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China’s yuan carry trade, an anchor and a risk for Asia

When China averted a default in its shadow banking industry last week in the midst of an emerging market meltdown, investors globally heaved a sigh of relief.

They may however be overlooking another major stress point in China's backyard: a mountain of foreign money invested in the yuan carry trade.

The foreign dollars invested in China's high-yielding yuan and credit stayed there through the past week's emerging markets selloff from Argentina to Turkey, taking comfort in the currency's stability, China's unstated support for its banking sector and the view that Beijing will not let the economy stall.

(Read more: Are China shadow banking woes exaggerated?)

That confidence could be put to the test if the emerging markets selloff continues and China shows any signs that its own outlook is darkening. Such a test could come this weekend, when China releases its official monthly survey of manufacturing in the wake of a private-sector report that showed the sector was contracting.

Adam Young | Flickr | Getty Images

The emerging world's biggest economy has been an anchor for Asian markets so far in the selloff, providing relative stability to the region's currencies and preventing what has been so far a hasty but selective exit of investors from turning into an indiscriminate stampede.

"It is a very large trade and part of it is carry driven, so if it unravels then you are talking of a Lehman crisis here, I think," said Mirza Baig, the head of Asian rates and currency strategy at BNP Paribas in Singapore.

"But I don't think it will unravel. To get that trade to unravel, you need a complete credit meltdown in China, something that causes a run on the currency."

Confidence that the yuan carry trade – essentially foreign investment chasing yuan appreciation and yield – will not unravel, stems from how tightly China's authorities manage the currency.

(Read more: China must accept global banking standards: Ex-UK PM)

Technically, it is a highly managed floating currency, but in reality it rarely strays far from a daily fixing set by the central bank.

Still, there are several factors that could spook investors and put the yuan positions at risk.

One is that the emerging markets selloff becomes indiscriminate. So far sellers have focused on the weakest developing economies and most of emerging Asia has avoided the worst of the selling.


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