Hedging Strategies for the Renminbi International Finance Prof: Rich Lyons

Transcription

1 Hedging Strategies for the Renminbi International Finance Prof: Rich Lyons Marcos Canihuante David Weisz Shing Wong

2 INTRODUCTION Multinationals doing business in China have inherently greater currency risk than in countries that have open capital markets. For this reason, the prospect of Chinese Reminbi (RMB) devaluation and limited ability to hedge this risk is a daily concern for these firms. In this paper, we examine two hedging strategies espoused by currency strategists that claim to deliver proper downside protection from RMB devaluation. Both strategies take advantage of the more open capital markets of Hong Kong. These strategies are: 1) Hedging through the use of the HK dollar forwards and, 2) Hedging through the use of HIBOR floating rate agreements (FRAs) In presenting our analysis, we first give an introduction to the nature of the capital markets in China and Hong Kong. Although Hong Kong has returned to Chinese rule post-1997, it still maintains relative autonomy in its financial markets. We describe the different policies toward currency control by the two governments. Next, we discuss in depth the strategies employed by multinationals to alleviate a potential Chinese RMB devaluation. We explain in detail the methodology we used to evaluate the different strategies. Then, a discussion of the findings and related critique of the strategies is presented. Finally, we offer recommendations on which strategies makes the most sense in light of our research. BACKGROUND Although China has recently been admitted to the WTO, it has stubbornly kept its capital markets closed. In public comments, the Chinese government has maintained a policy of managed float of the RMB with the goal of maintaining a sound balance of payments. Naturally, this has become a concern for multinationals that have receivables in Chinese RMB. A devaluation of the RMB will create substantial currency exchange losses for these firms and threaten their operations in China. China s central bank, the People s Bank of China (PBOC), controls the value of the RMB through setting its exchange rate in the world currency markets. Unlike countries with free-floating currencies, the RMB s value is directly tied to the whims of the central government. Thus, although the RMB has been remarkably stable even throughout the Asian financial crisis in 1997, it has been known to move, sometimes dramatically. For much of the 1980 s and the early 1990 s, the RMB depreciated in step-like fashion with small incremental drops. However, large unexpected devaluation shocks do happen. An unexpected devaluation of the RMB by 33% in dollar terms occurred during the new year of 1994, when the RMB/US$ exchange rate went from for the week of 12/30/1993 to 8.69 for the week of 1/6/1994. Because a closed capital markets system does threaten the flow of foreign direct investments, China has created onshore non-deliverable forwards (NDF) of the RMB. However, unlike free market NDF, these RMB NDFs do not offer competitive pricing since they are issued and controlled by the PBOC. In response, multinationals have been Hedging Strategies for the Renminbi 1

3 seeking NDFs on the RMB outside of mainland China. Naturally, the Chinese government does not condone these transactions and the market that serves them. As a result, the offshore NDF market is illiquid with small daily volumes of $ million. Hong Kong, on the other hand, has maintained a fixed peg of the Hong Kong dollar (HK$) to the US dollar through the actions of its currency board. The board maintains the peg by using its foreign currency reserve in buying or selling its currency. Hong Kong s capital markets are considered open, offering very liquid currency derivatives instruments like NDFs, currency swaps, and interest rate swaps. Thus, given the two very different currency policies between China and Hong Kong, currency strategists have exploited these differences by creating proxy hedges for the RMB using the HK$. What follows is an examination of some of the strategies being recommended by these strategists. PROBLEM DEFINITION In an article titled Vibrant dragon, golden snake? 1, Mr. Frank Gong, a Strategist at Bank of America, suggests the following additional hedging strategies: Hedging using HK$ forward as proxy and Hedging forward HK interest rates. The first strategy, hedging using the HK$ as a proxy for the RMB, assumes that fluctuations in currency exchange will move in parallel with each other. If this is the case, one could use a HK$ NDF to protect against a devaluation on the RMB. The HK$ forward market is very liquid, and positions trading up to $100 million at a time are not uncommon. If the HK$ and the RMB were to behave differently from each other, that is, if a devaluation of the RMB was not matched by a predictable movement of the HK$, the hedge would not be effective, and in fact a higher level of volatility would be introduced through time. In this paper we will evaluate the soundness of this strategy by analyzing whether the HK$ is indeed a good proxy for the RMB. The second strategy, hedging forward interest rates, assumes that a devaluation of the RMB will lead to an increase in the HIBOR. If this is the case, losses incurred from a devaluation of the RMB, will be offset by gains on the long position on the interest rate. The article does not state specifically what mechanism Mr. Gong had in mind. In this study, we tested the use of non-deliverable FRAs, which are explained in more detail in the Methodology section. The key assumption we set out to test is whether there is evidence of strong correlation between the devaluation of the RMB and changes in the HIBOR. METHODOLOGY - Hong Kong Dollar Forwards In order to implement a hedge using a HK$ forward contract, a firm with an RMB receivable would sell HK$ forward at the expected time the receivable would be paid. 1 Leong, Elaine Vibrant dragon, golden snake? FinanceAsia.com, May 23, Hedging Strategies for the Renminbi 2

