The views expressed in this column are solely those of the
author and do not reflect the views of SVB Financial Group, or Silicon Valley
Bank, or any of its affiliates.
The Chinese lunar New Year is upon us. According to the
Chinese zodiac, this is the Year of the Rabbit when creativity, prudence, and patience
should be rewarded. This is supposed to be a year where diplomacy,
international relations, and politics will supersede conflict and force. We can only hope.
As most are aware, China has operated a managed
floating currency regime with strict capital controls. There has been
tremendous international pressure on China to liberalize their currency, the
Chinese renminbi, sometimes referred to as the yuan (CNY). My colleagues, Mark
Noble and Fernand
Kong,
recently provided insightful updates in the SVB’s Investment Strategy Outlook newsletter on China’s attempts to open
its currency to a more freely traded currency. This article will try to
summarize this ever-evolving topic and provide a window into what we can expect
in the future.
In June of 2010, the People’s Bank of China and the
Hong Kong Monetary Authority signed an agreement, launching an offshore CNY
settlement. The simple explanation they
created an offshore deliverable foreign exchange market in Hong Kong. This
government-led controlled experiment allows use of Beijing’s currency abroad. Hong
Kong is now the center for getting exposure to China’s renminbi without internal
domestic disruptions. The “new” currency has been given the code CNH. The value
of the CNH will remain fairly close to the onshore CNY value because the
central bank will allow the conversion between on shore and offshore currencies
if used for personal or trade related reasons — with some restrictions of
course.
The offshore RMB (CNH) market has grown at a tremendous
pace since inception, with continued demand forecasted. According to the Hong Kong Monetary Authority,
CNH offshore deposits climbed to 314 billion ($48 billion) this past December.
That is up 12 percent from November, and nearly triple from August 2010. There is also a tremendous demand for offshore
RMB-denominated bonds. Yields are generally
lower in the offshore market. For instance, five-year Chinese government bonds
are yielding almost half of the onshore government bonds. This disparity has corporations
and others lining up to issue cheaper yuan debt, nicknamed “dim sum” bonds. In August of 2010, McDonald’s was the first non-financial
corporate to enter this market as a means of issuing yuan-denominated debt.
Other well-known names like Caterpillar and the Asian Development Bank have
joined. Last month, the World Bank,
which is AAA-rated, set a record low for offshore RMB bonds when the coupon
yield was .95 percent for two years. Meanwhile, the buyers of these bonds are willing
to accept the lower yields in return for indirect exposure of the currency (CNY),
a currency that will likely continue to strengthen over the long term. The
problem for the average investor is that the demand for these assets is larger
than the supply. Offerings have been quickly consumed by only the largest of institutional
investors and hedge funds.
Historically, the non-deliverable
forward (NDF) market was the only way for offshore corporations to hedge CNY
exposure. The good news is the NDF market was, and still is, very liquid. The bad
news is the NDF curve was based mostly on the market outlook on the future
value of the yuan. In the case of the
CNH deliverable forwards, the curve is based more on the USD and
RMB deposit rate differentials in the offshore market. Thus, the CNH forward
discount points can be less than that of the NDF market. For now, the estimated
average daily turnover in this forward market is around 350 million dollars equivalent.
Transaction sizes are reported up to USD 100 million for one month, and up to
$20 million out to three months. However, as the CNH market grows, the forward market
will continue to look much more attractive, making these deliverable forwards a
cheaper alternative to hedging payables compared to the NDF market.
Capital
Controls
Ironically, the CNH in
Hong Kong is treated like foreign currency by Chinese regulators. The amount of
time it takes to move offshore RMB to onshore RMB is still tightly controlled. The
last thing China wants is “hot money” introduced into its already overheated
economy. The People’s Bank of China Bank is trying
to contain inflation, after November’s CPI climbed to a 28-month high of
5.1 percent. The central bank recently
hiked bank reserve requirements, its seventh
increase since early last year, to a record 19.0 percent for
the largest banks. Therefore, to retain control, cross border
payments are still dependent on the location of the beneficiary’s mainland
operation. Only the local provincial government can process cross border
payments. Currently, settlement with
counterparties based in Mainland China (CNH to CNY) must meet the following
requirements: 1) the underlying transaction is related to commercial trade
settlement; 2) the Chinese recipient must be located in 1 of 20 designated
cities or provinces and 3) the Chinese recipient must be a Mainland Designated
Enterprise (MDE) if the underlying transaction is for the export of goods from
China. An MDE is a Chinese enterprise
that has been granted approval by the central authority to participate in cross
border payments of CNY. The list of
Mainland Designated Enterprises is updated on an infrequent and unpredictable
basis by the PBOC. Currently, there are almost
70,000 approved mainland exporters and importers.
The
Future is Bright
The rapid development of the offshore yuan market in
Hong Kong seems to be a success on most accounts. China is able to redirect
speculative money offshore. Borrowers are
getting access to cheap yuan for their funding, or to better settle trade
related payments. Investors now have
another mechanism for direct exposure to the currency that will likely
strengthen over the long term. China may ultimately be perceived as a
legitimate alternative in the international investment community. On the risk
management side, the ability to trade, invoice and settle currency outside the
mainland will enable offshore corporate and institutions to buy, sell, actively
hedge their exposures using CNH products. This will give rise to greater demand for risk
management and investment products. As a result, the size of the CNH forward
and offshore bond market is expected to continue to grow.
In this Year of the Rabbit, patience is required. Remember, these changes are the first steps of
a long journey.
Foreign exchange transactions can be highly
risky, and losses may occur in short periods of time if there is an
adverse movement of exchange rates. Exchange rates can be highly
volatile and are impacted by numerous economic, political and social
factors, as well as supply and demand and governmental intervention,
control and adjustments. Investments in financial instruments carry
significant risk, including the possible loss of the principal amount
invested. Before entering any foreign exchange transaction, you should
obtain advice from your own tax, financial, legal and other advisors,
and only make investment decisions on the basis of your own objectives,
experience and resources.