As the US Federal Reserve embarked on its quantitative easing (QE) programme in late November 2008 during the global financial crisis, the accumulated US dollar (USD) foreign exchange (FX) reserves took a significant hit. This, in turn, made China realise just how dependent it was on the USD. To avoid this ‘dollar trap’ China started to increase the acceptance of the renminbi (RMB) in neighbouring countries by establishing currency-swap agreements between its central bank, the People’s Bank of China (PBoC) and the respective neighbouring economy.
In later steps, the geographical reach of such agreements was expanded to the Asia Pacific (APAC) region as well as Latin America, Eastern Europe and the Middle East. Today, more than 20 such swap agreements are in place globally. Besides following this geographical expansion strategy, China is pursuing a three-stage internationalisation path for the RMB to become a global trade currency, global investment currency and global reserve currency
Global trade currency: The pilot scheme for RMB trade settlement, which commenced in 2009, can be considered the start of the trade flow-related RMB internationalisation process. Demand from the private sector to settle invoices in RMB picked up quickly, especially for trade flows between emerging market countries and mainland China. Since then, continuous easing of regulation has led to an entirely convertible current account allowing RMB trade settlement for all companies.
Global investment currency: In 2010, the offshore RMB market (currency code CNH) was introduced, which set the basis for the development of products enabling market participants to engage in hedging (for example, hedging dividend payments or trade flows in the CNH market), financing and investing (such as the dim-sum bond market and CNH time deposits). The offshore market first emerged in Hong Kong which is still the main offshore center, followed by Singapore, the UK and Taiwan.
Key milestones of the gradual capital account opening include:
- The possibility for China mainland companies to issue bonds in the offshore market.
- The launch of RMB overseas direct investment.
- A RMB Qualified Foreign Institutional Investor (RQFII) scheme.
- The setting up of an offshore RMB reference interest rate.
- The possibility for cross-border FX cash pooling in the Shanghai Free Trade Zone (SFTZ).
Global Reserve Currency: For the RMB to become a global reserve currency in the future, the currency needs to be widely accepted for investment, financing and payment purposes. Enablers of such a development are:
- The availability of a broad range of instruments and products for risk management purposes.
- Deep markets that enable large onshore/offshore flows.
- Large capital markets to ensure investor confidence in the liquidity of the RMB.
To begin with however, China needs to reform its domestic financial market. The liberalisation of interest rates, the development of a strong institutional framework and the strategic realignment of domestic banking are important first steps China needs to make. In addition, potential risks stemming from local government debt and shadow banking need to be addressed. Also important is the role of foreign central banks, which need to be willing to hold the RMB as part of their reserves. Some foreign central banks have already started holding RMB assets as part of the reserve portfolio, regarding the Chinese currency as a good diversifier but not yet as reserve currency.
Renminbi Framework and Instruments
For the RMB, three different markets exist:
- Onshore (CNY).
- Offshore Non-deliverable (CNY).
- Offshore (CNH).
Onshore (CNY): The onshore RMB is fully convertible for current account transactions and FX spot transactions can be executed if eligible underlying documentation is in place. For FX forwards and swaps an underlying exposure must exist. FX options may also be traded, but restrictions apply to ensure options are used as a non-speculative instrument. Cross-currency swaps and interest rate swaps are subject to regulation and restrictions. For capital account transactions, restrictions and approval requirements apply.
The CNY trades in the interbank market within a daily trading band of the CNY against the USD +/-2% around the daily fixing rate (announced by PBoC at 9.15am Shanghai time). To ensure that the trading band is maintained the PBoC intervenes in the USD/CNY spot market. It uses open-market operations such as government bond repos/reverse repos and issuing, buying and selling PBoC bills. The market is regulated by the PBoC and the State Administration of Foreign Exchange (SAFE). The forward curve is influenced by onshore interest rates.
Offshore Non-deliverable (CNY): The offshore non-deliverable RMB was an important market for hedging purposes before the introduction of the deliverables offshore RMB (CNH) and is decreasing in size. Unregulated, it allows corporates to hedge their RMB exposure in the name of an offshore entity using FX forwards, FX options, cross-currency and interest rate swaps. Being non-deliverable in nature, at expiration instruments are USD settled, using the non-deliverable forward (NDF) fixing, which is based on the onshore CNY fixing rate. The NDF curve is influenced by market expectations and the deliverables curve.
