Renminbi convergence: Is it inevitable and what are the risks?

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Fuelled by the belief that China’s controls are holding back the value of its currency, investors around the world are keen to take advantage of the perceived one-way bet on the appreciation of the renminbi. While there is currently a dislocation between on and offshore pricing of the currency, eventual convergence looks inevitable.

Woon Khien Chia, Head of Local Markets Strategy, Emerging Asia

For the rest of the world to accept the Chinese renminbi or yuan (CNY) as the settlement currency for their trade with China, it must be deliverable. At the moment, the world’s second biggest economy remains largely a closed market. But to promote the use of CNY in its cross-border trade, the People’s Republic has allowed the currency to become partially deliverable, or convertible, outside China. It permitted Hong Kong to set up an offshore deliverable-CNY market in 2009, which is known as CNH.

The offshore market has been a great success and it looks increasingly likely that China will liberalise its domestic market to pave the way for the convergence of the pools of offshore CNH and onshore CNY money. This is evident from the steps taken to further promote the use internationally of the renminbi for trade and investment, such as the currency agreements signed with foreign central banks and that on 16 April it will widen the trading band against the US dollar in the foreign exchange spot market.

Since late 2008, the People’s Bank of China (PBOC), the country’s central bank, has signed a total of 17 CNY currency agreements, called swap lines. These are important for instilling confidence in China’s trade partners to use the CNY for settling their bilateral trade. They also offer a clear sign that Beijing is seeing the benefits of foreign involvement in its currency.

With the expansion of the trade settlement scheme comes the confidence of global investors in holding CNY-denominated investment assets. China has opened up more avenues for both Chinese as well as foreign borrowers and investors to do this and to tap into the pool of offshore CNY money. China’s Qualified Foreign Institutional Investor Scheme (QFII) currently allows 147 selected foreign investors to own almost USD25 billion of Chinese stocks and bonds.

All of this suggests that China is ready, and wants eventually, to handle all of its foreign trade in its own onshore currency. This would require a full joining of both its onshore and offshore currencies and clear the path for the renminbi to become a true global reserve currency.

The Chinese government has set no timeline for the full and final liberalisation of its capital markets. But the creation of the CNH market, along with a spate of other initiatives in recent years, suggests liberation could follow even more quickly as we move into the second half of 2012. Investors into both the CNH market and Asia in general, must therefore factor in the potential risks of an eventual CNH/CNY convergence.

Uniting the on and offshore RMB becomes even more likely as new offshore centres develop. The size of the CNH market is likely to soon overwhelm Hong Kong, and China is expected to allow the creation of other offshore centres. After discussions last year, the Chinese and UK governments announced they will support an offshore centre in London. This will bring the CNH outside Asia and into the G7.


PBOC’s CNY swap lines

In light of this expected competition, in May 2011 the Hong Kong Treasury Markets Association announced that it would start providing a daily spot price fixing for the USD/CNH foreign exchange (FX) trades. This is yet a further signal that the CNH market is maturing. This is good news for investors because it prevents multiple pricing of forwards and rates. It is good news for Hong Kong because it makes the city the global pricing centre for all offshore CNH FX trading in future. The fixed spot has also reduced differences between CNH and CNY pricing, which provides further growth opportunities for the market.

As the CNH expands into other jurisdictions, it will broaden the range of investors. This will give the Chinese government more ways in which to test the resilience of the CNH on its way to convergence with the CNY and could increase their confidence. It is more a question of when, rather than if, the renminbi internationalises. However, it could be a gradual process and investors should prepare for the unpredictable.

The ways of investing in CNH and potential pitfalls

Bonds

By far the most popular way for investors to gain exposure to the offshore currency has been via so-called dim sum bonds, which are CNH-denominated bonds issued in Hong Kong. So far in 2012 there has already been CNH76 billion of new dim sum issues with CNH291 billion of bonds outstanding. In August last year, China sold CNH20 billion (USD3.1 billion) of government dim sum bonds, the biggest ever offshore renminbi bond issuance, and demand among institutional investors outstripped supply by almost five times. China’s intention in issuing government bonds in the offshore CNH market is clearly to set a sovereign benchmark curve for all the other issuers. This is its third batch of bond auctions.

Dim sum bonds are currently priced against the USD/CNY cross currency swap (CCS) curve. While the Chinese authorities retain tight control over their currency, the market’s expectation that the CNY is undervalued and will continue to appreciate can be factored into the CCS curve and therefore the pricing of both short and long-dated bonds. The pricing becomes much more difficult given the uncertainty around when China’s onshore market will open up. Investors therefore need to factor the uncertainty over the timing of the convergence of China’s currencies into their bond-purchasing plans.

Equities

It is extremely tricky to assess accurate pricing of CNH equities, which take two factors into account. Firstly, China’s central bank’s long-term debt, which is seen as virtually risk free, is benchmarked against dim sum bonds. The second factor used to price equities, the risk premium, is benchmarked against the listings of Chinese companies in Hong Kong’s Hang Seng Index (H-shares). These command a low-to-negative price premium over the equivalent Chinese onshore A-shares. The discrepancies between these benchmarks and their onshore equivalents make it hard to fairly value stocks in the offshore CNH market.

Currencies

The rapid growth of the CNH market could cause problems for Hong Kong as a trading centre. CNH deposits in Hong Kong reached CNH575 billion in January 2012, which is 9.2 per cent of Hong Kong’s total deposits and 18.2 per cent of Hong Kong’s total foreign deposits. The expansion of the deposit base has led to a huge amount of excess liquidity.

This has been exacerbated by the fact that Hong Kong banks have siphoned off excess Hong Kong dollars (HKD) by converting them into CNH loans. This will not dampen inflation pressures as the deposits still remain in Hong Kong, just in another form. Investors should therefore watch out for moves from the Hong Kong Monetary Authority (HKMA) to introduce macro prudential controls to curb the conversion of HKD into CNH loans.

The HKD peg to the weakening US dollar (USD) could erode the HKD deposit base further as residents and investors seek to exchange their HKD funds for the appreciating CNH. Despite the daily CNH20,000 conversion limit on CNH deposits for Hong Kong residents, this has become easier to do as the range of CNH-denominated financial instruments has increased. The HKMA could therefore also be compelled to look at ways to slowly allow the HKD to appreciate against the USD. They could do this, for example, by setting a distant target date for a change in the rate at which HKD is pegged to the USD.

Hong Kong deposit and loan growth in HKD and non-HKD (%YoY)

Hong Kong deposit and loan growth in HKD and non-HKD (%YoY) 

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