Analysis - After big shakeout, offshore yuan reforms are coming

HONG KONG Tue Oct 4, 2011 1:54pm EDT

A shop owner exchanges a Chinese yuan banknote with a customer in central Beijing April 13, 2010. REUTERS/David Gray

A shop owner exchanges a Chinese yuan banknote with a customer in central Beijing April 13, 2010.

Credit: Reuters/David Gray

HONG KONG (Reuters) - The biggest difference between the offshore yuan and other emerging market currencies these days is that a central bank has not come to the rescue of the so-called CNH market to smooth volatility.

As central banks around Asia keep selling dollars to slow downward pressure on their currencies amid global market turmoil, Beijing has taken a hands-off approach to Hong Kong's yuan market, which is central to its efforts to internationalise the renminbi.

However, the likelihood for prolonged volatility in the CNH market, which is barely a year old, may end up accelerating reforms of the market's structure to make up for its lack of a sole monetary authority as a lender of last resort.

Authorities in Hong Kong on Monday revealed one such reform, saying the yuan-denominated cross-border trade quota for the December quarter would be doubled to 8 billion yuan (815 million pounds).

High on the list of other potential reforms are the creation of dollar-yuan swap lines, an increase in offshore yuan deposit rates and further growth in trade settlement quotas.

"As CNH gradually becomes the key currency in Hong Kong, proper coordination between the Hong Kong Monetary Authority and the People's Bank of China regarding the responsibility for maintaining market order is needed," said Ju Wang, a strategist with Barclays Capital in Hong Kong.

CONSTRAINTS

A prime example of the CNH market's structural shortcomings materialised in late September. Worried about extended one-way bets, hedge funds and mutual funds began selling their CNH bonds, triggering an acute dollar short squeeze.

However, interbank liquidity for dollars just as quickly dried up, forcing market participants to line up at the door of Bank of China Hong Kong (BOCHK), the CNH market's sole clearing agent and the only institution that could at that point swap offshore yuan for dollars.

BOCHK's 4 billion yuan quota was exhausted quickly given it was near the end of the quarter.

In the resulting illiquidity, the offshore yuan rate weakened below the onshore rate by the most since the CNH market was born.

Usually the offshore yuan trades at a slight premium to yuan in the mainland because of the tight supply of yuan available outside China.

For Chinese importers who hedge via the CNH market because of its premium, the jarring moves and shrinking trading volumes have probably caused some pain.

However, the quota boost on Monday in itself may be too little, too late. The longer that CNH stays in discount to CNY, the more of an incentive that offshore investors have to cut their exposure.

Robert Minikin, a strategist at Standard Chartered Bank, said authorities should have intervened a bit sooner if they didn't want the rates to diverge so widely to ensure stable market conditions for companies.

"The ultimate objective is to boost the yuan's usage in trade settlement, to make it as a currency of choice for invoicing and in that light, they should have been a bit more proactive towards managing the currency," Minikin said.

SOLUTIONS

Analysts agree the recent spell of weakness in the CNH market may be overdone and recommend building short dollar bets again, the lack of an authority does little to boost fragile market confidence.

While the People's Bank of China and the Hong Kong Monetary Authority may not have minded a shakeout of purely speculative positions in the offshore market, a bigger selloff would like spark some form of more direct action to stabilise markets.

The offshore yuan is still considered a foreign currency by Beijing.

However, Beijing could ask the HKMA to set up dollar-yuan swap lines with large banks in the territory to ensure markets function normally during stressful periods, similar to the Federal Reserve's swap lines with other major central banks.

That would help keep liquidity from vanishing.

Beijing could also pay a higher interest rate to BOCHK for CNH deposits. CNH one-year deposit rates are regulated by China and stand around 0.7 percent compared to 3.5 percent for yuan deposits on the mainland.

BOCHK would then pass on higher deposit rates to Hong Kong-based banks, creating an incentive to keep funds in yuan.

Augmenting BOCHK's role further though would be difficult. The bank has already said thin net interest margins on its offshore yuan business have hurt its bottom line.

Finally, Beijing could aggressively move the yuan's mid-point fixings to the U.S. dollar higher on the mainland, sending a message to offshore market participants about how serious it is to promote the yuan's role in international trade, according to RBS strategists.

Confidence in a stronger currency would encourage more foreign companies to use it in trade rather than dumping the yuan for dollars at the first signs of market stress. Judging by the shakedown a few weeks ago, the CNH market has not yet achieved that confidence.

China's ambitions of promoting the yuan in international trade has gone hand-in-glove with the renminbi's rise.

Ten percent of China's total trade is now conducted in yuan compared to less than 1 percent at the start of 2010, while yuan deposits in Hong Kong banks stands at more than 600 billion yuan at the end of August.

In that period, the yuan has appreciated by more than 6 percent against the dollar.

"One thing this episode has highlighted is the need for a comprehensive solution to iron out market inefficiencies rather than relying on quotas," one head of trading at a European Bank in Singapore said.

(Editing by Kevin Plumberg)

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