Expert Briefing. and inbound china. The Offshore RMB Group. Briefing notes. The group is sponsored by Standard Chartered

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1 Expert Briefing Date 8 May 2014 Expert briefing Taking control of your RMB FX risk and lowering your borrowing costs in outbound and inbound china Presenters Robert Minikin, Global FX Strategy team, Standard Chartered Bank Yuhin Gan, Co-head of FX, Rates and Credit Structuring, Greater China & Japan, Standard Chartered Bank Brian Leung, Treasury Solution Advisor, Director, Transaction Banking, Standard Chartered Bank The Offshore RMB Group The offshore RMB group is for companies who are currently using, or are planning to use the offshore RMB for financial transactions and trade settlements. Members share experiences and best practices on all aspects of the topic through private peer group discussions and expert briefings. Briefing notes This is the third in a series of ECTN expert briefings on Offshore RMB sponsored by Standard Chartered Bank. Treasury professionals from Europe, the Middle East, Africa, Asia and the Americas participated in the webinar on April 10, In this report: An overview of the Offshore Renminbi (CNH) and key market trends (Robert Minikin) A brief overview of the tools to mitigate RMB FX exposure (Brian Leung) A detailed interpretation of RMB FX and rate structures (Yuhin Gan) MORE INFORMATION For more information about the Corporate Treasury Network, please contact: Rupert Keenlyside Director Product Development rupertkeenlyside@eurofinance.com Emma Brady Project Manager emmabrady@eurofinance.com The group is sponsored by Standard Chartered ECTN Report Page 1

2 AN OVERVIEW OF THE OFFSHORE RENMINBI (CNH) AND KEY MARKET TRENDS There has been a profound change in China s FX policy over the past couple of months with important implications for investment and FX risk management. The headline development came on March, 15 when the People s Bank of China (PBOC) doubled the width of the offshore and onshore FX trading bands from ±1% to ±2%. There were similar steps in the past but this was a more significant step as the Chinese authorities delivered more profound FX volatility, inter- and intra-day. Structural change The trading band of ±1% was about 0.1 RMB wide before it was widened, but the actual daily trading range was far narrower and hardly moved within the band. But after March, 15 there was a structural break, when not only was the band wider but there was much more day to day volatility in the spot rate, with a wider gap between the high and low of each day. This is clearly a new environment. The widening of the band was a sign of confidence by Chinese authorities in the RMB. At the same time the band was widened there were some important signals to the market. Firstly the authorities indicated that the FX market was relatively healthy and developing and that it was ready for such a move. It was signalled to be part of the overall FX reform and carried relatively low risk for the broader economy. It was not a signal about appreciation or depreciation, the PBOC said the RMB would be kept broadly stable. But most significantly it signalled that the Central Bank wants to step away from regular FX market intervention and only intervene when there is abnormal volatility. The view of Standard Chartered is the bounce in the spot rate in recent weeks seems to have been inspired by heavy FX intervention in late 2013 and early In many ways the volatility has been prompted by the official intervention strategy. The question is why do authorities want more volatility, and to understand that one has to examine how the Chinese external payments dynamic has been evolving in recent years. The need for change The China reserve build last year was around $430B, not far off the recent years peaks but significantly more than in 2012 when it was $200B. But what was interesting was its composition. The current accounts surplus last year was only about $190B, the balance of $240B was from financial account inflows. This was understandable because the Chinese chose to have independent monetary policy with high yields and rates. The Chinese authorities are also internationalising the currency which creates more openings in the capital account and the currency has been on a very gentle appreciation path year by year. High yields and FX rate appreciation were simply not sustainable in the broader macro-economic context. The Authorities had to change the risk reward characteristics around the RMB in order to avoid being overwhelmed by short time capital inflows. So they need and created more two-way variability and uncertainty in the direction of USD/CNY and USD/CNH rates so the interest rate differential in favour of RMB is less powerful as an attractor of capital inflows. The view of Standard Chartered is that realised volatility must be higher now, not just in early 2014, but in the coming months and years, as part of the overall FX reforms. In effect the realised volatility of the RMB has to move up towards those of the major developed currencies or closer to what we have in the emerging markets. Permenant change Looking at the realised volatilities of some other Asian currencies against the USD we see that RMB has had significantly lower volatility than they had until mid-march when it increased about three fold, moving up close to the Korean wan and the Taiwanese dollar. Moving ahead from this analysis and looking a bit further forward, the PBOC has taken a decisive step which is not just about a wider band but a decisive bid to boost FX volatility. It doesn t mean that CNY appreciation is over for the medium-term but the short term one-way CNY appreciation is over. Standard Chartered still thinks the RMB ECTN Report Page 2

