CNH: Creating Choice for Offshore Investment into China · PDF file• Please also see...

CNH: Creating Choice for Offshore Investment into China

INVESTOR SERVICES Foreign Exchange

Changes in regulations by the Chinese authorities have led to the development of a deliverable offshore renminbi currency market, commonly referred to as “CNH”. This paper explores CNH and CNH denominated assets as a vehicle for creat-ing renminbi (CNY) currency and investment exposure. It also explores the rele-vance and performance of the CNH currency forward market in comparison to the onshore CNY forward and offshore CNY non-deliverable forward markets.

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CHRISTOPHER GOTHARDVICE PRESIDENT, FOREIGN EXCHANGE

[email protected]

+44.207.614.2188

JAY MOORE, CFASENIOR VICE PRESIDENT, FOREIGN EXCHANGE

[email protected]

+1.212.493.4903

THOMAS HAIMELINVICE PRESIDENT, FOREIGN EXCHANGE

[email protected]

+1.212.493.4953

CONTRIBUTORS:


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Since 2006, the Chinese renminbi (CNY) has appreciated nearly 30% relative to the US dollar and 25% relative to the Euro. This sustained appreciation has ignited interest among offshore investors looking to gain exposure to CNY and CNY denominated assets. While the trading choices available to these investors had been limited by tight gov-ernment restrictions, recent regulatory changes have led to the development of a market that provides an efficient, and often more accessible option than those previously available. This option is CNH, a freely traded, deliverable currency whose informal name originated from the term “CNY traded in Hong Kong.”

This paper explores CNH and CNH denominated assets as a vehicle for creating (and protecting) renminbi currency and investment exposure. It also explores the relevance and performance of the CNH currency forward market in comparison to the onshore CNY forward and offshore CNY non-deliverable forward (NDF) markets.

PART I: OPTIONS TO CREATE RENMINBI EXPOSUREHistorically, the two options to create or protect CNY exposure were the onshore deliverable CNY forward and CNY NDF markets. Neither provides an optimal choice for offshore investors due to insurmountable financial or regulatory challenges. However, in order to fully evaluate the CNH forward market as a viable CNY proxy, we will first explore the benefits and drawbacks to these two markets. Following this review, we will delve deeper into CNH forwards, as well as the investment opportunities this market creates.

Onshore CNY Deliverable ForwardsEstimates on the size of the renminbi markets vary greatly, but according to a 2013 survey conducted by the Bank of International Settlements, overall daily trading volume may be as large as USD 120 billion (including the onshore and off-shore deliverable markets and the non-deliverable forward

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market). This survey does not break down the market components, however BBH research indicates that the vast majority of this volume is related to the onshore market. We would expect that up to half of this is in forwards.1

For most offshore investors, the onshore CNY market is not an option due to tight government restrictions. However, it is available for onshore investors and theoretically should be the most straightforward trading option for this group. The reality is that trading onshore CNY forwards poses signifi cant operational challenges and performance constraints. These can take the form of gross physical settlement requirements for forwards and swaps; margin requirements for forward positions; and limited third-party options for FX execution which can lead to higher trading costs. These conditions have driveninvestors to explore other alternatives, which include not trading at all.

Despite its challenges, the onshore CNY forward is the most representative instrument for the desired renminbi exposure, and therefore will be used as the benchmark for determining a viable proxy alternative.

Figure 1 illustrates the return of maintaining a constant long forward position in onshore CNY against the USD from

WHAT IS CNH?• CNH is an informal name referring to deliverable

CNY (the currency code for renminbi) traded off-

shore. It originated from the phrase ‘CNY traded

in Hong Kong’.

• CNH is an unrestricted, freely tradable currency

between offshore entities.

• CNH is a deliverable currency with settlement

characteristics just like any other developed market

such as sterling or the euro.

• The CNH market is driven by supply and demand

with no explicit management by any central bank

offshore. However there is a sizeable arbitrage

channel between mainland China and offshore. With

the People’s Bank of China actively managing the

value of the onshore currency, these arbitrage chan-

nels typically lead to CNH and CNY spot rates that

trade closely together.

