By Nilly Essaides
While China may be years away from floating the renminbi, there are ongoing signs of progress, which in turn can help treasury chart its capital, cash and risk management strategies for the country.
The recent, highly politicized and highly visible debate about China’s currency regime has again brought China into the forefront for MNC treasury managers. Not that treasurers needed a reminder of the growing challenge of managing cash (building up and increasingly in local currency) and risk in China.
While the simple answer is that there’s no sign of any imminent change in China (e.g., floatation of the currency or even a peg change), there are certainly signs of progress that point to the path that China is following toward eventual liberalization of its FX and capital controls, and this can help guide MNC treasury strategy.
Will they, or won’t they?
Most experts on China agree that there’s no reason to expect the government to change its current exchange regime, at least in the foreseeable future (ditto for its capital account controls).
“China has indicated that it’s committed to making the renminbi freely convertible—eventually,” says Howard Chao, Esq, head of the Asia practice for law firm, O’Melveny & Myers LLP. However, before China can do that, it must rehabilitate the Chinese financial system, i.e., shore up the local banks’ weighty portfolios of bad loans, and create a financial infrastructure that would withstand any “run” on the banking system a’ la the ‘90s Asian crisis.
Less dramatic changes, such as (a) altering the peg system or pushing up the peg (currently at Rmb8.277:US$); or (b) widening the band around the central rate, are more likely in the intermediate term, Mr. Chao notes. “The exchange rate may eventually move,” he says. “That’s an easier issue than full convertibility. There’s no chance that’s going to happen any time soon.”
Clyde Wardle, HSBC’s emerging markets currency strategist agrees that banking reform is a prerequisite step on the way to currency liberalization. Currently, he notes, there are several reasons why China should not and will not alter its approach to FX:
(1) External pressures won’t do it. China simply does not want to bow, or even appear to bow, to external pressures. Plus, the motivation for these outside pressures is highly suspect (for American politicians, in particular). Equally suspect (read: uncertain) is broad US support for such moves, given that among the largest beneficiaries of the undervalued renminbi are US companies with operations in China.
Mr. Wardle notes that China also holds enough “purse strings” (via its massive holdings of US government debt and euro reserves) to deflect any sanctions; plus, as a WTO member, it enjoys its protection (see box).
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What’s manipulation? The latest anti-Chinese FX regime move came last week, when the US National Association of Manufacturers asked the Bush Administration to lodge a formal trade complaint against China with the WTO for “manipulating” its currency for the purpose of gaining an unfair trade advantage. The complaint is that the peg is an unfair trade practice for China and others. The reality is broader and more complex. A bi-polar FX world The bigger picture, notes Steven Roach, chief economist with Morgan Stanley, is the increasingly bipolar nature of the FX market: Dollar + linked (or de-facto dollar) currencies vs. the euro. In practical terms, such a a bipolar approach means continued EUR/USD volatility, since it’s the only outlet for the pressures. Asia, he notes, has more reasons than trade to keep its pegs going. (So much was proven when China did not devalue when Asia was falling apart.) Another key reason is that the peg is a nominal anchor for inflation control. “By and large, Asia’s banking systems are still weak,” he notes. The pegs are a substitute for “using an explicit inflation target or central bank credibility.” It also helps “harmonize” Asian monetary policy, by using the Fed as a proxy. Of course, even if some Asian countries abandoned their soft pegs, they can always continue to “manipulate” their rates like Europe and the US have done, by open-market intervention. |
Mr. Chao also points out that the Chinese government has demonstrated that it will not give in to pressure on either side of the peg, when it did not—as many had feared—devalue its currency in the wake of the Asian crisis.
(2) Domestic “fundamentals” speak against it. Indeed, there are solid internal reasons not to liberalize the FX regime at this stage. And those seem to have the support of the Europeans and the IMF, which has been concerned about the Chinese banking system.
Currently, the export sector is China’s main engine of growth, and revaluing the currency would be counter its purpose of leveraging exports to help weaker areas.
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FX rules The renminbi is only convertible on the current account since 1996, for trade-related transactions and on the capital account for approved capital items. • Foreign investors can sell FX for local currency, when they inject capital with SAFE approval. • FX transactions must be executed by the China Foreign Trading System through a Designated Foreign Exchange Bank. • The quoting of the exchange rate against the US dollar is limited to 0.15% on either side of the reference rate. • The buying price of other currencies against the renminbi should not exceed 0.25% against spot and the deviation against the yen is capped at 1%. • FX forwards (onshore) are permitted with 4 SOE banks, with 12-month duration and one roll over (to 24 months). • Currency options are not available (onshore). • Hedging of expected risk, or projection hedging, is not allowed. Source: HSBC |
(3) It’s not so “undervalued.” Finally, the renminbi, while estimated to be about 20-25 percent undervalued, is not outrageously undervalued, compared to its neighboring currencies. (Korea’s won is about 20 percent undervalued, for example.) And, even if the renminbi were to revalue, say by 10 percent, that would not do much to eradicate the vast cost differential between producing in China (where average factory workers earn $1,200 annually) and the US (where the same workers earn nearly $30,000).
