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Nick Johnston, Commerzbank Asia
A Tumultuous 18 months in China’s Financial Markets – Implications for International Corporates
- It has been a tumultuous 18 months for China as it seeks to rebalance its economy to a more consumption-led basis and address the key economic issue: excess leverage in the system.
- Overall debt to GDP is 255% which is comparable to the US at 251% but less than the Eurozone at 266%*.
- However, what is worrying is the speed at which debt levels have grown and the proportion represented by the corporate sectors, which at 171% of GDP is well in excess of any other comparable economy*.
- With USD3.2trn in foreign currency reserves, gross saving/GDP rate at 46% and external debt only 16% of GDP*, China has ample resources to address these challenges, albeit while accepting a slower level of growth, which this year Commerzbank forecasts at 6.0-6.7%* versus the double digit growth of the last three decades.
The financial markets reform agenda has continued with a number of notable developments, such as the inclusion of the RMB into the IMF’s Special Drawing Rights, further liberalization of China’s bond and equity markets granting greater access to international investors, and a move by the PBOC to a more ‘market based’ approach to setting the daily RMB fixing rate.
However, there have been a number of upheavals in the financial markets. Spurred by excessive margin lending actively encouraged by the government, China’s equity markets saw unprecedented volatility. Supply and demand imbalances have caused a divergence in the property market with prices in tier 1 city Shenzhen rising by 47.4% in the last 12 months, while tier 3 cities have averaged only 2.1% in the same period*. In early 2016, margin trading restrictions in the equity markets and curbs on property transactions in tier 1 cities resulted in ‘hot money’ moving into commodities with onshore exchanges seeing a huge increase in trading volumes, driving prices up 60%* in onshore rebar futures, before these too came back down to earth.
The difficult juggling act for the government has been most intense when it comes to FX rates as the level and stability of the RMB is critically important for the real economy.
As a result of the slowing economy in China and expectations of rising rates by the Fed, sentiment towards the RMB has shifted from a strengthening towards a weakening bias. While the Chinese government has been willing to accept a weakening currency to help exporters, it has sought to stem the rate of decline in the RMB to limit capital flight and to protect Chinese issuers who have tapped the foreign currency markets.
The various policy responses have confused the markets. These included the ‘one-off’ devaluation in Aug 2015 followed by further devaluation in Jan 2016. In a counter-intuitive move, there was a period of heavy intervention to support the RMB and prevent further falls by the PBOC after each devaluation. This was undertaken initially directly by the PBOC in the onshore spot market. When this proved ineffective due to offshore speculation, the PBOC first intervened via Chinese agent banks in the CNH spot market, before moving into the CNH forward market thereby making shorting the currency prohibitively expensive. Additional restrictions have been placed on anyone seeking to sell RMB in the onshore market, such as the pre-approval of trades above a certain size and the need by banks to put aside 20%* in margin for all forward sales of CNY.
This heavy handed intervention has adversely affected the RMB markets in a number of ways.
Firstly market liquidity has suffered with volumes down by around 25%* from peak to trough. This has resulted in spikes in short term rates and a material decline in liquidity in both onshore and offshore markets. Some liquidity has returned to the market, but this could clearly evaporate in the next bout of market stress.
Secondly, CNH has diverged from CNY during times of market stress. Over recent years market liquidity in the offshore market had moved to CNH from CNY NDFs. Basis risk between CNH and CNY was minimal with CNH becoming the preferred hedging tool. However, in August 2015 and January 2016 there was huge basis risk meaning that CNH was a poor hedge for underlying CNY cash flows.
This has had a major impact on best practice for international corporates managing their RMB risk. While for many corporates, hedging the RMB had never been a priority due to its steady upward path, this has now changed with risk in the currency at the forefront of treasurers’ minds.
There are a number of pros and cons between hedging in the onshore versus the offshore markets. The onshore markets are the better hedge, but regulatory restrictions make it administratively more cumbersome and expensive. Additionally there is the question of which time zone to hedge in, with liquidity of CNH in European hours improving, but still nowhere near as good as in Asia hours.
The challenge now is how to effectively manage RMB exposures in these difficult and ever changing markets.
*Source: Commerzbank Research
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