Markets adjust to new RMB normal
Analysts foresee a surge in corporate FX hedging activity, onshore and offshore RMB spreads to normalize, and a dip in dim sum issuance after the RMB’s shock adjustment.
The devaluation of the RMB last week has increased divergence between the onshore and offshore markets, with spreads between USD-onshore (CNY) and USD-offshore (CNH) at almost 400 basis points from the pre-devaluation spread of 50bp to 100bp.
Beng-Hong Lee, head of markets for China at Deutsche Bank in Hong Kong, says the spread went up to almost 1,400bp after the fixing down of the currency by the People’s Bank of China’s (PBoC) on August 11, and eventually came down to about 300bp to 400bp by August 13.
The PBoC changed its fixing methodology for the USD-CNY exchange rate to create a more market-oriented FX rate, triggering a 3% devaluation in onshore spot rates from around 6.20 to the dollar to almost 6.4 to the dollar.
The central bank provided policy guidance on the onshore rate on August 13, making a case for the currency’s inclusion in the IMF’s special drawing rights (SDR) basket.
Gerrard Katz, Hong Kong-based managing director and head of Asia FX sales and trading at Scotiabank, says that options demand in the CNH market was an important factor in maintaining the elevated spread between the onshore and offshore RMB markets. “A lot of options books that were short vega and gamma especially along the longer-dated curve have been forced to buy spot [USD] as a hedge,” he says. “There has also been an unwinding of the some of the corporate positions as well.”
The CNY will need a 15% to 30% depreciation over the next one to two years to regain its competitive advantage
Although the spread is around three to four times what it was before last week, Deutsche’s Lee believes it will take between two to four weeks for the current divergence to return to pre-depreciation levels.
“Short-term market movements might lead to a change in the supply demand dynamic in the offshore markets, leading to a widening of the spread,” he says. “But as the capital account is liberalized within China, the spread will continue on a convergence trend.
“So because of demand/supply mismatch, the spread will go up, but it will always revert to its narrower basis.”
In an August 14 note, analysts at Standard Chartered wrote that previous stability in the spot basis between the onshore and offshore rates reflected a “very stable” onshore rate. A pick-up in onshore volatility has resulted in spread volatility, but the analysts don’t expect this to continue as onshore FX market volatility retreats from the highs after the fixing regime change.
Further, they note that the PBoC has “signaled that it will take new steps to develop a ‘single exchange rate in both onshore and offshore markets’. This should reinforce China’s case for the CNY to be included in the SDR basket.”
Issuance in the offshore RMB or dim sum bond market might suffer in the short-term as a result of increased outflows from the currency depreciation, according to an August 13 note by Standard Chartered.
Scotiabank’s Katz also expects greater flows into the offshore swap markets, adding: “Investment in the CNH is less attractive on an unhedged basis. So investments in the dim sum bond market may see greater hedging activity through cross-currency and FX swaps.”
However, hedging activity by mainland exporters might slow down, he adds, as market participants wait to see the new FX regime play out. Katz expects corporate hedging activity to increase in the next six to 12 months as a two-way market in the CNY develops.
Market participants expect greater volatility in the CNY, even as the onshore rate has remained stable this week at around 6.39 to the USD.
In a note, Katz wrote that the next step for the PBoC could be to abolish the trading band. However, he says, this might be some time away as China allows its markets to operate more efficiently in the new regime.
According to Kay Van-Petersen, Singapore-based Asia macro strategist at Saxo Capital Markets, the CNY is in the midst of a structural depreciation.
“Almost all of China’s biggest trade partners [Europe, Japan and southeast Asia] have depreciated their currencies to about 20pc to 40pc and continue to have a loosening bias, in a world where the USD is rising,” he says.
“So the CNY will need a 15% to 30% depreciation over the next one to two years to regain its competitive advantage. With over $3.5 trillion in FX reserves, the PBoC has a lot of room to manoeuvre.”
However, Lee says volatility in the CNY is not sufficient for a truly liberalized market.
“We expect the band to widen from 2% to 3% by the end of the year to early next year,” he says. “But although allowing greater volatility and a market-driven fixing regime is important, it’s not enough. Greater access to onshore capital and hedging markets for investors and corporates is key for the formation of a market-driven FX market.”