Changing dynamics of RMB: Hedge depreciation via forward-forwards
For months, China’s authorities have been telling the market they believed their currency had moved towards equilibrium, yet forward rates seemed to continue to reflect the expectation of further CNY appreciation. That’s all changed in recent weeks and there has been a massive move to the right in RMB forward curves. Can it continue?
The forward curve has now steepened substantially, which means that forward rates are now predictors of interest-rate differentials rather than an expectation of where the market believes the currency to be trading in the future. For instance, a year ago, CNY forwards had a negative implied yield on the one-year non-deliverable forward. That is now trading with an implied yield of 1.5%, but what is interesting here is that the forward curve is still continuing to steepen.
And this all comes as Chinese authorities have continued to reiterate that a depreciating currency would be favourable for exporters. The timing of such pronouncements is also noteworthy, given that the US might be more focused on domestic politics right now.
This week, China's export growth slowed to just 1.0% from a year earlier in July, down from an expansion of 11.3% in June, according to data from the General Administration of Customs. Additionally, exports to the EU were down 16.2% in July from a year earlier.
It is also noteworthy, say traders, that Chinese authorities have not had to intervene to buy dollars for nine months. In fact, they have more recently had to sell dollars unofficially through agents to keep it within the trading band as the currency has weakened.
All of this price action represents a complete U-turn in China’s currency policy. This also comes at a time when China’s current-account surplus is not as large as it once was.
It should also be noted that the behaviour of Chinese corporates seems to be changing too.As EuromoneyFXNews noted last month, Chinese corporate have oversold dollars to the tune of $700-$800 million, which is also distorting the move in the CNY onshore forward curve.
Traders say these corporates are selling these dollars in Hong Kong to buy CNH, and then remitting it onshore for trade purposes. What that has done is tighten up liquidity in the offshore market and caused the curve – which has typically been inverted – to start normalizing. If anything, say traders, it could steepen further.
However, after such a big move, is there anything left in this trade?
Possibly, say some analysts, and that is because of one of the peculiarities of this market where traders might typically trade to certain points of the curve, such as the one-year point, for instance. Therefore, trading in the forward-forward curve might offer some value, the analysts argue.
With the straight one-year forward trading at 1,250 points, there might be better value trading the six- to 18-month forward, which currently prices at around 1,000 points. And which curve should one trade?
This comes at a time when China is cutting interest rates in an effort to stimulate the country’s economy when the RMB is trading at the weak end of its band. This week, the People’s Bank of China (PBoC) lowered the RMB reference rate by 0.06% to 6.3482 per USD, a cut that brought CNY to its lowest level against USD since November 30.
Furthermore, PBoC figures on Wednesday showed CNY FX outflows in July were equivalent to RMB3.8 billion. The phenomenon of RMB depreciation is a mounting policy problem for China at a time when the government is anxious to sell RMB to buy USD.
Persistent CNY outflows, coupled with the interest-rate cuts, have left the FX market wondering how sustainable an environment of RMB outflows and lower interest rates could be for China through to the end of the year. It is the first time China has faced such a conundrum since it unified its currencies in 1994.
What if these outflows continue to accelerate?
Recent data from the Shanghai Composite Index show that Chinese equities are trading 54% below the price/earnings average for the year, as the basket of Shanghai Stock Exchange listings has failed to respond to RMB rate cuts.
Correlation of RMB to China composite
In a note this week, Société Générale wrote that a worsening growth outlook for China means FX market risk could increase if the Chinese government works to purposefully depreciate the RMB further this year.
“Given the worsening growth outlook, the bigger risk is now of a depreciation of the currency to stabilize exports, breaking the appreciating year-on-year trend in place since the CNY de-peg in July 2005,” the French bank wrote.
SocGén said that CNY onshore and offshore forwards will come under selling pressure during the rest of the year, as FX investors look to hedge longer-term depreciation risks as RMB volatility declines.
CNY one-year onshore forward
Despite these market concerns, the Chinese central bank maintains around $3 trillion in foreign currency reserves, creating a fundamental hedge for FX market wariness of RMB depreciation.
Nonetheless, Chinese Premier Wen Jiabao warned on Thursday that the country’s economic growth rate is under pressure as GDP growth in the April-to-June period grew at an annual rate of 7.6%, the slowest pace of expansion for China in three years.