The Renminbi: Two Currency Pools and Hedging

Not only is the transfer of RMB out of China highly restricted or even impossible; the RMB exchange rate is fixed daily by the central bank and kept within a 1% range around the fixed rate. The fixed exchange rate used to be linked exclusively to the US dollar (USD). More recently, the RMB has been tied to a basket of currencies, which includes the USD, euro, yen and various others. The detailed composition of this basket is not published. Nevertheless, the RMB still seems to be highly correlated to the USD.

It is also necessary to distinguish between the ‘onshore renminbi’ (CNY) traded in mainland China, and the ‘offshore renminbi’ (CNH), which is mainly traded on the interbank market in Hong Kong. This separation has established two distinct currency areas for the same currency traded differently. The CNY is regulated as above; the CNH exchange rate freely fluctuates on the Hong Kong market without interventions from the Chinese central bank. The CNH follows the CNY to some extent, but basically it represents a separated currency pool with its own price fixings. As a result, there are differences between the CNY and CNH spot rates. The chart below illustrates historical spot rates between August 2010 and January 2012.

 
PwC Renminbi Fig 1
In general, CNY exposures could be hedged using plain vanilla instruments, such as CNY-non deliverable forwards (NDF) or CNH-forwards. Due to the frictions mentioned above, the CNH-forward market in particular is relatively illiquid, has high bid-ask spreads and faces CNH basis risk. This risk arises because of the differences between the CNY and CNH spot rates. Also, the market data availability (FX-rates, interest rate curves, tenor and cross-currency basis spreads) makes the fair value measurement of CNY/CNH derivatives challenging. So, many companies are looking for ways to hedge Chinese currency risks more effectively.

One approach is the ‘cross/proxy hedging’, which is very common and widely implemented in commodity markets. This method can be used when the asset underlying the hedging instrument is different from the asset considered to be hedged by the derivative. For example, an airline hedges the price risk of jet fuel by using heating oil futures contracts to hedge its exposure because of the non-existence of jet-fuel hedging products. As those underlying transactions have an economical connection, their spot and future prices should be highly correlated. Knowing the standard deviations of the underlying prices and the correlation between the two, a so-called minimum variance/optimal hedge ratio can be calculated to tailor a hedge.

This basic approach can also be adopted in FX markets: one currency pair can be hedged by using a different, highly correlated currency pair. As mentioned, the CNY is tied to a currency basket that consists mainly of the USD, so the Chinese currency is highly correlated with the USD. This can been seen if one looks at the historical euro (EUR)-CNY spot rates and split them into two parts, building a cross-rate: the EUR-USD and the USD-CNY spot rates. As the correlation between USD and CNY is still very high, the USD-CNY risk component has only a small impact on the effectiveness of the hedge. The price volatility between the euro and the renminbi is currently very dependent on the EUR-USD exchange rates, as the price movements are alike. Knowing this, you can calculate a tailored hedge ratio, and the CNY exposure can be simply be hedged by using plain vanilla derivatives on the USD.
 
PwC Renminbi fig 2 
Based on the assumption of stability in the correlation coefficients, it is also possible to use proxy hedging for performing low-cost transactions in highly liquid FX-markets. However, as soon as the currency basket changes, the correlations and optimal hedge ratios would also be expected to change. So the hedging strategy would face rising risks if correlations were no longer stable. It’s possible that a hedging position gets over- or under-hedged just due to a shift in correlation patterns. Furthermore, hedge accounting might not be possible any more, due to poor effectiveness tests. Proxy hedging also creates basis risks as the hedging deal refers to a different underlying (EUR-USD) than the hedged item (EUR-CNY).

Those advantages and disadvantages of the proxy hedging approach can be summarised as follows:
PwC Renminbi fig 3
Outlook

Proxy hedging could be a solution for hedging FX exposures of an illiquid currency by using hedging instruments of a freely traded/liquid currency. The necessary condition for this approach is a high correlation between the two currencies. In the end, this innovative method is always a trade-off between liquidity and simplicity on the one hand, and rising basis risk on the other.

China is slowly opening its currency for international capital markets, but it is still far from a freely floating FX market. As long as the restrictions on the free movement of capital and the managed floating approach of the Chinese national bank remain, the hedging approach above might be an effective alternative for MNCs facing FX risks by doing business in China.

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