Yuan Hedging: New Options for Treasurers

One small statement from Beijing; one giant leap for EU trade. That’s a reasonable way to view a brief and largely unnoticed press release in mid-February by China’s State Administration of Foreign Exchange (SAFX). The body that regulates dealings in the Chinese currency announced that yuan options could be traded in China from later this year.

This statement is profoundly significant for many corporate treasurers. It means that companies – banks, manufacturers and other firms – already resident in China can use the options to hedge their exposure to the currency. As Qu Hongbin, HSBC’s chief economist for China, points out, the freedom to trade yuan options represents the latest step in Beijing’s progressive liberalisation of the currency that will underpin trade with China in the long run by making cross-border buying and selling much easier than it was until as recently as last year.

As far as British exporters are concerned, the latest relaxation of Beijing’s highly protective attitude towards the renminbi (RMB) builds on another relatively recent landmark event: it was July 2010 when HSBC designed the first transaction for a British business – Sheffield-based firm Neill Tools – that was settled in yuan. The organisation, whose group of companies dates back more than 250 years, can therefore claim its place in the history of the yuan’s liberalisation.

Since that deal, yuan-settled trade has been growing fast in Europe and further afield. According to HSBC data, the average monthly volume jumped from a mere ¥600m (US$90m) in 2009 to ¥68bn (US$10.4bn) between June and November 2010. And today, according to Bernhard Esser, emerging markets analyst at HSBC in Germany and an authority on the currency, yuan-settled transactions could already amount to as much as 3% of China’s total trade with the world.

The Chinese authorities have been doing all they can behind the scenes to promote the yuan’s wider use. For example, from December the Bank of China’s US branch began offering yuan-based deposits, exchange, remittance and trade finance services to business and personal customers. This followed remarks early last year by Premier Wen Jiabao that he was “worried” about the future of China’s massive holdings of US dollar-denominated assets – estimated in February at about US$890bn. China’s central bank has long been concerned by how much a depreciating greenback will devalue this giant storehouse of US securities.

Neill Tools’ watershed transaction took advantage of a series of little-known steps taken by Beijing over the past three years. Until 2009 all cross-border transactions were restricted to hard currencies (in effect, the US dollar). By law, no capital transactions in or out of China could be executed in RMB. Then came the financial crisis. As trade with the rest of the world started to decline, the Chinese government recognised that it had to do something to lubricate exports – and an easing of controls on the RMB could be just the solution. The result was a pilot scheme launched in mid-2009 that allowed fabric exporters in four cities in the Guangdong province – where the economic hub of Shenzen is located – plus Shanghai to do deals in the currency of the buyer, but only if those buyers were based in Hong Kong or Macau. With typical caution, the authorities wanted to dip their toes in the water first.

The results were encouraging. “The programme was an unqualified success from the beginning and it’s been rolled out right across China,” Esser reports. “It now covers 90-95% of all exporters selling right across the world.”

Appreciation Society

The liberalisation helps European firms trading with China in several ways, according to Esser. First, it allows the purchasing company to bring the management of the currency risk back in house. This is because Chinese exporters, most of whom have built their businesses on an appreciating RMB, expect it to continue doing so and typically insist on building its rising value into their quotations. That’s also the view of most authorities on the yuan – namely, that it will continue growing in value against other key currencies because that’s what it has been doing since 1994. Against the US dollar – the crucial comparison – it appreciated by 23% in 2005-08 alone.

In practical terms, if a Chinese exporter expects the yuan to appreciate by, say, 4%, between order and delivery – i.e. from ¥6.59:US$1.00 to ¥6.35:US$1.00 – it will ensure that the quoted price compensates for the assumed loss. But, according to Esser, many European companies have their own corporate treasury departments and it makes more sense to manage currency risk at base rather than having the Chinese company do it for them, even indirectly. Also, it gives them more negotiating flexibility. “They can take out the foreign exchange [FX] risk in pricing, manage that down using their own resources and negotiate on everything else,” he explains. “That’s the main point of yuan-settled transactions.”

