The sad fact to the China story is it was seen coming since January 2015. Nobody looked nor reported but now everybody reports. I myself wrote in the RBNZ Preview in FX Trader magazine that NZD/CNY and NZD/HKD had serious correllational problems but I never investigated because it wasn’t the concern then. Great Deng Xiaoping quote found in Danske Bank research to perfectly describe China, “China prefers to cross the river by feeling the stones”. The complete CNY, HKD story follows.
What is China’s currency, CNY. Its a hybrid currency as Yuan was issued since Mao’s takeover in 1948 in both Silver and Gold. Renminbi is the official name as RMB and means people’s currency. Yuan is the unit and traded as 0.0001 which is the same as most nation’s currencies in Europe, AUD, NZD, CAD, USD. But not the same currencies in India and Japan and probably others. The Chinese link to Hong Kong and HKD was perfect because HKD is not only stable but its firmly fixed to USD.
China and Japan share a 3,000 year rivalry as China linked to Hong Kong and Japan linked to Singapore. Japanese bonds and financial instruments trade on Singapore exchanges while Chinese bonds and financial instruments trade on Hong Kong exchanges. Chinese traditionally were educated in Japanese universities. But each share a vastly different orientation towards their currencies in movements, constructions and designs so the remainder Asia currencies designed their currencies either as the Japanese Yen or the 0.0001 as China Yuan. I believe Yen is a gold currency and Singapore’s SGD while China Yuan as a hybrid threw their lot to Silver because HKD is a Silver currency. But each nation also shared a British tradition and GBP is traditionally a Silver currency yet today its a hybrid. The formal name Sterling means Silver penny.
The best guard against the China / Japan currency differences was to institute trading bands as was designed by the IMF in 1944 Bretton Woods Agreement. China now has a 2% trading band, 2% for Vietnam, 2% Singapore, 2% HKD. The CNY band is held in place by the PBOC spot CNY Fixing at 9:30 am China, 9:30 pm EST but further by Offshore CNH traded on Hong Kong exchanges as CNH futures can’t trade against 0.0030. its not allowed cause exchange controls are enforced. Any wonder why CNY trade3d last week directly to the 2% band. But China’s trading band began as 0.5 in 2005 then increased to 1% in 2010. Its a slow and gradual approach but that’s Asia as they limit huge volatility. Why HKD.
HKD is managed by a currency board since 1983 under the Hong Kong Monetary Authority. Hong Kong’s Monetary base is backed with USD at a “Linked Exchange Rate of 7.80 and maintained in Hong Kong’s Exchange Fund. In 2005, the Monetary Authority reported USD 122.8 billion in the fund and 6 times the currency in circulation. The monetary Base is backed by foreign reserves so changes in the base matches changes to foreign reserves at the Fixed exchange rate. Hong Kong is an export economy so to prevent volatility and crisis it linked to USD. As the Monetary Authority issues Exchange Funds and Bills on behalf of the government, purchasers of Bills and Notes must by law purchase a Certificate of Indebtedness which is backed by bank notes. Along with purchases, an equivalent amount of USD’s must deposit in the Exchange Fund. USD deposits allows HKD’s to be backed by USD’s in the Exchange Fund.
In 2005, a Strong and weak side convertability was allowed so HKD to USD was allowed a band between 7.85 – 7.75. Overnight Base rate money is obtained by repo rates at the Discount Window and Repo rates are set by USD and Hibor interest rates. The current Base Rate is 0.50 since January 2008 while Hibor fluctuated between 0.080 – 0.030 in 2014 and 2015. Liquidity adjustments are done at 0.50. Exchange Fund Bills are reported in Yields like Australia and New Zealand and reported / Traded from 7 days, 30, 91, 182, 273, 364 days. Bonds range from 2 year, 3, 4, 5, 7, 10 and 15 years. Since June 2013, Hong Kong instituted the CNH / Hibor Fix at 11:00 am Hong Kong, 11:00 pm EST to allow CNH currency futures to trade and provide liquidity.
HKD was born from the Silver tradition until 1935 then linked to GBP at HKD 16. Then 1967 – 1972 1 GBP = 14.55 HKD. Banks surrendered Silver bank notes in exchange for Certificates of Indebtedness that later achieved legal backing for note issuing banks and became the basis for the Currency Board. In 1972, GBP free floated so HKD linked to USD at 5.65 then in 1973 5.085 but a 2% Intervention band was enforced.
CNY and CNH
USD/CNY began life Fixed to USD during the first George Bush administration in 1990 as China was granted Most Favored Nation Trade status. In 2005, CNY was a managed float to a basket of currecncies while 2008 was again the USD Fix. In 2008, Offshore trading began as USD/CNH. Here’s where the story begins.
Offshore trading means currency futures were established for trading on Hong Kong exchanges as USD/CNH. The Fix ocurrs at 11:00 am Hong Kong, 11:00 pm EST. If futures trade that means forwards, hedges and options trade as well. But it also means CNH legitimates Offshore as forwards are deliverable in CNH and legitimates / internationalizes the currency as 0.0001. If the PBOC cut the reference 1.9% as it did last week then Offshore Yuan or RMB depreciated 2% Offshore. USD/CNH held since January between 6.18 – 6.28 now its 6.3 and hasn’t seen those levels since 3 years ago. Offshore means current CNH deposits in Hong Kong total 830 billion by end 2013, higher today as Hong Kong markets are used for trading and exporting.
The difference between CNY and CNH is the direction in exports. If companies buy goods from the mainland in USD then ship to Hong Kong in RMB and transact in RMB or CNH but with an option to also transact in CNY spot. Goods exported to China in USD are transacted in RMB. Currently 23 market makers transact in CNH dealing rates, most are big banks. To understand profits in export transactions its price minus price X 100,000 X number contracts. Then comes the Hedge. If RMB or Yuan is appreciating then sell USD/CNH futures as the hedge. If the Yuan is depreciating then buy USD/CNH.
For example, convert RMB 6.3000 to USD 6.3600 uses USD say 1 million to buy commodities overseas. Then sell USD/CNH at 6.3800. later sell the commodities for 1.02 USD million. Convert back to RMB at 6.1800 and get RMB 6.2800 but close at 6.1800. The gain is 0.2 million profit and = 6.48 nillion. 6.38 = 6.18 X 100,000 X 10 contracts.
So USD/CNY hit an all time high in trading volume Offshore, 8.061 contracts or USD 806.1 million notional. Option Delta Risk Reversals long saw last week coming as Risk Reversals jumped from 1.2% to 4.1%. Further depreciation is coming for CNY as calls are favored in USD/CNY.
What happened was a gap was created between the FIX and close price to value CNY, CNH. The Gap closed from 900 pips to 56 pips but Onshore CNY Vs Offshore CNH widened.The carry portions flattened and been flattening since 2014. The Onshore CNY/USD Carry Trade return index dropped to 1.056 and Offshore CNH/USD index dropped below 1,000.This means the Flow of funds into RMB will be hurt as low rates borrowed overseas won’t travel into high yielding RMB assets. Maybe the PBOC is set for a Fed Rate hike, its possible. Implied Vols 1 month since January has been trending down from 6.1 to present 1.5%. 1.5% is an interesting number as the Spot to Mid point is currently at 1.5%. Did anyone see last week coming, nope but nobody looked.
Brian Twomey, Inside the Currency Market, btwomey.com