By Simon Jessop and Saikat Chatterjee
LONDON (Reuters) - A record slide in the Chinese currency in June has paid rich dividends for some of the world's top macro hedge funds, though they say those trades do not reflect growing bets on an economic crash.
The world's second biggest economy certainly has its problems. It is exposed in any escalation of its trade conflict with Washington and its massive debt pile has raised concerns about the health of its banks and state-owned companies.
And betting against its yuan, either through the offshore markets or currency derivatives, has been a hedge fund favourite for years.
Having laid heavy bets in 2015 and 2016 thinking China's red-hot economy would crash, those funds felt the heat as central bank intervention cushioned the currency's fall and made their short yuan trade too expensive to maintain.
While that play has faded since Beijing allowed more access to its onshore markets and tightened its grip, some hedge funds have continued to bet against the yuan for different reasons.
For Kevin Smith, chief investment officer at hedge fund Crescat Capital, June's record slide of more than 4 percent in the yuan against the dollar was vindication of a three-year-long bet the Chinese currency would weaken.
After originally paying off, it contributed more then 80 percent of the firm's 23 percent loss in 2017.
"We have been bearish on China for three years and went through the desert last year. It's something that really kicked in for us back in 2015 and is kicking in again for us now," Smith said.
Crescat used options to maintain a position at a cheaper cost last year and keeps the yuan devaluation theme among the $56 million fund's top trades.
"The options give us a way to stay in the game and have substantial exposure when it eventually moves and minimises the downside. Using our risk controls, we were able to stay in it when a lot of other hedge funds... have really been forced out."
In the summer of 2015 and early 2016, Hyman Capital and Corriente Advisors led the charge in betting against the Chinese economy via currency derivatives, which paid off when Beijing engineered a shock devaluation to stabilise its markets. Both funds declined to comment on current positions.
Those trades also peaked at a time when Beijing's ambitions to encourage the overseas usage of its currency fuelled bets that China would find it difficult to stem an avalanche of capital outflows as its stock markets plunged.
But since then, China has taken steps to improve markets and allow more access to foreigners by launching investment channels between its big stock markets in Shanghai and Hong Kong.
"For hedge funds, the world has moved on from the view of a disorderly China devaluation," said Stephen Coltman, a senior investment manager on the Alternatives Investment strategies team at Aberdeen Standard Investments.
While specialist currency funds were still playing moves in the yuan, macro hedge funds - which bet on macro-driven moves in stocks, indexes, rates and currencies - were largely absent.
That can be seen in the offshore derivatives market in non-deliverable forwards, which were not pricing massive yuan depreciation, Coltman said.
Forward prices on one-year offshore yuan contracts show a discount of 56 pips from spot levels, but back in early-2016, the discount was more than 350 pips as concerns about a sharp slowdown in China convulsed markets.
Though a gauge of one-month and three-month risk reversals, a ratio of puts to calls, for the yuan have edged higher in recent days, it remains far below the levels of third quarter of 2015 and early 2016.
Yuan moves have also been more orderly this time.
As trade tensions between the world's two biggest economies escalated, the People's Bank of China let the renminbi weaken nearly 5 percent over 11 trading sessions from mid-June to an August 2017 low of 6.7204 yuan per dollar.
The currency is now holding near one-year lows.
Contrasting with the "hard landing" fears of 2015, most investors reckon that China's economy is on a strong footing, and yuan weaknees could be just a policy-loosening tool, alongside targeted reserve requirement cuts.
"Our big data indicators on the ground are pointing to an upside risk to the consensus regarding economic activity." said Isabelle Mateos y Lago, chief multi-asset strategist at BlackRock Investment Institute in London.
More importantly, the cost of running short yuan positions has made betting against Beijing an expensive business.
With access to onshore markets improving, a falling offshore yuan pool - amounting to 600 billion yuan ($90 billion) compared to more than 1 trillion yuan in December 2014 - has meant short-sellers are vulnerable to sudden spikes in overnight funding costs as seen several times last year.
Even taking the currency derivatives route is relatively expensive. Implied volatility on the offshore yuan, a key input to pricing options, is more than its Asian counterparts.
"These are nose-bleeding positions to run over months and can drag on performance," said Kenneth Broux, a currency strategist at Societe Generale in London.
Greater China-focused hedge funds were down 4.18 percent in June, compared to global counterparts which posted flat returns in that period, according to data from Eurekahedge.
One late joiner was Bluebay Asset Management's Kaspar Hense, who started selling the offshore yuan at 6.45 per dollar last month, reckoning Beijing would accept the inflationary impact of a weaker currency.
While the yuan's drop has made his position far more profitable than expectations, he is not worried that it get out of hand and trigger an avalanche of capital outflows.
"We don't think the Chinese economy is in any danger and the currency losses are far more manageable to policymakers this time around," he said at the Mayfair-based fund which manages $60 billion.
Douglas Greenig, founder of Florin Court Capital, meanwhile, said he had profited from both the rising and falling currency in 2017 and 2018, as his quantitative fund models combed the market for trending prices and then leveraged those patterns to profit from them.
"The positioning seems much less extreme than (before)... When positioning is extended there are fewer people to come into the trade and push the trend further."
($1 = 6.6666 Chinese yuan renminbi)
(Reporting by Simon Jessop and Saikat Chatterjee, additional reporting by Maiya Keidan; Editing by Sujata Rao and John Stonestreet)