China winning offshore yuan battle, but may be losing the war

HONG KONG: In the space of about five years, the offshore market in Chinese yuan has gone from the poster child of Beijing’s financial market liberalisation to a battleground to regain control of the currency, spooking investors and raising questions about the future of the market.

While investor appetite for the offshore yuan, or CNH, as it is popularly known, took a blow after a shock devaluation last August, measures taken by China’s central bank in recent weeks to boost the currency’s value, including creating a shortage of the unit offshore, has shaken confidence further and increased uncertainty about Beijing’s currency policy.

Those actions meant the spread between onshore and offshore rates briefly evaporated on Tuesday, having stood at more than 2% last week – which was potentially embarrassing for Beijing following an International Monetary Fund (IMF) decision to include the yuan as a reserve currency.

“This kind of market volatility does no good for companies who have significant exposure in renminbi as such sharp swings in the value of the currency and its funding costs make hedging nearly impossible,” said a treasurer at a European multinational company in Hong Kong, who requested anonymity in the absence of permission to speak with the media.

The People’s Bank of China (PBOC) did not immediately respond to a request for comment.

Since its beginnings in 2010, the offshore yuan market spread from Hong Kong to Singapore, then Taiwan, London and elsewhere, gaining popularity for the ability of investors to secure a market-determined price – unlike in the closely controlled domestic market.

An offshore market is critical for the internationalisation of the yuan as China moves towards opening up its capital account and turning Shanghai into a global financial hub by a stated goal of 2020.

Global deposits of the currency reached nearly 2 trillion yuan (US$300 billion) at a peak in 2015 and policymakers opened more channels to let the yuan flow more freely.

LIQUIDITY DRAIN

But the steps taken by the PBoC in recent weeks to narrow the widening gap between the offshore and onshore yuan rates, which was fuelling bets against the currency, have added to doubts about the credibility of the market.

Authorities have asked Chinese and foreign banks operating offshore to limit dollar purchases, halt onshore lending to offshore banks and have embarked on heavy intervention via its state-agent banks.

The intervention dried up market liquidity to such an extent that overnight funding costs in the currency briefly soared to a record 96% early on Tuesday, compared with below 10% usually.

Beijing intervened in the offshore yuan market for the first time in September, but the magnitude of the intervention this time has been far greater. Two traders at separate European banks estimated the central bank had sold US$10 billion-US$20 billion in the last week to prop up the yuan, compared with US$1 billion-US$3 billion in September.

“The frequent intervention will weaken investors’ confidence in the PBoC on whether it really is willing to liberalise the renminbi market as well as the credibility of its policies. Too much intervention in the market is negative in terms of boosting yuan internationalisation,” said Kenix Lai, a senior market analyst at Bank of East Asia in Hong Kong.

Barclays estimates that CNH deposits in Hong Kong, South Korea and Taiwan have dropped by around 193 billion yuan (US$29 billion) since the end of July as companies converted their yuan deposits into Hong Kong and US dollars.

“The PBoC crossed the Rubicon when they intervened in the offshore market last year,” said Adarsh Sinha, an FX strategist at Bank of America Merrill Lynch in Hong Kong.

Despite the heavy intervention, markets are still betting the yuan will fall.

One-year non-deliverable forwards, an offshore derivative, are signalling a dollar rate of 6.89 per dollar, a steep 4.9% discount to the current spot level offshore. Goldman Sachs sharply revised down its forecast for the yuan to 7.3 per dollar by the end of next year, from a previous forecast of 6.8.

Primary issuance in yuan offshore will be in doubt the longer funding costs are elevated and the longer offshore yuan trades at a discount to its onshore counterpart.

Chinese companies have already started to switch back to the onshore market as offshore yuan and dollar funding costs rise.

Some have moved to redeem offshore bonds early.

Dim sum bond issuance fell to 163 billion yuan in 2015, less than half of that sold a year earlier, Thomson Reuters data show. The slide was heaviest in the second half of the year as China markets crashed and Beijing unexpectedly devalued the yuan.

Steep declines offshore are likely to prompt further intervention from the central bank, especially if the gap widens too far against the onshore rate.

“It’s going to kill the offshore yuan market if the intervention lasts for too long,” said the head of FX trading at an Asian bank in Hong Kong, who declined to be identified. – Reuters