Lenovo is a significant importer into China and sells in renminbi, while most of its costs are in dollars, and stands to gain from an appreciating Chinese currency. But as China moves to currency liberalisation, he says short term volatility will rise.
“If you are a commercial company working in a low margin business then you need to focus on short term currency volatility and the Chinese government has made clear in recent weeks it is happy to see a wider band of fluctuation for the RMB. In addition they have engineered a decline in the currency, with the clear objective of sending the message that, as they move toward liberalisation, you can expect two-way movement.”
The People’s Bank of China (PBOC) in mid-March announced that effective March 17, the exchange rate will be allowed to rise or fall 2 percent from a daily midpoint rate set each morning by the central bank. The central bank previously doubled the trading band to 1 percent from 0.5 percent in April 2012.
Lenovo prefers the forward market for hedging its currencies exposures, because it is simpler than the alternatives and less expensive than options.
“The main challenge we face is that we have the onshore and offshore markets, which don’t always trade at the same price, so you can end up with conflicts in terms of which one you trade in. To the extent you use the onshore market the existence of exchange controls makes life quite challenging.”
Under Chinese exchange controls firms must produce documentary evidence of an underlying physical import and there can be a timing mismatch.
“When you are doing hedging you are planning a future date but there may be all sorts of reasons why you won’t pay your supplier on that date.”
At the same time using the offshore market can lead to timing issues, with settlement in Hong Kong and cash still in China.
At the moment there is very little competitive bidding of FX in China. However, as currency liberalisation proceeds Glendinning expects that to change, though exchange controls must be loosened first.
“You can’t have a whole paper trail if you are likely to switch between bids, so all of these administrative challenges need to be removed. And Chinese banks are not yet accustomed to competing in this area.”
Another hedging option for Lenovo, and widely used by Asia corporates, is non-deliverable forwards (NDFs). However, with NDFs set to be traded on electronic venues under derivatives regulation, Glenndinning sees the market being severely disrupted.
“One of the issues with the NDF market is that it’s not very liquid. Now when we trade, the bank takes a position and warehouses that position. But their ability to do that is being challenged by the Volcker Rule, plus if these things are traded on an exchange there is likely to be a liquidity issue which will make it difficult to close.”
Already in Asia there are several currencies for which the fixing rates on the off-shore NDF market are no longer being published, after regulators took the view that they are too open to manipulation. In January 2013, internal reviews by banks in Singapore found evidence that traders colluded to manipulate rates in the offshore foreign exchange market.
“What all this means is that if I want to hedge the Indonesian rupiah I can jump through the hoops in Indonesia or do it in the NDF market in Singapore, where I no longer have a benchmark rate to settle against. So that means you are using the offshore rate, which is not optimal and increases your basis risk.“What regulation means is that you take away all this flexibility and you have a market which is clear and transparent but it may be a market that no longer exists!”