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HSBC Global Research outlines key themes in RMB internationalisation

07 February 2013

Category: News, China, Global
By Asia Asset Management

The RMB’s rapid evolution towards becoming a fully internationalised currency remains in full swing. There have been a number of significant developments in the past six months. Below is a summary of some the key themes, in Q&A format, released by HSBC Global Research on Tuesday (February 5).

How far is the currency from its ‘equilibrium’ level?

We have long stated that the appreciation over the last few years has seen the currency trade much closer to fair, or “equilibrium”, value than before. When comparing the real effective exchange rate (REER) – the weighted average relative to a basket of other currencies adjusted for inflation – to its rolling five-year average, the currency is now actually 7-8% overvalued.

The equilibrium story is supported by two other balance of payments metrics:

• The current account surplus has narrowed to less than 3% of GDP
• The capital account has delivered deficits and 2012 was the largest on record

This view appears to be shared by policymakers in Beijing and increasingly by the market too. People’s Bank of China (PBoC) Deputy Governor Yi Gang made this clear at the recent World Economic Forum in Davos and consensus forecasts for RMB appreciation have moderated from around 4% per annum to less than 2% since the middle of 2012.

2. The PBoC is intervening less in the FX market – what does this mean?

China’s FX reserves data over the last year show how the PBoC’s FX policy has shifted to allowing a more market driven exchange rate. The PBoC has been intervening less in the FX market and only “leaning against the wind” during periods of excessive uncertainty, even though USD-CNY traded close to the strong side of the band for long periods.

By being more hands off, the central bank has cut the link between FX inflows and base money supply, leaving interest rate policy more independent, a key goal of its ongoing financial reforms. This has made the onshore CNY (China yuan renminbi ) forward curve more market driven, more accurately reflecting interest rate differentials.

This shift in FX policy should make onshore and offshore forward curves increasingly driven by differences in interest rates and liquidity conditions.

3. Why are RMB forward curves no longer pricing in appreciation?

Historically, many investors used the RMB forward curves as an indication of how much appreciation the market was expecting, as the curves were more driven by demand and supply rather than interest rate parity. It was seemingly the only FX forward market in Asia, if not globally, where market participants did this.

This is no longer the case. Not only are RMB appreciation expectations more balanced (see question 1), but FX forward curves better reflect interest rate parity.

Interest rate parity has been driven by a number of factors. Importantly, onshore USD funding costs have declined due to increasing private sector FX deposits and various regulatory developments. This led to a higher interest rate spread between USD and RMB onshore than before, which helped push the forward curves to the right earlier this year.

This is also the case in the offshore USD-CNH market, where CNH (Chinese offshore yuan) deposit rates are higher than offshore USD rates. The USD-CNY nondeliverable forward (NDF) curve has to some extent followed suit, as divergences between the curves are usually closed by market participants taking advantage of material price mismatches. The shift in liquidity from CNY NDFs to the CNH market is another key factor. For some time we have argued that CNH FX liquidity would improve at the expense of CNY NDF trading volumes. Indeed, since about late-2011 average daily CNH FX liquidity has become larger than the CNY NDF market. And this has only become more noticeable over the past year.

The subsequent lack of liquidity in the USD-CNY NDF market has made it a much less reliable guide as to how much is ‘priced in’.

In the long run, as liquidity declines further in the NDFs, the curve may become more volatile, which could also make it more difficult to trade spread positions between the offshore RMB curves. Ultimately, there will be no need for an offshore NDF when the RMB become fully deliverable and convertible offshore.

4. Will USD-CNY trade outside the policy band?

For periods during Q4 last year, USD-CNY spot appeared to be trading outside the onshore daily trading band of +/-1% around the daily mid-point fixing (according to the price feed from Bloomberg at least). This was a reflection of stronger appreciation pressures onshore and a lack of direct FX intervention. With only limited official USD demand on the strong side of the daily trading band, the market found alternative channels to secure the USD that were needed.

There are three main ways in which this can happen:

• Through selling other currencies versus the CNY where the intra-day band is wider than for the USD. An onshore exporter can buy EUR-USD spot and then sell EUR-CNY, where there is a wider band, helping to avoid selling USD-CNY directly when there are no bids at the bottom of the USD-CNY trading band.
• Via the forwards or swaps. CNY buyers can sell USD-CNY in the short-dated onshore deliverable forward market, where there is no band. In this instance, short-dated forward points can turn negative very quickly as they did in late November 2012.
• Buy RMB in the offshore CNH market. In our view this helped lead to the divergence between the onshore USD-CNY rate and the offshore USD-CNH rate last year.