• The majority of CNH volume is executed during

local Hong Kong hours. However, “off” hour trading

has been gaining share of CNH volume as a per-

centage of the total.

• CNH forwards have many different characteristics

to CNY non-deliverable forwards (NDFs), includ-

ing separate operational, regulatory and forward

curve considerations.

• Please also see pages 9-11 for a brief history of

the CNH market.

Figure 1 – CNY Onshore Forward Return Breakdown

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CNY Onshore Spot CNY Onshore Fwd CNY Onshore IRD

Source: BBH and Bloomberg

1 According to a quarterly private interbank survey of banks in Hong Kong and China conducted by Brown Brothers Harriman and focused on the CNY FX markets.


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January 1, 2012 through June 30, 2013. The total return can be explained by a combination of spot appreciation over the period as well as the favorable interest rates available in China relative to the US.

When choosing a proxy trading alternative to the CNY forward market, it is important that the price of that instrument is reflective of this combination of factors, specifically the spot rates available onshore and the interest rate differential (IRD) between the two currencies; i.e. they are representative of the risk free rates available in their respective home countries.

Taking into account the characteristics of CNY and the CNY forward market as a baseline, we’ll now examine how each of the alternatives performs when traded as a proxy for CNY onshore.

CNY Non-Deliverable ForwardsDaily CNY NDF trading volumes are in the USD 2-3 billion range and have shown a decline since the inception of the CNH market.1 Unlike the onshore CNY forward market, the CNY NDF market is available to both onshore and offshore investors, largely because there is no intention to exchange the actual currency in a NDF transaction. Instead, non-renminbi cash (typically USD) is settled based on the gain or loss

between the original contracted forward rate and a current fixing rate two days prior to settlement.

Some asset managers consider CNY NDFs to be a less attractive alternative than deliverable currency forwards because NDF pricing is dominated by future spot expectations, rather than IRDs as is the case in a typical currency forward curve.As a result, the implied annual yield/cost of buying CNY forward using the NDF market has rarely been reflective of interest rates, undermining a key aim for the proxy decision.

This relationship is evident in Figure 2, illustrating a significant difference in performance between the onshore CNY forward market and the NDF market. While the CNY NDF has outperformed onshore CNY forwards over the time horizon shown, the disconnect between the benchmark (onshore CNY) and the realized NDF return clearly breaks the requirement for proxy eligibility. The uncertainty in relative returns can just as easily result in underperformance if market expectations for future prices change.

CNH ForwardsAs a freely tradable market for global investors, CNH is not subject to the regulatory restrictions present with deliverable CNY trading, making it an intruiging target for long-term investment by global asset managers. While still relatively

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CNY Onshore IRD CNY NDF IRD

Figure 2 – CNY NDF Comparison


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CNY Onshore IRD CNH IRD CNY Onshore Spot CNH Spot

Figure 3 – CNH to CNY Comparison


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“ Much like the migration to CNH for renminbi currency expo-

sure, market limitations have led many investors to explore

CNH denominated assets or CNH overlay strategies as a

means to create renminbi investment exposure.”


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new by conventional standards, this market has matured considerably in the last three years and daily trading volumes are now in the range of USD 5-8 billion.1

The forward market makes up approximately USD 3-5 billion of total CNH trading volume, with more than 75% of forwards in relatively short 1-3 month tenors.1 As the CNH market has grown, the CNH forward market has evolved to demonstrate:

• Strong liquidity

• Consistent, competitive pricing

• Implied interest rates that provide comparative performance to the onshore CNY forward curve

• Availability of net settlement for swaps similar to other deliverable currencies, resulting in a simpler, lower-risk settlement process

Figure 3 provides a breakdown of the forward returns for both onshore CNY and offshore CNH, including separation of the spot rate and the IRD. This illustrates that, while not perfect, CNH is an effective spot proxy for onshore CNY. Further, the chart demonstrates how well the implied interest rates in CNH track the onshore yields or IRDs.