4 When the receivable is paid, any loss due to the RMB/US$ exchange rate would be offset by a gain on the NDF. In order to evaluate the efficacy of this technique, we obtained weekly data on the HK$/US$ and RMB/US$ spot rates and the HK$/US$ one-and six-month forward rates from January 1986 to present. We separately analyzed the one- and six-month strategies. For example, to evaluate the one-month hedging strategy, we computed the change in value of the RMB/US$ exchange rate over a one-month period and compared it to the gain/(loss) on a one-month HK$ forward compared to the one-month HK$ spot rate. We plotted and regressed these two series against each other to see if there was any correlation between movements of the RMB/US$ exchange rate and gains/(losses) on HK$ NDFs. We repeated this analysis over two time periods; using one with the entire data set and one with just data since January 1998 (post hand over) and using toth the one- and sixmonth NDFs We also reviewed the data to see if any of the larger fluctuations in the RMB/US$ (specifically the 1993 devaluation) were matched by the HK$ and conducted a brief literature review about the likelihood of a simultaneous devaluation of the RMB and HK$. RESULTS See Exhibit 1 for results of our analyses. Examining plots of movements of the RMB exchange rate against gains/(losses) on HK$ forward contracts reveals little consistency. Regressions on these data indicate that R-squared values are all less than 0.03 revealing that little of the change in exchange rate can be tracked by the gains/(losses) on forward contracts. In addition, it appears that the volatility of gains on the forward contract is approximately double that of the movement in the RMB exchange rate. Is it possible that this hedge might be more useful simply in hedging a devaluation of the RMB as opposed to small day-to-day fluctuations? Evidence from the 1990 and 1993 RMB devaluations (approximately 10% and 30%, respectively) suggest that this is not the case. In addition, an August 2000 study suggests that, although a RMB devaluation might trigger a speculative attach on the HK$, there would be little effect on Hong Kong s trade balance following a Yuan devaluation. 2 METHODOLOGY Hedging forward interest rates A second method of hedging a RMB exposure employed at Bank of America involves taking long positions on HK$ interest rates. One way of taking a position on HK$ interest rates is the use of an FRA. This is essentially a non-deliverable interest rate swap. Should the interest rate rise over the time period of the FRA, the seller of the FRA would compensate the buyer for the higher interest rate which the buyer would be 2 Wei, Liu, Wang, and Woo, The China Money Puzzle: Will Devaluation of the Yuan Help or Hurt the Hong Kong Dollar?, submitted to China Economic Review, August 8, Hedging Strategies for the Renminbi 3

5 required to pay on a notional amount borrowed. The formula for the settlement is as follows 3 : Settlement = Hibor forward rate 1+ Hibor We gathered data on the three-month HIBOR and three-month forward on the threemonth HIBOR as well as the exchange rates discussed above. To evaluate the efficacy of this hedging method, we assume a $1,000,000 exposure to the RMB. Over the same time periods used in the previous analyses, we evaluated what the gain/(loss) would have been given the actual fluctuation of the currency. We then evaluated what notional amount of an FRA would have been required to offset this difference. To further refine the method and given that this strategy may be more appropriate in hedging a potential devaluation of the RMB then the small day-to-day movements, we took the average notional amount from the time period around the 1993 devaluation and calculated what would have happened over the entire data set if an FRA for that amount was carried continuously. RESULTS The results of our analyses indicate large variability in the size of FRA required to hedge a RMB exposure of $1,000,000. The following table should give some sense of just how unpredictable this method could be. Initial Gain/(Loss) Notional Amount 1990 through through 2001 (post handover) Average ($) St. Dev. ($) Average ($) St. Dev. ($) (10,200) 51, (4,119,333) 223,680,535 (9,650) 421,455 However, with the exception of the devaluation periods, the unhedged losses were minimal. If we chose to hedge against a devaluation by utilizing the average size FRA which would have protected us during the 1993 devaluation (notional amount $(70,000,000)), and carry this contract over the entire data set, we would have the following net gains/(losses) including the hedge: Gain/(Loss) with Hedge 1990 through through 2001 (post handover) Average ($) St. Dev. ($) Average ($) St. Dev. ($) 119, , , ,364 3 Shapiro, Alan C., Multinational Financial Management, Sixth edition, 1999, p Hedging Strategies for the Renminbi 4

6 Here, the mean gain has increased greatly over the initial (loss) shown above. However, the volatility of the return has been magnified by a factor of seven and 495 for the entire data set and post-hand over, respectively. As our research indicates, this hedging strategy does not provide any protection for a RMB devaluation. On the contrary, when the RMB and HK$ pegs hold, the proposed hedging strategy will add more volatility than if left unhedged. See Exhibit 2 below. CONCLUSION We conclude from our study that neither hedging strategy proposed would have been effective over the period of time we conducted our analysis. Hedging the RMB using HK$ forwards would not have worked because we found no evidence that their values closely track one another. Furthermore, the likelihood that the there could be a devaluation on the RMB without a corresponding devaluation in the HK$ casts doubt on the future effectiveness of this strategy. Hedging using interest rates would also not have been effective because we did not find strong evidence that a devaluation in the RMB is accompanied by an increase in the HK$ interest rate; instead, we found a great level of volatility in the payouts and unrealistic required contract sizes. It is possible that the limitations in our data sample and lack of information on what specific instrument Mr. Gong would use to hedge using HK interest rates could have led our invalidation of the proposed strategies. Still, the optimal solution to the problem of hedging the RMB would seem to lie in a more liquid offshore NDF markets for the RMB, and better still on a change in the Chinese government policy to open up the capital markets and provide competitive onshore NDF hedging alternatives. In addition, in evaluating the interest rate hedge, we only considered one interest rate term, the three-month Hibor. We have also only considered one method of taking a position on the interest rate. It seems likely that Bank of America has an alternative to this method. Hedging Strategies for the Renminbi 5

7 EXHIBIT 1 Hedging using the HK$ forwards as proxy 1/86-12/97 RMB (1 month spot - spot) y = x R 2 = HK$ (1 month forward - 1 month spot) 1/98 to present 0.04 RMB (1 month spot - spot) y = x R 2 = HK$ (1 month forward - 1 month spot) Hedging Strategies for the Renminbi 6

8 EXHIBIT 2 Histogram With Hedge Without Hedge Frequency - With Hedge Bin More Frequency - Without Hedge Hedging Strategies for the Renminbi 7