3 will be on an appreciation path in the medium term. Standard Chartered Bank forecasts CNH and CNY breaking below six later this year to be at 5.91 and 5.92 respectively and this is to continue into 2015 (5.89 and 5.90 by mid-year), reflecting that the global recovery is likely to boost China s current-account surplus back towards 4% of GDP in 2015, particularly if global commodity prices are relatively well contained. To conclude, there has been an FX regime change in China; this is not a short term burst of volatility which will be followed by calmer markets. There will be more volatility and there is a challenge now for corporations to manage transaction and balance sheet exposure more proactively. A DETAILED INTERPRETATION OF RMB FX AND RATE STRUCTURES There are now a few different things that can be done to manage FX risk and reduce borrowing costs in this current environment. The market has changed quite significantly since the start of the internationalisation of the RMB a few years ago. The good thing is the market outside China has also developed and there are quite a lot of instruments available now. FX risk management instruments The spot market, forward market and options markets as well as the swaps market are all fairly liquid for CNH giving a lot of hedging and FX management opportunities. In terms of structured lending to reduce borrowing costs there are ways to do these using cross-border transactions. There have been quite a number of regulatory relaxations in terms of inbound and outbound money movement over the past few years. A lot of it has been about internationalising the RMB and the Regulators relaxing cross-border controls. An example: How to manage FX risk There are a few ways to manage FX risk but let s take as an example a company with non-rmb liabilities and RMB revenues. In the current environment one-way appreciation may not have disappeared over the medium term but two-way volatility is coming into play in the short term. So what is a company to do to manage this FX mismatch? Firstly it could do nothing and retain full FX exposure. If the RMB appreciates there would be a gain but it may not, and the question is whether this an appropriate risk-management strategy? Alternatively it could hedge. The most straightforward hedge is a cross currency swap, hedging the RMB risk back into its base currency. In this case the company is completely hedged so it would not participate in any potential RMB appreciation. If the company wanted to benefit from some RMB appreciation, another solution would be to enter into a call option so it could fully benefit from any RMB appreciation but still be hedged against the downside risk. Such instruments involve the payment of a premium to purchase the option. This premium can be lowered if the appreciation participation is capped. The final example is where the company enters into a call spread. If the appreciation participation is capped the premium paid is reduced accordingly. These then are instruments that can be used to manage RMB FX risk Cross-border funding Now let s briefly consider some cross-border structures that can be used. There are inbound and outbound structures which are quite different in nature because of the regulations controlling cross-border movements of funds. For the inbound side, the movement of funds is controlled by quotas. If an onshore company borrows offshore this requires the use of its foreign debt quota. The benefit of doing this is that offshore funds tend to be cheaper than onshore funds, typically by a couple of percent. If the company then wants to hedge the exposure into USD it can enter into a cross-currency swap so the net liability is back in USD, typically this swap would be done offshore where it is less regulated. In terms of outbound structure these are typically situations where companies have excess liquidity onshore in RMB and want to use this to lower borrowing cost offshore. In this case the company can place its funds with a bank in China, then that bank opens ECTN Report Page 3

