for other currencies to replicate fully.

In contrast, China's capital controls significantly limit the yuan's utility for unrestricted carry trades. The Singapore dollar market is substantially smaller, while the Canadian dollar's reliance on commodities introduces volatility risks, making it less suitable for consistent low-cost funding.

Claudio Piron warns that cheap funding alone is never sufficient for the successful execution of a carry trade. The ultimate profitability of such a trade critically depends on the currency's performance after the money has been borrowed, particularly its stability or gradual depreciation.

The renminbi's utility as a funding currency will hinge on its ability to maintain contained volatility. As Japan shifts its monetary policy, the global search for a new major funding currency continues, underscoring the complexities beyond just low borrowing costs.