While CNH has become an effective proxy for CNY, it should be noted that this was not always the case. Prior to

2012, there was more frequent divergence between CNY onshore and CNH offshore spot rates. This rightly caused some investors to question the reliability of CNH as a proxy for onshore CNY movements at that time. However, when Chinese authorities made changes to the offshore trade settlement scheme in March 2012, the increase in trading created more effi ciency in the market, narrowing the gap of exploitable arbitrage opportunities between onshore and offshore markets. The resulting improvement in correlation between the two spot rates has bolstered investor confidence in the use of CNH as a reliable proxy for CNY. This is supported by the data in Figure 4.

Like any proxy decision however, it is important to constantly monitor spot correlations between CNH and CNY, forward point trends and liquidity developments, which can all have a significant impact on the efficiency of the trading strategy.

PART II: INVESTMENT OPPORTUNITIES CREATEDTHROUGH THE CNH MARKETWhile in recent years, the Chinese government has created the Qualifi ed Foreign Institutional Investor (QFII) and Renminbi Qualifi ed Foreign Institutional Investor (RQFII) structures to give global investors limited access to onshore renminbi denominated assets, global distribution potential has been limited by regulatory restrictions and quotas. Much like the migration to CNH for renminbi currency exposure, these market limitations have led many investors to explore CNH denominated assets or CNH overlay strategies as a means to create renminbi investment exposure.

Examples of offshore investment opportunities created by the expansion and maturity of the CNH market include:

• CNH Denominated Securities: Hong Kong based securities,denominated in CNH (Dim Sum Bonds), are available, yet scarce relative to demand.

• CNH Forward Contracts: As mentioned previously in this paper, CNH forward contracts are recognized as a practical channel for potentially more precise CNY expo sure than that achieved via the CNY NDF market. 0.9800

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CNY Onshore Fwd CNY NDF Fwd CNH Fwd

Figure 4 – Full Comparison


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• CNH Denominated Share Classes (for purchase in CNH): Given the maturity of the CNH forward market and its viability as a proxy for onshore CNY exposure, a number of investment managers have developed creative and scalable products to meet market demand. Through the use of share classes for traditional offshore products like Cayman Trusts and Luxembourg/Dublin based UCITS products, managers can offer their clients exposure to traditional investment strategies (e.g. equities, fixed income) denominated in CNH. These products typical-lycome in the form of fully hedged CNH denominated share classes. They allow investors to buy units in CNH (retaining exposure to CNH), which are then converted to the fund currency for investment in the underlying securi-ties (USD fi xed income for example) and hedged back to CNH, protecting the value of the renminbi. This structure is particularly appealing for investors who hold CNH and are seeking a more effi cient investment structure than simply holding cash.

• Non-CNH Denominated Share Classes with CNH Overlays: Similarly, for those investors who may not already hold CNH, non-CNH denominated share classes are available and allow investment from a multitude of currencies (e.g. USD, EUR, GBP and JPY). For a USD-based class, subscriptions occur in USD and are then converted to the fund currency (if necessary) for asset investment paired with long CNH forward contracts to provide the desired currency exposure.

While there are many investors who remain bullish on the renminbi, it must be noted that currency risk is a two way street. There are some investors (QFIIs and RQFIIs for example) who may demand securities traded onshore in China, but that want protection against implicit currency risk in holding those assets by selling renminbi forward.

LOOKING AHEADChinese authorities continue to give overseas investors broader access to onshore security and currency markets through increased QFII quotas and the introduction of the RQFII structure. They are also taking measures to accelerate regulatory reforms with the goal of more complete renminbi internationalization in the years to come. While global inves-tors are readying themselves to take advantage of opportuni-ties as they arise, demand for renminbi access continues to outweigh the limited supply.

The CNH market is closing this supply/demand gap for many investors, and the continued maturity of this market has helped solidify CNH’s position as a proven and viable renminbi proxy - not just for currency market access, but as an important channel for global investment managers to create and distribute new products to investors across the world. While the pace of internationalization and off-shore access is diffi cult to predict with any precision, we expect CNH to remain a viable option for offshore inves-tors for the forseeable future.