4 a collateralised stand by letter of credit (SBLC) in favour of an offshore bank which in turn makes a loan back to the company s offshore affiliate. With existing regulations an RMB SBLC does not require the use of quotas; this is a relaxation by the authorities of cross border controls which is part of the RMB internationalisation initiative. Recently there has also been a further relaxation which allows, in certain quite specific cases, a corporate to pledge onshore cash directly in favour of an offshore lender. By this means a company collateralises an offshore loan with onshore cash and by securing the loan, lowers its borrowing costs. A BRIEF OVERVIEW OF THE TOOLS TO MITIGATE RMB FX EXPOSURE This is the year of regulation relaxation and increasing FX management for corporates in China. Many people have expressed surprise that the RMB deregulation is going much faster than was expected a few months ago. This probably started with the PBOC Circular 168 last July and most recently we have the widening of the FX trading band to ±2% coming just after the Shanghai Pilot Free-trade Zone (SPFTZ) relaxation announcements. The SPFTZ basically introduced two-way cross-border sweeping and since then everything has changed. If you put centralised payments with netting together with cross-border sweeping it has really enabled corporates to manage their RMB funding and foreign exchange management with control and flexibility that has not been seen before. No matter what a corporate s China activities are the flexibility for moving cash in and out of China has been greatly improved. For example, if you re running negative working capital in China, the two-way sweeping scheme, will enable you to use overseas operating cash flow to fund the China need. With such newly available treasury flexibility corporates have much improved hedging and funding flexibility. This is true no matter what phase of the business cycle a corporate is in. In addition to the two-way sweeping, centralised payment in the form of cross-border RMB netting is also approved in the SPFTZ scheme. Two-way sweeping practically enables an RMB cash pool in China to link up with the regional or global cash pool, which could be multicurrency, and so increases the attractiveness of RMB billing to corporations. What it means is corporates can create natural RMB hedges for China entities by billing internal and external third parties in RMB instead of in USD or in EUR. This should be welcomed by many corporates as it reduces FX exposure and removes the responsibility of managing FX exposure from the local Chinese treasury. RMB billing opportunities For corporates with intercompany transactions, RMB billing would enable them to move the RMB exposure offshore where it can be hedged more efficiently or netted against other RMB positions. Third-party RMB billing is getting more widely requested and accepted, and with these regulatory changes corporates can remove or minimise their resulting RMB FX exposure. RMB exposure can also be managed more effectively if it is centralised. Corporates can now decide whether to hedge in or outside of China just by choosing their billing currency. This development really comes in handy with the increased volatility in the RMB exchange rate. Some European organisations are using RMB internal billing to move RMB exposure outside China because they think that they can hedge more effectively. This has been going on for quite some time. Initially it was a very strategic and pioneering move, but nowadays with RMB netting it can also be done effectively through the SPFTZ scheme. Intercompany RMB accounts payable (AP) and accounts receivable (AR) settlements can also be streamlined by netting in the SPFTZ. Compared to billing in foreign currency, the savings in the spot FX conversion of the AP and AR intercompany transactions can be quite significant. ECTN Report Page 4

5 Trapped cash and offshore funding With two-way sweeping the worry of trapped RMB in China is much less. In the past when a corporate wanted to move trapped cash out of China (for example for dividend repatriation, equity reduction or cross-border loans) it involved a lot of approvals and paperwork and it would take a long time to complete. But with two-way sweeping cash generated in China can be used to fund overseas operations by participating in the regional or global cash pool, and some of the so called trapped RMB can be put to good corporate use. On the other hand a corporate which is expanding in China, so in need of working capital can fund its China operations by using cash from the overseas cash pool which is usually cheaper than borrowing in China. More importantly, internal funding is a much more reliable source of funding than bank borrowing and involves less paperwork than borrowing in China. Finally with the cross-border netting process corporates could reduce financial expenses from the foreign exchange conversion, reduced settlement amounts and obtain the benefits of improved settlement discipline with better information for accounting and management purposes. Shanghai pilot free-trade zone opportunities In conclusion when corporates put all the pieces from netting and hedging together with RMB two-way cross-border sweeping and participation in a regional or global pool the benefits are quite clear. They are concentration of FX exposures and natural hedging opportunities from RMB billing, use of an SPFTZ scheme to improve control and efficiency, cheapen overall funding and get more flexibility from two-way sweeping and better hedging opportunities. Policy review With such changes some RMB hedging policies may need to be revised. For example, there could be RMB hedging instruments or arrangements that would be appropriate for managing RMB exposure outside China which was not allowed before because RMB hedging was done in China. Secondly regional or even global liquidity management structures may need to be modified to include RMB from China. QUESTIONS AND ANSWERS 1. can you tell us about the opportunities for cross border netting and payments on behalf of (POBO) using offshore RMB? There have been some activities, but as the whole scheme is in the pilot stage so the China government will look at it on a case by case basis. 2. Does Standard Chartered have specific predictions for CNY and CNH rates in 2014? Yes, we expect there to be further appreciation, albeit with greater volatility, with year-end rates of 5.92 for CNY and 5.91 for CNH, with further appreciation in It s fair to say the recent incoming data, particularly today s trade data being a bit softer than expected; this really reinforces the case for variability in the short term. The message is the appreciation trend likely remains intact. The way the currency trades will be more related to the economics and PBOC intervention will be less important. CNY still looks like a relatively safe haven, but it can swing significantly in both directions. 3. Do we expect diversion again in the forward rates for USD/CNY and USD/CNH? Yes, we have seen quite different pricing dynamics between deliverable and non-deliverable forwards particularly in recent weeks. Deliverable has shifted up but is relatively flat. For non-deliverable there has been broader market liquidation dynamic and the forward curve has been getting progressively steeper these last few weeks. Divergence will continue. Investors and corporations are moving away from the Non-deliverable forward (NDF) as a hedging tool to forwards options in ECTN Report Page 5