Authorities will look to prevent USD-CNY from trading outside the official band. As such, during periods of strong USD or RMB demand, the market will have to get the liquidity either via the PBoC or in the CNH market. The latter could open up short-term divergence between the onshore and offshore exchange rates.

5. How does offshore CNH bond issuance affect the CNH FX market?

The offshore CNH bond market (also known as the dim sum market) has grown from RMB56bn in 2010 to RMB237bn in 2012, as measured by outstanding bonds and Certificates of Deposit (CDs). This influences the CNH FX market in two ways:

• Through liability swap activities which impact the longer dated USD-CNH FX curve. Some dim sum bond issuers need to swap the RMB proceeds back to USD. They do this by receiving USD-CNH cross-currency swaps
• (CCS), generally in the longer dated tenors (concentrated between two to three year, where most CNH bond issuance takes place). This leads to lower CNH forward points further out on the curve.
• Banks which buy CNH bonds tend to use sell/buy FX swaps to fund their positions. This is particularly true when USD-CNH FX implied yields are significantly lower than bond yields.

This has put upward pressure on USD-CNH forward points in tenors less than one year. The combined effect is some flattening pressure for the USD-CNH one to two year forward slope. This is one reason why this segment of the FX forwards curve has flattened in periods when dim sum bond issuance was high.

6. How do recent reforms (SLO, RLF) aid CNH liquidity?

Since HSBC’s last Q&A a number of efforts have been made by policymakers to help ease liquidity pressures, both onshore and offshore. On January 18 the PBoC announced the launch of the Short-term Liquidity Operations (SLO). This enables 12 “systemically important” banks to access RMB funding from the PBoC every day of the week on a permanent basis. The SLO should be seen as a measure to ensure a properly functioning and liquid money market, rather than as another monetary tool to ease monetary conditions.

HSBC FI Research expects the SLO to narrow the trading range for money market rates. For the FX market, these regular injections of RMB liquidity should lessen the need for onshore market participants to source RMB funding through the FX swaps market, contributing to less upward pressure on forward points, particularly in the onshore curve, during periods of tight RMB liquidity.

In addition, reduced concern over seasonal liquidity squeezes should also help cap volatility in onshore forward points (and, indirectly, offshore), and limit the occasional upward pressure we have seen in the forward points when liquidity has been historically tight. The broader move towards liberalisation of both FX and interest rates will make them more market driven through 2013.

Other factors have helped liquidity in the offshore RMB market. Amid liquidity tightening in the CNH market, the Hong Kong Monetary Authority (HKMA) introduced a RMB Liquidity Facility (RLF) in June 2012. This “backstop” facility gives banks access to RMB funds when needed and should cool concerns of an offshore RMB liquidity squeeze.

On January 16, 2013, the HKMA shortened the settlement period from T+2 to T+1 for this facility. This means banks can receive RMB liquidity from the monetary authority more quickly if required. The change was the result of co-operation between the PBoC and the HKMA and is another example of support for the Hong Kong CNH market. Over time, improvements in offshore liquidity should keep some pressure on CNH FX forwards points to the left.

7. What impact will the new cross-border RMB loans scheme have?

In late December 2012 the PBoC approved a cross-border RMB loan pilot programme in Qianhai, part of the Shenzhen economic zone bordering Hong Kong. Enterprises registered there can borrow RMB from Hong Kong based banks and settle the funds via financial institutions in Shenzhen. Interest rates for such loans will be decided freely between the lender and borrower, unlike domestic RMB loans which are floored at 70% of the benchmark lending rate. The indicative lending rates for these loans are around 4.3-4.5%. This is lower than the typical onshore lending rate of 6% and hence should see strong demand from onshore borrowers.

On January 28, 2012, 15 Hong Kong banks signed an agreement to participate in this programme.

The amount committed initially was 2 billion RMB, which will be provided for 26 projects in the pilot zone, while the tenors of these loans will typically be around one year. The Shenzhen Daily reported that the likely total quota would be up to 50 billion RMB, less than 10% of the 603 billion RMB (deposit and CDs) liquidity balance in Hong Kong at the end of 2012. This, together with the initial loan size of 2 billion RMB, indicates policymakers’ intention to avoid an over-tightening in offshore RMB liquidity. But overall the scheme adds another important channel of capital flows between the onshore and offshore RMB markets, and will result in more convergence between onshore and offshore RMB curves over time.

