China: Currency contortions threaten dim sum

By:
Chris Wright
Published on:

Gap between onshore and offshore exposed; Hong Kong dim sum market in doubt.

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The turmoil in China’s currency and assets has caused ructions in markets all over the world, from stocks to other currencies. But a little-observed consequence may be a change in the issuance and investment dynamics of China’s onshore and offshore bonds and, maybe, a death knell for the dim sum bond market.

Ever since China began liberalizing its currency, and in particular since the launch of the offshore dim sum bond market, there has been a difference between the onshore and offshore behaviour of the currency and the bonds priced in them. Often volatile, this gap reached an all-time high in early January – only to vanish completely a week later. 

The difference in rates, spreads and values happens because there are tighter controls on the onshore than the offshore currency. In the latest volatility, investors took the view that the currency would depreciate; it is easier for them to express that view in the offshore market than the onshore, and so the gap increased. 

That is embarrassing for China, the more so since it was granted status as a Special Drawing Rights currency for the IMF; that status requires the currency to be, in the IMF’s words, "freely usable", and a gap between the currency’s behaviour in two separate markets suggests that it is not. For this reason, last August the People’s Bank of China pledged to narrow the gap, but it has not always been within the central bank’s control.

To narrow the gap this time, it appears the PBoC used state-owned banks in Hong Kong to buy up renminbi, thus supporting the offshore currency, known as CNH (as opposed to CNY for onshore), despite widespread selling by investors expecting the currency to depreciate. By January 12, it had succeeded, and the differential had gone from a record to parity in a matter of days. But it’s only a matter of time before the differential is likely to appear again.

What does all this mean for the onshore and offshore bond markets? Firstly, it presents a challenge for investors. 

"For offshore investors, the prospect of further CNY devaluation would mean that investors will stay clear of CNH bonds as they attach higher risk premium to them on higher volatility, lack of liquidity and expensive hedging costs," all of which outweigh any benefits from yield, says Magdalene Teo, fixed income research analyst at Julius Baer. Depositors in Hong Kong may convert their CNH deposits back to Hong Kong dollars, increasing pressure on the currency offshore, she says.

That sort of flight is not available to onshore investors, which should have the effect of supporting the onshore currency, Teo says. And that, in turn, will have an impact on issuers. 

"As both corporate and individual money cannot move out of China easily, we expect the onshore bond market to continue to see strong issuance," says Teo. "We expect the issuance of onshore and CNH or dim sum bonds to continue to take highly different paths in 2016."

It is already happening. 

Relentless

According to data from Dealogic, total dim sum bond issuance almost halved from $33.4 billion-equivalent in 2014 to $17.4 billion in 2015. 

Meanwhile the onshore bond market is growing relentlessly in size and sophistication: CNY7 trillion ($1.06 trillion) in 2012, CNY14.6 trillion in 2015, a doubling in three years and up 24% year on year from 2014. The dim sum bond market stands at CNH523 billion, so the onshore market is already almost 30 times bigger than the offshore. 

"The trend is not expected to reverse," says Teo. "Eventually, the CNH bond market will just be a small market alongside a larger and deeper bond market onshore." 

It’s tempting to wonder if this is the beginning of the end of the dim sum bond market. Ultimately, it surely has no future: if China does what it says it eventually will and makes the currency truly, globally convertible, then there will be no onshore and offshore, as they will be the same thing. Dim sum has simply been a means to an end, to begin the circulation of renminbi through debt securities offshore. 

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Linan Liu, strategist at Deutsche Bank, thinks the onshore market looks better for anyone who can access it, whether a buyer or an issuer: "As an investor in renminbi bonds, the onshore market is much deeper and with good secondary market liquidity, while offshore Rmb liquidity risk implies a rising liquidity risk premium on bond yields, so investors have to look at these based on volatility-adjusted potential return." 

"From the issuer’s perspective, the onshore market seems more attractive as the absolute cost of funding is lower than in the offshore market and less volatile to make it possible to lock in cheaper funding."

The corollary to that argument is that not everybody can access the onshore bond market, but that, too, is changing as China sets about the 13th five-year plan

"We believe financial deepening in the Rmb bond market will accelerate in 2016, with China gradually liberalizing bond market access by foreign investors and borrowers," says Liu. She calls the onshore bond market "an emerging global asset class", and expects it to grow by 20% year on year in 2016, reaching a level equivalent to 79% of China’s nominal GDP.

Within that, she expects Rmb500 billion of bond market inflows from foreign investors, and Rmb20 billion of panda bond issuance – onshore bond issues in China from overseas issuers. 

If she is right, those foreign inflows would be equivalent to almost the entire outstanding dim sum bond market. Dim sum bonds have captivated the market for years, but they are looking steadily less relevant.