6 USD/CNH. Liquidity in the NDF will gradually thin out and USD/CNH will be the dominant forward in a trading context. 4. in terms of saving for RMB offshore settlement, could you estimate (in percentage points) the saving for our clients? I think the question is about netting. I don t have a firm number, but if a corporate is doing payments with no netting, there are FX spot conversions, hedges and transaction fees, so with netting the volume comes down a lot. The savings are in FX and transaction fees and depending on volumes could be quite a lot. 5. please confirm if there are any tax implications in cross-border lending? We need a tax expert to answer this. All usual business taxes will apply. Sweeping is treated as a two-way entrustment loan so the tax treatment will be the same. 6. which are the main offshore markets outside China and Hong Kong, and what are the prospects for the CNH market in London? We have our RMB Globalisation Index which comprises trading in a number of offshore centres including Hong Kong, Taiwan and Singapore and we have just added London. We see the offshore market being gradually extended out, Hong Kong still has an extremely important role in terms of pricing and also the derivatives trading is far deeper than in mainland China. London is going to be an extremely important offshore centre. There are several reasons for that; London is a major international financial centre, and an FX trading centre. It has a time zone benefit spanning Asia and the USA, and covering Europe. But the one counter influence to prevent it becoming dominant is the we expect the RMB to play a building role in international financial transactions, but it seems likely that the underlying trade and trade settlement will be an important driver for the role of CNY globally, so countries with strong trade links with China will have more of a role in trading the offshore currency, than the pattern of trading generally. For example, Frankfurt is becoming a CNH trading centre and the direct German trade with China gives a very important boost there. 7. how are companies hedging their CNY balance sheet exposures? One way is to use derivative hedges like currency swaps and options. Another way is to re-denominate balance sheet liabilities into CNH to obtain the overall balance sheet hedge. ECTN Report Page 6

7 Standard Chartered is a leading international banking group, with over 150 years of history operating in many of the world s most dynamic markets across Asia, Africa and the Middle East. RMB internationalisation offers a unique opportunity to corporate, financial institution and investor clients, helping them to grow their business in China. As a key RMB liquidity provider with a strong and sustainable balance sheet, we are able to support client needs across the full suite of RMB product offerings and transactions: Improving working capital management Managing currency exposures and risks Lowering cost of funds for onshore and offshore markets Raising debt capital Broadening investment scope and diversifying investment risk We are at the forefront of market developments and maintain close working relationships with industry regulators, which enables us to facilitate a number of market first deals, including the first RMB cross-border trade settlement for payments and collections, the first domestic trade in Hong Kong settled in RMB, and the first RMB bond issuance for a foreign multinational corporation in Hong Kong. Standard Chartered was awarded best partner bank for service trade by the People s Bank of China in 2012, and is the only foreign bank to receive the PBOC s accolade for outstanding RMB Settlement and Account Management. Standard Chartered offers an unparalleled onshore and offshore RMB service network, enabling smooth implementation of cross-border transactions. We have strong on-theground presence in China (100 locations), and are a top 3 clearing bank in China. In addition, we have local market presence offering RMB services in over 36 countries outside China. We believe the internationalisation of the RMB is an irreversible process. Standard Chartered s Renminbi Globalisation Index (RGI) shows that the international use of the currency has soared nine-fold since we started tracking it in December Our comprehensive capabilities, deep market knowledge and geographic strengths enable our clients to take advantage of the opportunities and benefits RMB internationalisation represents. For more information, visit: Disclaimer: While every effort has been taken to verify the accuracy of this information, EuroFinance Conferences Limited does not accept any responsibility or liability for reliance by any person on this information. ECTN Report Page 7