There are also advantages for the growing number of Europe-based multinationals with operations in China. As Esser points out, many of them need to purchase at least some of their raw materials outside China. But now, instead of having to buy in US dollars, they can do so in yuan. “The local operation always has to deal with a mismatch between the local [RMB] earnings and its foreign expenditure,” he says. “Now it can take that mismatch out of the equation. The currency effect is removed.”

Lastly, there’s what may be called the treasury effect. Because the management of the cross-rate is restored back to headquarters, it should significantly improve a company’s ability to price more accurately, according to Esser. “Most companies operating in China will have excellent purchasing or sales staff on the ground who are used to working with the RMB, but not many firms have a treasury function there,” he says. “The people in China will be experienced in the local currency but not in the bigger picture of currency cross-rates. This way the FX risk is handed back to treasury.”

A Sterling Achievement

The liberalisation can only facilitate European dealings with China. The value of British trade with China, for example, is about £30bn a year, but David Cameron wants to double this figure by 2015. As far as avid RMB watchers are concerned, the SAFX’s latest measures will surely help UK firms to hit that target sooner.

For observers such as Esser and his colleagues, this is one of those rare events in the turmoil of the currency markets where everybody wins – or nearly everybody. UK companies should extract a better price for orders and get to manage their own currency strategies. More export opportunities will open up for Chinese companies. And China’s government will steadily reduce its dependency on the US dollar by selling the yuan to the wider world in exchange for other currencies.

“The relaxation gives Beijing an effective way to diversify out of the US dollar,” Esser says. “The only loser is the US government, because this may depreciate the US dollar further.” It’s relatively easy for companies to take the opportunities created by the liberalisation of the yuan. Something of a nightmare as recently as a year ago, the procedure for gaining the essential regulatory approvals has been simplified. Instead of Chinese exporters having to seek permission on behalf of buyers in a time-consuming process with the central bank, non-Chinese companies can now do so. Most of them use an international bank with offices in China to jump through the hoops on their behalf. These institutions are now largely familiar with the system and the Chinese company does not need to get involved at all. In practice, most applications are approved.

The natural question for treasurers managing the ¥:US$ cross-rate is where the yuan is heading compared with the US dollar. There’s certainly a consensus on this subject. “In the long term China’s growth story is valid, which means that a long-run appreciation of the currency is likely,” Esser says. “Certainly, a depreciation is not on the table. It’s important to keep in mind that the Chinese government’s greatest concern is stability.”

In that light it’s also important to note that the February reform does not permit the trading of put options common in short-selling and other speculative strategies based on currency movements. It’s designed only to aid call-option transactions typically used to hedge currency exposure during the trading of goods and services.

Looking into the crystal ball, experts on the yuan are excited about its international future. Qu Hongbin predicts that the latest liberalisation round could presage full convertibility. Pointing out earlier this year that the currency “has been underrepresented in global trade and capital markets compared with its trade and economic scale”, he sees this happening in big steps, with a third of China’s cross-border trade being settled in yuan by 2016.

The greenback will have a role to play in this. As Stephen King, HSBC group chief economist, explains: “As quantitative easing in the US drags down the US dollar’s value and hurts investor confidence in the currency’s future, the internationalisation of the yuan is set to take off.”

How it Works in Practice

It’s relatively simple for a company to set up an account to trade in RMB. Corporate treasurers won’t generally need new software, advanced expertise, detailed knowledge of the ¥:£ or ¥:ÿ cross-rate – or indeed much else. But they will benefit from expert guidance. According to Bernard Esser at HSBC in Germany, it’s simpler to make the essential arrangements in Europe to avoid the unnecessary red tape involved when applying in China.

He finds that most companies, once they have the right documents in place, prefer to dip their toes in the water by doing their first deals at the prevailing spot rate. As they gain confidence, most work out hedging techniques against the currency risk. There are three different avenues for this: through mainland China, the EU or Hong Kong. Prices differ in all three, but arbitraging among them to gain the best price is forbidden. For predicting trends in the RMB, the standard comparison is against the US dollar because of the close relationship between the two. But Esser’s advice is to bet on a steady and stable appreciation.


Related reading