8. How do QFII, QDII, RQFII, RQFII2 and QDII2 impact RMB FX markets?

The original Qualified Foreign Institutional Investor program (QFII), which allows licensed foreign investors to buy/sell RMB-denominated A-shares in mainland China, has been expanded from US$30 billion to $80 billion. By the end of December 2012, the State Administration of Foreign Exchange (SAFE) had approved a combined $37.4 billion of new quotas for 207 institutions. Policymakers also eased the individual QFII cap for banks and sovereign wealth funds (SWFs) in December 2012 and further easing may come. QFII gives offshore market participants access to RMB assets onshore, putting appreciation pressure on CNY.

The RQFII (Renminbi Qualified Foreign Institutional Investor) scheme was initiated in December 2011 to allow offshore RMB denominated funds to invest in China’s domestic market. The quota has been 270 billion RMB since

November 2012. No less than 80% of the approved investment amount must be in fixed income funds, with up to 20% invested in equity or equity funds. At the moment, only offshore branches of Chinese fund managers or securities houses are allow to participate, although this and the equity/bond split may be relaxed in the near future. As of 18 December 2012, the amount invested under RQFII had increased to 67 billion RMB.

RQFII fund allocation can temporarily cause USD-CNH spot to head lower, as some fund managers buy RMB in the offshore market to participate in the programme. The RMB is then remitted back to mainland China to buy domestic assets, tightening RMB liquidity in the offshore market. This, alongside the other channels allowing RMB to flow back to the Mainland, tends to cause the USD-CNH curve to steepen. These RMB flows from offshore to onshore have been increasing and will continue to do so as the RQFII programme expands.

On January 13, 2013, Guo Shuqing, chairman of China’s Securities Regulatory Commission (CSRC), told an economic forum in Hong Kong that further expansion of the QFII and RQFII schemes to allow individual investors to participate was under consideration.

A trial programme (QDII2) is being considered to allow individuals to take positions in overseas capital markets in a bid to boost outward investment. Any increase in QDII should reduce RMB appreciation pressure by balancing inflow channels with more potential for outflows.

Another key takeaway from these changes is that they widen the channels for onshore-offshore flow, and increase the range of investors who can participate in both the onshore and offshore markets. The effect of this is that price mismatches between the onshore and offshore FX markets (USD-CNY and USD-CNH) should be closed more quickly and the spot and forward curves should converge more readily.

9. What are the latest developments for other offshore RMB centres, such as Taiwan?

The creation of new offshore RMB centres has been a key focus of RMB internationalisation. The spotlight has recently been on Taiwan, which signed a Memorandum of Understanding on cross-Strait currency clearing with China on August 31, 2012. The PBoC signed a RMB clearance agreement with Bank of China (Taipei) on 25 January 2013, completing the last step for starting RMB business in Taiwan.

This made Taiwan the third place with a RMB clearing bank, after Hong Kong and Macau. This is important as it allows Taiwan to build up its own RMB liquidity pool, which can be used to offer a range of RMB businesses.

At the time of writing, there is still not enough detail to gauge how the market, which is set to be known as the CNT market, and forwards curves will function and behave. We think over time that the CNT should be fungible with the CNH, but initial divergences could exist should any regulations be put in place to prevent RMB liquidity from flowing freely between Taiwan’s domestic banking system and other offshore RMB markets.

10. What reforms are still to come?

At its annual work conference on January 10-11, 2013, the PBoC summarised its 2012 achievements and laid out priorities for 2013. The central bank is set to carry out further interest rate liberalisation, improve the exchange rate mechanism, steadily increase capital account convertibility, and expand the use of RMB in cross-border activities.

In line with these policy guidelines, we expect the central bank to do the following:

• Encourage the use of RMB in trade settlement and direct investment, push for more currency swap agreements with other countries, and encourage the development of offshore RMB centres, all aimed at RMB internationalisation.
• Further deepen capital account convertibility via deregulation of existing channels: QFII, RQFII, QDII, and RMB cross border loans. One example would be allowing individual investors to invest overseas (via QDII2).
• Continue onshore exchange rate mechanism reforms, with a potential further widening in the onshore FX trading band and changes in the USD-CNY fixing mechanism.

HSBC expect these changes to take place during a period when RMB appreciation/depreciation pressures are more balanced. Historically, this has tended to be in the second quarter.

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