[Originally published on 7/21/2014]
In mid-January, the renminbi strengthened to a rate of 6.0406, its strongest level against the US dollar since China de-pegged its currency from the dollar in 2005. Since that time, USDCNY had effectively been a one-way bet; the CNY was both an attractive vehicle for carry traders seeking to exploit the renminbi’s juicy yield (currently almost 5%!), as well as a way for corporate treasurers to boost profits, often using structured derivatives (such as target redemption forwards) to capitalize on a view that the CNY would continue to strengthen.
Beginning in January, however, the renminbi began to weaken, posting four monthly losses in a row against the US dollar (there had never been more than two monthly losses in a row in the nine years since the establishment of the managed float regime). In March, the Peoples Bank of China (PBOC) upped the ante even further, doubling the USDCNY daily trading band to 2%.
It is widely assumed that the driver behind this about-face on the part of the Chinese authorities was a desire to stem the high level of speculative inflows, which were threatening to have a destabilizing effect on the Chinese financial system. Despite this recent weakness, there are a number of factors which continue to point to a continuing strengthening of the renminbi. The two factors which are most closely related to moves in the USDCNY exchange rate are the level of Chinese economic activity (as measured by industrial PMI, industrial production, exports and GDP) and the interest rate differential between the US and China (both of these variables have exhibited a negative correlation to the USDCNY exchange rate of about -30% since 2010).
As both of these drivers continue to look relatively favourable for the renminbi, market consensus remains heavily biased towards further renminbi strengthening. In fact, the current Bloomberg poll puts the USDCNY rate at 6.01 by 2015, and only one institution predicts that the USDCNY exchange rate will be higher in 2015 than it is today.
Traditionally, many corporates, especially in Asia, would use directional hedging strategies (strategies designed to outperform if the market moves in a certain way), especially when they were looking to hedge a short renminbi, long dollar position (for example, Chinese exporters). Managing a portfolio of dollar receivables can be a painful exercise when the renminbi is continually strengthening; one way to mitigate this problem was to use specialized hedging products, such as target redemption forwards (tarfs) which would allowed the hedgers to lock-in an enhanced rate. However, this apparent windfall came at a price – if the CNY weakened by enough (typically about 2.5% or so), the hedger would be exposed to potentially large losses. This is exactly what happened this year – and analysis by the investment bank Morgan Stanley recently estimated the total losses facing Chinese companies using these products at $3.5 billion.
As such, there are two key questions facing corporate treasurers assessing how to manage their renminbi exposure:
- Is the “one way bet” for continued renminbi strength a thing of the past? and
- If so, how should corporate hedging strategies be adjusted going forward?
In terms of the first question, it is fair to assume that even if the longer term trend for the Chinese currency remains higher, it will not be a smooth path (or at least not as smooth as it has been). The PBOC seems committed to reducing the appeal of the renminbi to speculative carry traders, and the best way to do this is to increase the volatility of the currency – something the PBOC have already telegraphed through their recent widening of the USDCNY trading band.
Increased volatility means increased risk – therefore the directional hedging strategies that have been so heavily favoured, particularly by Asian companies, in the past may become less advantageous. By definition, such strategies are based upon a high confidence market view. Looking forward, hedgers may prefer to stick to more plain vanilla approaches. For CNY buyers, forward contracts (currently subsidized by a favourable interest rate differential) may work quite well. For CNY sellers (where the forward points are disadvantageous), the use of currency options is worth considering – especially as CNY options are significantly cheaper than options on many other currency pairs, such as EURUSD or GBPUSD, as indicated by the lower implied volatility (see figure 2), although it should be noted that the options prices remain higher for CNY sellers than for CNY buyers at the current time.