Offshore (CNH): The offshore RMB is a fully deliverable currency and all common instruments are available. The daily fixing rate is published by the Treasury Markets Association (TMA) of Hong Kong at 11.15am Hong Kong time. Various clearing hubs have been established since its introduction in 2010. In Hong Kong, the Bank of China (Hong Kong) (BOCHK) acts as clearing bank and connects the China National Advanced Payment System, aka CNAPS, with Hong Kong’s real time gross settlement (RTGS) system. In Singapore, ICBC Singapore was nominated as the clearing bank and connects to CNAPS via ICBC in China. Taiwan is connected through Bank of China Taipei. London directly uses the Hong Kong infrastructure. This market is regulated by the Hong Kong Monetary Authority (HKMA) together with the PBoC. The forward curve is influenced by offshore interest rates.
Considerations for Corporates
Invoicing: The internationalisation of the RMB has created the opportunity to do trade settlement in the Chinese currency instead of USD or euro (EUR). For international companies one key advantage is gaining access to a wider base of Chinese business partners (supplier and buyer side) by offering RMB denominated transactions in supplier/buyer agreements. Additionally, Chinese counterparts are adding an FX risk price premium of 3-7% for transaction currencies other than the RMB, assuming the FX risk potentially creates the opportunity to both renegotiate pricing and payment terms of existing contracts and also negotiate tighter conditions in new business deals. It also strengthens the relationship with the onshore partner.
These aspects can be important drivers of a company’s competitive advantage in the Chinese market. From a treasury perspective, RMB invoicing provides the opportunity to concentrate FX risk management with existing treasury hubs and therefore replace mainland China-based risk management functions. Key topics to be addressed in changing the invoicing strategy are:
- Volume and frequency of flows with China.
- The RMB account location.
- The FX risk strategy.
- ‘Advertising’ the new invoicing strategy to trading partners and internal stakeholders.
At this stage, moving to RMB invoicing is mainly used for intercompany transactions and the related FX risk management is carried out by regional treasury centres. Germany’s engineering multinational Siemens, for example, has already embarked on the next stage and included third-party cross-border payments and collections in its RMB invoicing strategy.
FX Risk Management: As mentioned earlier three different RMB FX rates exist, each having its own forward curve. This type of environment poses different challenges as compared to hedging any other currency. One key consideration is to look for the potential benefit from being flexible as to which curve to use. This mainly depends on a company’s flows to be hedged. If exposures are small, the benefit from exploiting small differences between the curves might be negligible. However, if exposures are significant such small differences can have a major impact.
For example, a German auto manufacturer with an annual exposure of approximately €4bn-6bn used a combination of onshore CNY hedges with offshore non-deliverable hedges whenever either rate was more opportune at the hedge implementation date. For repatriation of the annual dividend the same company used the CNH market in combination with the non-deliverable market. The complexity of the three curves also requires a proactive monitoring approach and a deep understanding of their dynamics. Finally, accounting processes and systems need to be aligned to handle different fixings and interest rate curves.
Liquidity: Regulatory easing opens up opportunities for cross-border lending, which allows the RMB to be part of company-wide liquidity management. It enables moving funds in and out of China and its integration into global cash management operations. The SFTZ, which allows cross-border FX pooling with automated cash sweeps, is a recent regulatory revision which is expected to have a significant impact on global cash management practices at multinational corporations (MNCs). From a funding perspective, the offshore RMB debt-capital market – popularly known as the dim-sum bond market – increases in importance due to the described relaxed cross-border lending rules. The ability to tap the dim-sum bond market also provides opportunistic funding opportunities at times of favorable CNH/USD basis swap spreads.
In contrast to the dim-sum bond market, issuing local bonds in mainland China (a so-called ‘panda bond’) as a western company remains a tedious process due to applicable Chinese regulations. Germany’s Daimler AG was the first western company to issue a panda bond in early 2014.
Due to the importance of the Chinese economy and its increased interrelationship with the rest of the world, the RMB should be on the agenda of every internationally operating company. China has made significant steps to successfully make the RMB a trade currency and pushes it to become a widely accepted currency for investing.
The major reforms of the Chinese financial market currently either in progress or pending means that the RMB as a reserve currency remains a future scenario. The speed of regulatory change poses risks and opportunities for both corporates and their treasurers in particular and their ability to turn these changes into a competitive advantage can make all the difference in this market.
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