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.
As we push through into the second quarter of 2011, China-related financial headlines appear on what seems like a daily basis. The country’s economy continues to expand despite the uncertain and fragile global recovery, but elevated inflation pressures remain the primary focus of the Chinese government. Despite the well-publicized and aggressive monetary measures taken on the Mainland to cool the rate of growth this year, the other major story focuses on the developing offshore RMB market in Hong Kong (known as CNH), as China continues to take big steps toward legitimizing its currency to the world. My FX Trading Desk colleagues and I have recently written and presented several macroeconomic and currency-related thought pieces on China, but given the evolving story, an update to those materials is in order.
Economic backdrop
From an economic viewpoint, inflation continues to be a major problem. In the last few years a 2-3 percent GDP growth rate in the G-7 universe has been considered a very successful economic cycle; however, China’s routine/double-digit growth performance, as seen again in 2010, is expected to cool to a more manageable 8.5 percent GDP level by year end. The expected 2 percent drop in GDP this year reflects aggressive efforts by its central bank (PBoC) to slow the economy. Despite the monetary actions, elevated inflation is reported above the 4 percent target rate. CPI Inflation is expected to peak by mid-year at around 6 percent, but is now being felt via consumer sentiment, though overall consumption levels still remain solid. The economy may also experience a bumpy ride further in the year as the overheated housing construction market rapidly slows due to stricter government controls on home sales and tighter credit. Once inflation peaks, central bank policies surrounding credit are expected to loosen again, which many see as a consistent PBoC business cycle adjustment.
Another facet of the inflation issue is giving the PBoC an extra incentive to push for accelerated currency appreciation, which is now expected to reflect over 6 percent by year end. Traditionally, the rate of appreciation has been seen as a highly politicized issue, as the Chinese government attempts to satisfy the West’s ongoing outcry to correct its undervalued currency, although due to the current environment, the PBoC is finding this monetary tool quite useful as it tries to rein in its overheated economy.
FX activity
On the foreign exchange front, 2011 has presented a flurry of new rules for the onshore and offshore FX markets. As a result, most of the price action has been in the FX forwards, rather than spot. Onshore USDCNY outright forwards have been quite volatile in recent weeks following new cuts in banks’ net cash position limits. The result of this volatility has seen a divergence between the USDCNH deliverable forward and the USDCNY non-deliverable forward (NDF) curves, while ongoing changes to offshore clearing bank counterparty rules are also seen as reinforcing the role of CNH deposits as a “buy and hold” asset class. These new developments are offering enhanced opportunities for both corporate hedging and global value investors.
Offshore RMB presents new opportunity
Another major development at the end of last quarter was the announcement by the Hong Kong Monetary Authority that the PBoC is actively considering new rules that would make it easier to bring offshore RMB (CNH) funds to onshore RMB (CNY), marking another major step towards internationalizing the Chinese currency. Creating new regulations for cross-border trade settlement is seen as the true driver of CNH liquidity growth. According to the PBoC, there were $77.1 billion of trade transactions settled in CNY last year despite a very controlled and restricted process. As the nearly 67,000 local exporters that have been pre-approved by the PBoC complete the registration process, the corresponding CNH-driven settlement flows will expand dramatically.
The development of CNH capital market products also continues to expand rapidly. From a cash management and trade finance perspective, these products include CNH-denominated demand deposit accounts, time deposits, payments and receipts, FX conversion services, import letter of credit issuance and payment, and import post shipment financing.
Another major area of growth is in the area of foreign direct investment (FDI) in CNY versus USD, which is seen as removing another major choke point in the rapidly expanding offshore CNH market in Hong Kong. This potential move would also play into Beijing’s broader efforts to promote wider use of its currency, and potentially decrease its reliance on the U.S. dollar. This concern was underscored last week when Standard and Poor’s cut its outlook on U.S. government debt to negative, directly affecting the value of China’s vast foreign reserves, which are nearly all in U.S. dollars.
Mini-QFII
Later this year, the next probable step to be taken by the Chinese government to promote the CNH market will likely be the introduction of a new program to allow participating offshore banks greater access to the Mainland’s equity and bond markets. In what is widely dubbed as mini-QFII after the original Qualified Foreign Institutional Investor (QFII) scheme launched in 2002, this new program will enable qualified institutions to invest their CNH deposits back into China, but like its namesake, is expected to be quota-based. The precise cap is as yet unclear, but the expected total is seen at approximately CNY 20 billion. This long-awaited next step will provide another channel through which the repatriation of CNH to the Mainland can occur, and will be viewed as both important symbolically and practically. The anticipated launch of QFII is expected to be sometime in Q2 or Q3 this year.
Given that China is now the world’s second-largest economy, and the largest exporter, growth of CNY trade-related settlement is set to expand rapidly. China’s desire for an internationalized currency to match its standing in the world is partially restrained by a general fear of losing control of exchange rates and of a rapidly higher-valued CNY, along with all of the domestic social issues that its elevated status would bring. How Mainland authorities balance these conflicting demands will probably be the defining influence on the pace of CNY internationalization.
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. This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decisions. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.
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