This cost comparison is a key driver of the nearly 50 percent hike in Foreign Direct Investment (FDI) into China in the first five months of 2003. Yet the growth in fund inflows has also been causing much of the upward pressure on the renminbi. This has not only sparked the trade-related complaints from US politicians, but also active intervention by the local central bank. Plus, the inflow of funds has left the market awash in liquidity, raising concerns about potential inflation/overheating
Big plan, little steps
But while economists and FX experts predict that there’s little chance that China will dramatically alter its FX regime any time soon (i.e., in the next 12-18 months), there’s change ongoing in what the local authorities will allow companies and banks to do, regarding their capital flows and their FX exposures.
“There’s a trend toward loosening of controls,’” confirms Mr. Chao.
More hedge options. The latest news is that the onshore hedging market is slowly being expanded. Until recently, according to HSBC’s Mr. Wardle, the only onshore FX hedging permitted was:
(1) With the Bank of China (commercial, not central bank);
(2) Related to trade flows; and
(3) Under six months in duration.
That in part is why there’s such a flourishing, offshore, non-deliverable forwards (NDF) market to hedge local exposures. Those rules are now being relaxed, albeit only slightly.
• There will be four big, local (SOE, or state-owned) banks allowed to engage in onshore hedge activity;
• The hedges may not have to be related to underlying trade activity; and
• The forward contract duration can be 12 months, and the contract can be rolled over for an additional year, or up to 24 months.
Of course, entering a 12-month trade with a local bank is an iffy proposition, given the health of the local banking system, and foreign banks are unlikely to gain such privileges much ahead of the 2007 deadline for allowing licensed foreign banks to compete on equal footing. (Hence offshore NDFs are the likeliest choice for hedgers.)
Does hedging even make sense?
Since FX strategists do not expect any massive change in the renminbi’s fortunes, the cost of hedging local exposures is minimal. But does it even make sense to hedge long renminbi exposures? The answer depends on a few parameters:
• The cost of the hedge; and
• The market’s expectation of what the band may look like in 12-24 months.
• And worse-case scenario planning.
The answer to the first is that there’s no cost to hedging. In fact, recent NDF one-year forward rates were 2.5 percent below spot, so hedgers can earn money on the hedge.
As to the chance of revaluation, the market predicts a 5 percent shift in the renminbi’s rate over the next 12 months. Of course, the probability of such a move is very difficult to gauge, and so it remains up to companies to draw their own conclusions (and worse-case scenario planning; see IT, 5/5/03).
An offshore “halfway house?”
One potential intermediate step toward a freer FX regime, Mr. Chao says is the establishment of an offshore renminbi center in Hong Kong. While there’s been some political resistance to this step within China, this does not mean that idea won’t fly. Indeed, it appears to be one of the likely milestones on China’s path toward financial reform.
Exactly what an offshore center may include is not clear. Certainly, Mr. Chao notes, it would involve allowing banks in HK to take renminbi deposits and creating an interbank/clearing mechanism. (Currently, banks in HK have to physically cart their renminbi cash piles into China.) It may also entail giving banks the ability to lend/borrow in renminbi, and perform FX trades.
All this would be good news for foreign MNCs wanting to transact with more credit- worthy counterparts, and within the clearer legal framework of HK. It would also give China a chance to float a “trial balloon” to test the market’s reaction to a freer FX regime. “It [the liberalization of the exchange regime] will happen,” says Mr. Chao, “but it will happen in steps.”
Loosening the liquidity “noose”
A change in the FX rules is one way to relieve the building pressure in the currency system. Another is to allow more funds to exit China, more freely.
Historically, the government has been more concerned about capital flight than capital flow. It has therefore put in place elaborate official and less official systems to make it difficult for local and foreign firms to take money out of China.
For Chinese firms, for example, this has meant a difficult process for get approval for offshore investment, Mr. Chao notes, so much so that only a handful of the largest and best connected state-owned companies were able to make it work.
Yet, a pilot program that encourages the outflow of investment is likely to be rolled out nationwide, and there’s growing emphasis on streamlining the process so that more Chinese companies take advantage of the possibility.
The government may also allow local companies to invest in overseas bonds, or retain more of their foreign currency earnings.
The rules about repatriation of capital and profit for foreign firms, however, are unlikely to be changed soon. Formally, the government allows current account transactions (e.g., royalty payments, dividends, etc), but not the repatriation of capital.
In more practical terms, any transaction to take money back out requires detailed documentation, and very large or very complex current account transactions are likely to be given extra scrutiny. For most companies, the real issue is that their Chinese operations are making more local money more quickly than they can utilize or “export.”
There are also timing issues, Mr. Chao notes. Dividends are typically only paid out once a year, after the financials had been audited and taxes paid. Some companies may want more frequent outflows. However, says Mr. Chao, in special cases where there’s an interim audit and taxes paid, more frequent dividends may be permissible.
China also allows companies to engage in intra-company loans, but on a one-way basis: The foreign parent can lend to the Chinese sub, and receive interest payments. However, cash building up in China can not be used to lend to outside entities. Even intra-country, one sub cannot lend to another, without working through a third-party bank.
Bottom line: While managing cash/risk in China continues to pose a challenge, ironically, it is the country’s resistance to change which offers the best hedge: A relative assurance of no major disruption.