After a year of smooth and spectacular growth, the offshore renminbi market in Hong Kong is no longer complying with the bullish expectations of analysts. Instead, it has started to cause problems for banks and investors.
The market was first convulsed in September when investors abandoned their long-held belief that the Chinese currency would only ever rise against the US dollar. That idea had encouraged more than Rmb500bn ($80bn) of renminbi deposits to flow from the mainland to Hong Kong since the offshore market was launched in mid-2010.
Now, three months after international investors started selling renminbi for dollars in numbers, stress is spreading to more esoteric corners of the offshore market where investors fund themselves or hedge currency risks. And after renminbi deposits in Hong Kong fell in October for the first time in two years, some groups have been caught in the grip of a renminbi liquidity squeeze, causing funding costs to surge.
“On one hand, it’s a healthy thing that offshore [interest rates] are converging with onshore levels, but the way in which it’s happening – the volatility, the pace and suddenness of the move – is not healthy and is contributing negatively to the development of the market,” says Dariusz Kowalczyk, a strategist at Crédit Agricole.
On the surface, a semblance of calm has returned. On Monday the renminbi closed at Rmb6.3635 against the dollar in Hong Kong, just 0.04 per cent below its exchange rate of Rmb6.3608 on the mainland, having fallen to a discount of as much as 2 per cent during the September sell-off.
However, the convergence of onshore and offshore spot exchange rates is less about international demand for the currency than the fact that Chinese companies can and do arbitrage between the two markets. The People’s Bank of China directly controls the renminbi within a narrow trading band on the mainland, which in turn exerts a gravitational pull on the renminbi’s exchange rate in Hong Kong.
As a gauge of investor expectations for the future, the real action is in the offshore forwards and options markets, which, in the words of one analyst, are further away from the “deadening hand” of the PBoC.
Non-deliverable forwards were on Monday implying a 0.8 per cent depreciation of the renminbi during the next 12 months. Only three months ago the consensus among economists at investment banks was for the renminbi to rise at least 5 per cent against the dollar each year for the indefinite future.
Jim Walker of Asianomics, a Hong Kong-based research house, says there “could easily” be a 10 per cent devaluation of the renminbi against the dollar in 2012 if the Chinese economy slows in line with his forecasts. “But it would need the Chinese to admit that the economy was much slower than has been the case over the past 10-15 years,” he says.
Diminished expectations for renminbi appreciation have also led to swings in Hong Kong’s deliverable forwards markets. Forwards allow investors to buy or sell renminbi at a specified time at a specified price. In most markets, forwards are priced purely on the basis of interest rate differentials. However, the offshore renminbi market is still illiquid and underdeveloped, so renminbi forwards are heavily influenced by speculative demand.
Since May, renminbi forward points – the difference between the forward and spot rates – have surged and in recent days the one-year forward point hit a record high of more than 700 pips. At these levels, the implied yield on renminbi assets has reached 2 per cent, up from minus 1.4 per cent in May. In tandem, Hong Kong banks have tripled the interest rates they offer depositors to similar levels.
The surge in renminbi interest rates in funding and forex markets also reflects an unexpected tightening of liquidity conditions. Renminbi internationalisation in trade recently stalled, which caused Hong Kong’s renminbi deposit base to shrink in October by 0.6 per cent to Rmb618.5bn, confounding predictions by HSBC that the deposit base would keep rising and reach about Rmb1tn by year-end.
And while deposits have dipped, the supply of renminbi-denominated financial products such as dim sum bonds has continued to rise, absorbing a growing proportion of the offshore deposit base and causing yields to jump.
“The [renminbi] story has gone off script in a big way for people,” says one analyst, who expects renminbi yields to keep rising. “Given the one-way positioning in this market, even a very small change in the expectations for appreciation can have a very big impact.”