COTM: Paying Another Visit To The Chinese Yuan/Renminbi

This past month marked the 10th anniversary of the Chinese government’s decision in July 2005 to lift the Yuan/Renminbi peg to the U.S. Dollar, commemorating the country’s initial move toward joining a select group of economies managing global reserve currencies. So, we thought this currency would be an appropriate one to revisit in the latest installment of Currency of the Month.

First, a quick note about reserve currencies. Throughout history, the list of reserve currencies has varied, dating back to the fifth century B.C. when the Chinese liang and Greek drachma ruled supreme, through more recent history where we’ve seen a number of currencies in the primary spot since the 1400s. And today, the U.S. dollar occupies the top spot and has done so since the mid-1900s.1

The Chinese government’s move toward a managed exchange rate a decade ago was a small but meaningful step in a series of progressive moves to liberalize currency exchange rates and cross-border capital flows, transitioning the currency from a strict peg to the U.S. dollar to a “managed float” where the central bank would regulate the exchange rate of the renminbi relative to the dollar. In dropping the strict peg, the Chinese government believed a stronger currency would help transition the economy from an export-driven model to a more consumer-driven economy. This was a significant shift in philosophy for a central bank traditionally known for maintaining strict controls over the country’s capital movements.

Once currency controls were lifted, the renminbi immediately began a period of steady, but “managed” appreciation. It paused only briefly beginning in July 2008 when the Chinese central bank reinstated a temporary freeze on the renminbi’s exchange rate with the U.S. dollar during the global financial crisis to maintain an attractively valued currency and control capital flows during this period of intense volatility.2 Once these temporary controls were re-lifted in July 2010, the renminbi continued its upward climb. In total, the yuan/renminbi appreciated about 30% from its 2005 value, notwithstanding the Chinese central bank’s contention that the currency was “fairly valued” throughout the period. (Figure #1)

Source: EverBank Research Team, based on analysis of publicly available data from Investing.com.

Next Phase For The Yuan/Renminbi

The Chinese Central Bank appears, once again, to be at a crossroads for the next phase of liberalization of the yuan/renminbi. Market observers may point to the renminbi’s steady valuation relative to the U.S. dollar since March 2014 when the central bank widened its trading bands to plus or minus 2% versus the greenback,3 as justification for allowing the currency to freely float. That is assuming that the Chinese government may be more willing to reduce restrictions when the currency trades at levels approaching fair value. While this theory may help explain an aversion to “leaving money on the table,” it overlooks what is perhaps a larger motivation of the Chinese government: a place at the global reserve currency table.

Ardent readers of the Daily Pfennig® newsletter may recall my recent Currency of the Month article on the Chinese yuan/renminbi describing the progress needed for the Chinese government to gain acceptance into the International Monetary Fund’s (IMF) Special Drawing Rights (SDR) reserve basket of currencies. The IMF SDR is represented by four currencies: the euro, dollar, yen and pound sterling, and allocations are reviewed every five years. (Figure #2) The People’s Bank of China (PBOC) formally requested inclusion as a reserve currency in the SDR earlier this year; a decision will be made at the end of 2015 for the renminbi’s inclusion. Specifically, I opined that the Chinese government would need to further liberate capital markets and attract foreign investment through direct government bond sales in order to qualify for inclusion in the IMF’s SDR reserve basket.4

Source: EverBank Research Team, based on analysis of publicly available data from the International Monetary Fund (IMF).

Recent actions by the Chinese government appear to make my recommendations downright prophetic. On July 14, 2015, the PBOC relaxed rules on foreign investment in its domestic bond market, permitting central banks, supranational institutions, and sovereign wealth funds to access the country’s interbank bond market without the need for pre-approvals or quota allocations.5 China’s onshore bond market is one of the largest in the world, and the central bank’s actions provide relaxed restrictions for institutional investors to access these assets.

Furthermore, at the end of May 2015, the government announced plans to allow Chinese accredited investors to purchase overseas stocks, bonds and real estate assets directly from providers, rather than selecting from a list of government-approved foreign mutual funds.6 Both of these measures helped to further encourage unrestricted capital flows in and out of the economy, transitioning China closer to meeting the IMF’s requirements for including only freely usable currencies in the SDR reserve basket.

The stakes for the Chinese renminbi becoming a reserve currency in the IMF’s SDR appear to be at a critical point, as evidenced by the approaching IMF deadline and the PBOC’s recent liberalization efforts. It is further worth noting from my analysis of the Chinese renminbi that inclusion in the SDR could have a material benefit to the value of the currency, as the IMF would be required to purchase an estimated $1 trillion in renminbi for the SDR basket holdings.7 A key stipulation, of course, would be that the renminbi would be a fully floating currency.

Investment In China’s Free Floating Currency

Until recently, investment in the Chinese currency for outside institutions has been restricted to over-the-counter, non-deliverable forward contracts. These cash-settled contracts allow for hedging exposure to the government’s managed currency value, with profits or losses based on the difference between the negotiated forward exchange rate and the currency spot rate at a given fixing date. In a similar fashion, EverBank clients have been able to hold CNY deposits through our WorldCurrency Access® Accounts, which have not allowed for delivery of the currency.

A key step in the transition to market-driven pricing, regulations now allow for a market-driven yuan, which can be delivered through Hong Kong and beyond. This increases the liquidity and flexibility for institutions, and will also allow investors and depositors control of their owned currency as a direct means for conducting transactions within the domestic market and maintaining direct exposure to the currency. Exchange-based currency returns can be delivered to investors in the original currency, while NDF returns are required to be returned in U.S. dollars. Exchange-based currencies are not subject to government market controls as exchange rates are set by the market, but may be exposed to increased volatility levels absent government interventions. Investments in deliverable currencies may provide access to the payments of interest in the yuan as global interest rates rise. Clearly, investors looking for pure exposure to the Chinese yuan/renminbi may prefer to transition exposure to deliverable contracts.

Through the EverBank World Markets trading desk, clients will soon be able to convert their non-deliverable CNY renminbi WorldCurrency Access® Accounts into CNH yuan deliverable accounts.8 Keep an eye out for an announcement coming soon.

Until the next Daily Pfennig® edition…

Sincerely,
Chuck Butler
Managing Director
EverBank Global Markets Group
1.800.926.4922
www.everbank.com