“ The CNH market is closing this supply/demand gap for many investors, and

the continued maturity of this market has helped solidify CNH’s position as a

proven and viable renminbi proxy - not just for currency market access, but as

an important channel for global investment managers to create and distribute

new products to investors across the world.”


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ABOUT THE CNH MARKET: A BRIEF HISTORY

Since 2010, the development of activity in the offshore renminbi - a process commonly described as the ‘interna-tionalization’ of the renminbi - has been principally driven by the aim of the Chinese authorities to improve condi-tions for Chinese firms involved in global cross-border trade. Nevertheless most observers see this as a major step toward the full opening up of China’s currency, and more generally its capital markets.

The initial stage has seen regulations loosened specifi-cally to encourage the use of renminbi as a global trade settlement currency. This helps support Chinese firms involved in cross-border trade by reducing currency risk and the operational steps involved in managing FX activ-ity related to bringing trade revenues back to renminbi. The more of a Chinese firm’s trade that is invoiced in renminbi, the less FX exposure and necessary FX activ-ity for that firm, thus leading to lower costs and less risk. Since early 2012, all Chinese firms have been

allowed to move renminbi across the border when that renminbi is a result of trade settlement activity.

Though the main intent behind this initiative from the Chinese authorities was to support non-financial activi-ties for Chinese firms (cross-border trade), it was neces-sary to take other steps in financial markets to sustain the international use of renminbi. Quite simply, inter-national firms and other entities potentially involved in invoicing for cross-border trade in renminbi would only do so if similar financial services were available for off-shore renminbi as for any other currency. The changes in regulations have led to the birth of the CNH currency market (including spot, forwards, and options), and CNH interest rate and bond markets.

The following pages include a brief timeline of the events that have proven instrumental in the develop-ment of the CNH market.

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ABOUT THE CNH MARKET: A BRIEF HISTORY

2003 2004 2005 2006 2007 2008

December 2003: The People’s Bank of China (PBOC) agreed to provide clearing for banks in Hong Kong to provide personal (retail) renminbi banking services (deposits, remittances, bank cards).

June 2007: Entities incorporated in China

allowed to issue renminbi bonds in Hong Kong.

June 2009: PBOC launches pilot

scheme, limited to handful of mainland

cities, for renminbi set-tlement of cross-border

trade with Hong Kong and Macau.

September 2009: China’s Ministry of Finance sells the first Chinese sovereign ren-

minbi bonds offshore.

2009

Source: Research compiled by Brown Brothers Harriman


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2010 2011 2012

June 2010: Trade settlement scheme expanded to 20 mainland provinces and all overseas coun-tries. Firms involved must still be on Mainland Designated Enterprise (MDE) list; at this time MDE list includes all importers in the approved prov-inces, but few exporters.

July 2010: Supplementary Memorandum between the Hong Kong Monetary Authority (HKMA) and PBOC. Sometimes referred to as the ‘Big Bang’ for the offshore renminbi, this allowed all offshore companies, financial or non-financial, to open renminbi accounts in Hong Kong and use all regular services such as loans, currency conversion and payments. As long as the ren-minbi was kept offshore there was no restriction on its use. This agreement effectively facilitated the launch of all financial prod-ucts and markets for offshore renminbi, including the FX market.

August 2010: McDonald’s issues renminbi 200 million of bonds in Hong Kong – the first renminbi issu-ance (Dim Sum bond) by a non-Chinese, non-financial firm outside of China.

December 2010: Number of exporters on MDE list for renminbi trade settlement increased from 365 to 67,359.

April 2011: First CNH IPO launched in Hong Kong.

August 2011: China’s Ministry of Finance launches its third sale of government bonds offshore. At renminbi 20 billion, this was significantly larger than prior sales and seen as the official stamp of support from the Chinese government.

August 2011: All areas of China now included in the trade settlement scheme.

March 2012: MDE list process shut down and all Chinese companies approved for offshore renminbi trade settlement.

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This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries (“BBH”) to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area (“EEA”), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority. BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries. © Brown Brothers Harriman & Co. 2013. All rights reserved. 09/2013. IS-2013-09-11-0347

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