In light of China's status as the world's largest exporter with the largest trade surplus, undervaluation of the CNY has been criticized by other nations in the latest IMF and G7 meetings. This issue has dragged on for years, but has become increasingly sensitive lately in the face of lingering high unemployment in the U.S. and Europe amid the slow recovery from the recession.
A week earlier, the U.S. House of Representatives voted in favor of a bill that would authorize the White House to impose punitive tariffs on a variety of Chinese imports for unfair trade practices as a result of its undervalued currency. However, there is a long way to go before this becomes law as the Senate will not take the bill until after the November election. The Obama administration has also decided to delay the decision on whether it believes China manipulates its currency to create an unfair trade advantage.
China's plan to open up the CNY market
The CNY was fixed in Shanghai at a new all-time high against the USD at 6.6497 on Friday, and closed at a record high of 6.6435. In recognition of the political realities, China has allowed the CNY to appreciate at the quickest pace since the 2005 revaluation. CNY has appreciated 2.74 percent since China announced its de-pegging to the USD in June. However, do not expect China to accelerate the CNY appreciation in one big step. As Premier Wen pointed out in a recent CNN interview, an appreciating CNY will not by itself cure U.S. economic problems. But moderate appreciation of the CNY will not hurt continued solid Chinese growth. Premier Wen, in a speech in New York before meeting with President Obama, said that a 20 percent increase in CNY value would cause severe job losses and trigger social instability in China. He also emphasized that China will manage its exchange rate in its own "long term interests."
We, therefore, expect continuous, gradual CNY appreciation similar to the past few years, at perhaps a 5-8 percent annual rate, as a sign of cooperation in the global market in order to achieve its long-term goals. But bolder appreciation will be unlikely unless China achieves its long-term interests.
What are China's long term interests? Based on Premier Wen's CNN interview, one is to rely on stimulating domestic demand to stabilize and further grow the Chinese economy. China is already working towards that goal by pushing for real exchange rate appreciation through salary increases, rather than with the nominal exchange rate. Among China's 31 provinces, 27 have raised their minimum salary by an average of 22 percent this year and the remaining four will introduce measures to hike wage rates later this year. This can be seen as one of the many policy efforts by Beijing to shift the economy from export-driven to consumption-driven.
CNH – The irst step toward CNY internationalization
Another long-term interest is to internationalize CNY so that CNY can first become a global trade settlement currency, then an international investment currency and finally an international reserve currency.
The launching of offshore CNY settlement in June by China was the first step to speed up the voluntary adoption of the CNY as a trade settlement currency. The subsequent signing of the Supplementary Memorandum of Cooperation between the People's Bank of China and the Hong Kong Monetary Authority has effectively given Hong Kong a new unique role as an offshore center for trading CNY, or, as the new offshore currency deliverable in Hong Kong has been called, CNH. CNH will be a pilot market for China to gradually moving towards a freely traded CNY, without causing internal domestic disruptions before the onshore market is ready.
What does CNH offer?
Any corporate can now hold CNY in a CNH account with a Hong Kong trade settlement bank. However, CNY onshore and the CNH offshore are separate markets. CNH can be transferred to make onshore CNY payments to the extent that the transaction is trade-related. However, CNH can be traded and delivered in Hong Kong offshore without restrictions with its own liquidity and pricing, reflecting specific demand and supply conditions for CNH deliverable in Hong Kong. Forwards and options can now actually be settled in CNY offshore.
Economists have long pointed out that a major barrier to Beijing's plans to encourage overseas firms to use CNY to settle their trade with China is the lack of tools available for hedging foreign exchange risk. Foreign firms are blocked from buying swaps or forwards in the onshore market, and non-deliverable forwards and options are an imperfect substitute because they can only be settled in USD.
With the CNH market, overseas firms will be able to trade in a whole raft of CNY-denominated financial products, largely free of Beijing's oversight. As the CNH liquidity improves, it is hoped that exporters and importers will eventually give up on the USD as their settlement currency of choice, and consider using CNY as well.
Implications for foreign companies and investors
CNH will significantly extend the scope for multinational companies to manage their asset and liability exposure to CNY. An offshore company without immediate trade-related reason to hold CNY, but with potential future CNY exposure, can now build exposure on CNY by acquiring CNH-denominated assets. On the contrary, offshore companies can potentially issue CNH-denominated debt as a hedge to Chinese onshore assets.
The Shanghai authorities have recently indicated that they will allow CNH to be used to settle trade-related transactions, such as foreign direct investment. This has effectively formalized a route into the mainland for the proceeds of Hong Kong bond issues, which previously were subject to case-by-case approval.
Both offshore and onshore companies may now be more willing to accept CNH as payment, as they will be able to use it for trade-related payments in the future and have access to a broader CNH-denominated asset class in the near term. As CNH asset markets develop, a broader range of assets with higher yields will become available.
On a transactional exposure level, offshore companies with future payables in CNY can raise their hedging ratios by selling USD and buying CNH spot and park the CNH in a CNH account. As recent liberalization measures have allowed banks in Hong Kong to access the local bond market, these banks will offer yields on CNH assets which are closer to onshore government bond yields at around 2.5 percent across the curve.
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.
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.