Why foreign investors face an FX headache in China
Foreign investors in China face a growing currency headache as the proportion of their exposure to Chinese securities increases, according to some industry experts.
In particular, there are practical concerns about liquidity and hedging of the Chinese currency between onshore renminbi (CNY) and offshore renminbi (CNH).
In a report on Wednesday, Natixis illustrated how bond and equity markets were behind a sharp rise in non-resident renminbi holdings, partly fuelled by the inclusion of Chinese assets in leading stock and bond market indices (see chart).
But that, as Barnaby Nelson, former managing director of Standard Chartered’s securities services business in Asia and now chief executive of research firm The Value Exchange, based in Toronto, told AsianInvestor, creates something of a dilemma due to the regulatory discrepancies.
“People are buying bonds and equities onshore, where the currency is CNY, but they are using CNH to buy/sell them,” he said. “Really, investors want to be able to hedge their exposures in CNY – not CNH – but they can’t because they are still not allowed to access that market, as foreigners.“
This didn’t use to be a problem, Nelson said, but it is increasingly becoming one now that foreign portfolio investment into China is growing and the renminbi is less stable as China locks horns with the US over trade.
The renminbi has depreciated almost 15% against the dollar in the last 18 months. For its part, the US treasury department has labelled China a 'currency manipulator'.
Some money managers are predicting the renminbi will continue to weaken slowly over the next year. RBC Global Asset Management, in its Autumn currency outlook, said: “We believe the depreciation may be more significant than the consensus. According to Bloomberg, only one in 10 forecasters expects the renminbi to weaken by more than 2% in the coming year.”
LIBERALISATION EFFORTS
For now, the Chinese currency is freely convertible for trade under the current account but remains strictly regulated in the capital account, through which portfolio investments typically flow.
Even so, Beijing is keen to promote the renminbi as a global reserve currency and has been gradually internationalising the currency.
“Although the process is far from being completed, China has already established trade settlements with selected countries and launched a series of currency swap agreements with more than 20 central banks,” Focus Economics noted in a mid-October outlook paper. “In addition, China is rapidly expanding the [renminbi's] offshore market. The opening up of the country’s capital market will be a crucial step in the [renminbi's] journey to becoming a major reserve currency.”
Meanwhile, the onshore renminbi exposures and hedging question is getting “a massive amount of attention from the market infrastructures (the banks and clearing houses) who all want to find a way to make this work for global investors,” Nelson said. “The challenge here, though, is that China wants – above all – to know that no one is able to speculate using the CNY.”
To prevent that, foreign investors, who are largely investing via the Stock and Bond Connect channels, have to produce significant amounts of reporting daily as evidence that everyone is playing by the rules, he said
The real dilemma, said Nelson, is “how to liberalise the market whilst not killing everyone with an impractical reporting burden ... So this is a work in progress.”
One thing seems clear, though, and that is that the ongoing trade dispute hasn’t diminished Beijing's desire to open up.
“This is mainly because China needs to keep broadening its renminbi usage and keeping upward pressure on the currency. So they have their own reasons for wanting to keep foreigners hooked on A-shares and China government bonds,” Nelson said.
NEW PROBLEMS
However, while the initial administrative issues around China's MSCI index inclusion have been ironed out, new problems are arising as China's index weightings increase, spurring higher passive fund allocations.
“The more you use something, the more you scrutinise it,” Nelson said. “When people were investing 0.6% of their emerging market portfolios in China, they didn’t care too much about the lack of hedging, or the fact that you couldn’t make money from lending those stocks out,” both known issues with the Connect system.
“When you’re running 5% of your [emerging markets] portfolio, the opportunity cost of those issues is a lot bigger – and so people become a lot more noisy about their needing to be fixed. That’s why I don’t think we’re going to feel ready for more inclusions (for some time). The few remaining issues are going to get more and more attention,” he said.
The other problem with the MSCI inclusion program is behavioural, in that investors don’t pay attention to the administrative aspects of MSCI index adoption until the last minute.
“One of the biggest blockages on both Connects is account opening. The workflows require many parties to sign documents in order to allow trading to start,” he said. "Unfortunately the experience in 2018 and 2019 is that, despite multiple warnings not to, most people leave it until too late to open accounts, which inevitably leads to chaos on the day.”