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Foreign Exchange

CNH discount to CNY capped at 2% in 2012

The risk of a divergence between the offshore (CNH) and onshore renminbi rates remains amid market volatility, but the deviation is not expected to be as wide as last year’s 3% according Deutsche Bank, writes Asiamoney, a sister publication of EuromoneyFXNews.

The volatility of the CNH-CNY spot basis as dropped since late October last year, but growing risks of market contagion from Europe could lead to a near-term divergence between offshore and onshore renminbi rates. The spread between the offshore and onshore spot rates has narrowed from around 400 percentage points (pp) in October to about 200pp in April, according to a research note released by Deutsche Bank on May 29.

Following the widening of the onshore USD/CNY trading band on April 16, the CNH-CNY spot basis has narrowed further to about 100pp recently. In the forward market, the basis between the one-year outrights has narrowed from 800pp to around 300pp over the last two months.

However, growing headwinds stemming from the eurozone could potentially increase the near-term likelihood of another "blow-up" in offshore-onshore spot rates. The scenario could be similar to the fourth quarter of 2011, when spot USD/CNH was trading as much as 1200pp-1500pp.

"With markets getting more concerned over such blow-up, there has been an increase in market interest in inexpensive hedging opportunities," said Linan Liu, strategist at Deutsche Bank in the report. "Our view is that the CNH-CNY spot basis could still widen in the event of extreme market stress and a sharp US dollar squeeze."


Despite increased worries, Deutsche Bank believes that the deviation between onshore and offshore rates will likely be more benign this year. The CNH is anticipated to trade at a discount of 1.5%-2% or less this year to onshore renminbi, lower than last year’s 3% discount.

There are several reasons for this. Firstly, bets on renminbi appreciation have been reduced this year as China’s growth gradually slows and as the central bank introduces greater two-way volatility in its USD/CNY spot fixings by widening the spot day trading band to 1%.

Consequently, foreign exchange (FX) inflows have declined as well – the cumulative net FX purchase by the People’s Bank of China (PBoC) from October 2011 to April 2012 was Rmb77 billion (US$12.1 billion), compared to an average of over Rmb320 billion per month in the first three quarters of 2011.

"Increasing uncertainties of the spot fixings and concerns over a slow pace of renminbi appreciation due to weaker exports and a shrinking balance of payments surplus have dampened speculative appetite for US dollar shorts against the renminbi," added Liu.

Secondly, unhedged renminbi letters of credit (LC) exposures have been reduced, notes the bank.

"Recall that the persistent divergence in the CNH and CNY spot rates last year was due to increased US dollar demand by Hong Kong banks rushing to hedge their renminbi LC exposures following the sharp widening of the spot basis," said Liu. "We believe that renminbi LC discounting banks, after being caught off guard by the sharp divergence in onshore and offshore spot rates, have mostly hedged their LCs-related exposures to minimise spot basis risk."

Other market developments, including the increase in renminbi quota for the cross-border trade settlement and as onshore corporates become savvier at taking advantage of divergences in spot rates, are expected to minimise the divergence as well.

"Over the past two years, more Chinese corporates and multinational companies have learned to take advantage of opportunities arising from a divergence in different spot rates," said Liu. "We think that such opportunistic FX flows by onshore corporates will likely help to narrow the spot basis quickly should a divergence happens again."

Lastly, the PBoC has indicated this year that it will intervene much less in the FX market and allow the market forces to determine the renminbi FX pricing, notes Deutsche Bank. This is true as the central bank seeks to gradually relax its capital account controls.

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