Herbert Poenisch: RMB Hedging Forex Risk
2017-03-21 IMI
For comparison, the size of global debt markets in mid-2016 is USD 93 tr, mainly made up USD 72tr of domestic bonds and USD 21 tr of international bonds. The China onshore interbank bond markets amounted to RMB 56.3 tr or USD 8 tr, third in size after the USA and Japan (see table below).
Of this total only RMB 852.6 bn or 1.5% of the onshore interbank bond market are held by overseas investors. This share is much smaller than 9% of Japanese securities and 38% of US issued securities.There is a huge potential from both sides, supply and demand to increase the share of foreign holdings in China’s interbank bond market.
A boost of capital inflows is welcome at present when Chinese authorities are struggling to stem capital outflows.
Table 1: Summary of debt securities outstanding 2Q2016 in bn USD
Source: BIS Securities statistics Table C 1
2. Recent SAFE decision on hedging in the interbank bond market
Interbank bond market is a misnomer as it covers more than 90% of all traded bonds.
The recent decision to allow foreigners buying onshore bonds in China to hedge their currency risk is a major step forward to attracting international investment in its booming debt markets. These hedging transactions can be concluded with Chinese residents (banks foremost) and include forward contracts, swaps and options.
These measures are targeted at non-central banks, foreign institutional investors, including pension funds, charities and other investors who invest in China’s bond market through the Qualified Institutional Investor (QFII) programme. Foreign investors must trade the derivatives through a qualified onshore financial institution and conduct such trading based on ‘real needs’ for risk hedging. This requires verification to avoid speculative hedging.
Until now many foreign investors have been using derivatives available in the RMB offshore market, which is a costly and time consuming practice. In future China might be easing administrative measures, such as favourable tax policies, extended trading hours and shorter settlement periods. This will prove a challenge for the China International Payment System which will have to include settlement of bonds and derivatives with a central securities depository set (CSD) up.
3. Risks for foreign investors
Foreigners can now hedge their foreign exchange risk at a cost, bearing in mind the widely expected depreciation of RMB. Furthermore foreign investors still carry the interest risk, which in an environment of expected globally rising interest rates from which China cannot exclude itself, is not negligible.This step is also important as in most advanced bond markets the interest swap rate serves as a benchmark.
“Much remains to do with designing and operating a Chinese Government Bond market that will provide an efficient yield curve to find out the optimal interest rates from one year to fifty years”. At present this is a captive market as Chinese banks hold the bulk of CGBs. Furthermore, the absence of institutional investors diminishes the urgency to create a yield curve and for the PBOC to use this as basis for its operations.
Recent improvement in monetary operating procedures by introducing an interest corridor should facilitate the use of interest rate derivatives. The PBOC should be the leading institution to shape an ‘optimal’ structure for the CGBs yield curve. “In order to fulfill this societal responsibility, PBOC should design, develop and operate an effective and efficient monetary policy to manage RMB as an international currency”.
It therefore remains to be seen how much these measures help to attract foreign capital at a time when China is facing massive capital outflows.Selling more domestic debt securities to foreigners is a double edged sword, the inflows are welcome but reversals can cause stress for monetary policy. Enforcing strict capital controls is a return to administrative measures which is a temporary setback for the internationalisation of RMB. The outside world expected more market determined exchange rates and interest rates.
