Hedging Renminbi Risk – End of the One-way Bet?

Beginning in late January, however, the RMB began to weaken, posting four monthly losses in a row against the USD (there had never been more than two monthly losses in a row in the nine years since the establishment of the managed float regime). In March, the Peoples Bank of China (PBOC) upped the ante even further, by doubling the USD/RMB daily trading band to 2%.

Figure 1: USD/RMB: 2005 to the Present

 
Validus RMB fig 1

 
It is widely assumed that the driver behind this about-turn on the part of the Chinese authorities was a desire to stem the high level of speculative inflows, which were threatening to have a destabilising effect on the Chinese financial system. Despite this recent weakness, there are a number of factors which continue to point to a continuing strengthening of the RMB. The two factors which are most closely related to moves in the USD/RMB exchange rate are the level of Chinese economic activity (as measured by industrial Purchasing Managers Index (PMI), industrial production, exports and gross domestic product (GDP)) and the interest rate differential between the US and China (both of these variables have exhibited a negative correlation to the USD/RMB exchange rate of about -30% since 2010).

A Continuing Trend

As both of these drivers continue to look relatively favourable for the RMB, market consensus remains heavily biased towards further RMB strengthening. In fact, the current Bloomberg poll puts the USD/RMB rate at 6.01 by 2015, and only one institution predicts that the USD/RMB exchange rate will be higher in 2015 than it is today.

Traditionally, many corporates, especially in Asia, would use directional hedging strategies designed to outperform if the market moved in a certain way, especially when they were looking to hedge a short renminbi, long dollar position (for example, Chinese exporters). Managing a portfolio of dollar receivables can be a painful exercise when the RMB is continually strengthening. One way to mitigate this problem was to use specialised hedging products, such as target redemption forwards (tarfs) which would allowed the hedgers to lock-in an enhanced rate.

However, this apparent windfall came at a price; if the RMB weakened by enough (typically about 2.5% or so), the hedger would be exposed to potentially large losses. This is exactly what happened this year – and analysis by the investment bank Morgan Stanley recently estimated the total losses facing Chinese companies using these products at US$3.5bn.

As such, there are two key questions facing corporate treasurers assessing how to manage their RMB exposure:

  1.  Is the ‘one-way bet’ for continued RMB strength a thing of the past?
  2.  If so, how should corporate hedging strategies be adjusted going forward?

In terms of the first question, it is fair to assume that even if the longer term trend for the Chinese currency remains higher, it will not be a smooth path – or at least not as smooth as it has been. The PBOC seems committed to reducing the appeal of the RMB to speculative carry traders, and the best way to do this is to increase the volatility of the currency – something the PBOC has already telegraphed through its recent widening of the USD/RMB trading band.

Increased volatility means increased risk. Therefore the directional hedging strategies that have been so heavily favoured, particularly by Asian companies, in the past may become less advantageous. By definition, such strategies are based upon a high confidence market view. Looking forward, hedgers may prefer to stick to more plain vanilla approaches.

For RMB buyers, forward contracts (currently subsidised by a favourable interest rate differential) may work quite well. For RMB sellers (where the forward points are disadvantageous), the use of currency options is worth considering – especially as RMB options are significantly cheaper than options on many other currency pairs, such as EUR/USD or GBP/USD, as indicated by the lower implied volatility (see figure 2 below), although it should be noted that the options prices remain higher for RMB sellers than for RMB buyers at the current time.

Figure 2: Annualised Implied Volatility

 

Validus RMB fig 2

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