RMB depreciation expectations shift trading strategies
As China gradually loosens its grip on its FX regime, an ostensibly overvalued RMB is expected to fall back in line with global currencies, presenting a range of opportunities for traders, ranging from USD/CNH spot positions and the options market, to punts on the CNY-CNH differential.
In recent years, the Chinese FX market has expanded rapidly amid China’s partial relaxation of its capital account and a jump in offshore RMB trading.
“The size of the quotas and number of institutions granted licences to make onshore investments has been rising,” says Javier Corominas, head of economic research and FX strategy at Record Currency Management.
In recent months, Chinese authorities have provided intraday funds of up to RMB10 billion to authorized institutions participating in RMB business in Hong Kong to ease concerns about CNH liquidity upon the launch of the HK-Shanghai Connect.
This, along with the dim sum market, has further opened up Chinese onshore equity and bond markets. These moves have led to greater international flows into RMB, driven by real-money institutional investors.
This jump in the volume of liquidity and foreign-market players has coincided in a reversal of bets on the Chinese currency as a one-way appreciation play.
Instead, markets expect Beijing this year to engineer a further weakening of the RMB against the dollar, which has tested the lower-bound of its trading band in recent weeks, given its rapid rise in recent years and the need to boost export competitiveness as growth cools.
These structural improvements to RMB trading opportunities and liquidity, combined in a shift in bets in the currency’s direction, present a range of opportunities for traders and investors seeking to hedge FX risk.
Barclays analysts make one recommendation: “While the return in being long USDCNH spot has been somewhat negated by the carry cost of the position, we have maintained the trade and look for more upside in USDCNH, especially if we are correct in our view that a band widening and/or higher fixings are likely.
“Notably, investors who had undertaken long CNH positions versus USD for the relatively attractive carry are now exiting such trades as sentiment for the currency turns.”
Deutsche Bank also argues the year will see further RMB weakness and an increasingly hands-off FX policy, including even growing tolerance of CNY spot depreciation.
“With the overall exchange-rate regime becoming more open and market driven, historical DXY [US dollar index] sensitivity and beta of the USD/CNY fix is likely to reassert themselves,” it says.
However, given the punitive carry on going outright short the currency, Deutsche advocates using the options market, principally the USD/CNH call spreads to play the weakening RMB.
“We also see value in buying USD/TWD as a proxy trade to RMB, particularly given the close economic link between the two economies and the high beta TWD exhibits to RMB,” it says.
Analysts at BCA Research agree that a one-directional punt on the RMB is a risky proposition.
“It is unlikely that the RMB will fall far from the level priced in the non-deliverable forward market, or a 2% depreciation in 12 months, which is also largely consistent with interest-rate parity,” it says.
“We would be surprised to see the RMB decline by more than 3% to 5% against the dollar this year, unless the US dollar experiences a massive overshoot. From investors’ point of view, the RMB/USD rate may have exhausted the upside in the near term, but the risk-return profile of an outright short position on the RMB is not attractive either.”
Société Générale suggests the options market provides opportunities, in light of concerns that government intervention could mean downside risks in USD/CNH begin to outweigh the upside risks.
“Our preferred strategy is to own USD/CNH 6m put spreads, given the various possible policy outcomes, the likely evolution of the CNH, the forward curve, implied volatility and risk reversals. We do not recommend short USD/CNH spot positions due to binary risks of devaluation, while long USD/CNH positions require a very large move to break even.”
Interestingly, the frenetic rise in institutional investors punting on the RMB’s direction has raised speculation that the market could drive the onshore market. The CNY is already becoming sensitive to market forces, despite the control still exerted by the People’s Bank of China, say analysts.
Barclays notes: “The CNY has become much more sensitive to gyrations in other currencies, and vice versa. The correlation between USDCNY and most currencies has increased substantially over the past three months, highlighting in our view that China is finally yielding to the inevitable fact that it cannot maintain a strong currency in the face of USD strength.”
However, the counterpoint comes from Credit Suisse, which warns investors not to get carried away with predictions of CNY market sensitivity.
“The fact that China’s basic balance surplus plus its huge FX reserves dwarf its FX debt implies that China’s government will remain in complete control of its currency,” it says. “A market-driven devaluation is highly unlikely in our view.”
In any case, the differential between the CNY and CNH is providing ever-increasing arbitrage opportunities. In the past, CNH has traded at a premium to CNY due to excess offshore demand for RMB. However, last year expectations of RMB appreciation reversed, shifting the differential.
“The smart money plays the curves, go long one and short the other at different durations to capture the curve flattening,” says Sushil Bansi, trader at Record Currency Management. “This has been going on for years in the macro space, but now there are more institutional investors doing it.”
However, it’s not clear if the differential will be driven by fundamental or technical reasons.
The basis is heavily influenced by the net change in demand and supply for RMB, says Beng Hong Lee, head of markets, China, at Deutsche Bank.
Where there is excessive interest for investors to own RMB, CNH will trade more expensively compared with CNY, he says – but when there is risk aversion offshore, there is a tendency for CNH to be cheaper compared with onshore CNY.
“Divergence occurs frequently between CNY and CNH trading because of market segregation, which results from China’s closed capital account,” adds Chi Lo, senior economist for Greater China at BNP Paribas Investment Partners in Hong Kong.
Some domestic institutions have the ability to arbitrage the spread between CNY and CNH, but it is not encouraged. There have been reports of this happening via the over-invoicing of exports, where offshore capital was brought in and invested in the shadow banking system in exchange for false bills of sale.
Lee concludes: “While we expect CNY and CNH to converge/mean-revert over time due to the large cross-border flows and rapid pace of capital-account liberalization, at the moment, due to capital controls, there are no risk-free arbitrage opportunities.”