Sitting ducks left out of currency hedging game
There are increasing signs that Beijing will allow greater flexibility in the yuan, as indicated by recent comments by Premier Wen Jiabao and visiting officials from the European Commission. But whether the expected acceleration in yuan appreciation will mean a headache or a blessing for businesses on the mainland will depend on who you are.
For most export-oriented private entrepreneurs who receive revenue in US dollars and pay in yuan, it may feel like being a sitting duck with the country's restrictions on currency hedging. But for the privileged, it means more windfall profits.
Let's start with the lucky ones. Shenzhou International is a Jiangsu-based, privately-owned manufacturer making knitwear for international brands such as Uniqlo in Japan. It's listed here.
Given that the firm pays its raw materials costs and wages largely in renminbi and receives mainly US dollars, and given that the yuan has appreciated 7 per cent against the US dollar in the past year, one would assume some exchange losses.
But no; Shenzhou recorded 24 million yuan in exchange rate-related gains in the six months ended June 30. For a company earning 285 million yuan in operating profit, that's quite a figure.
The windfall came because the company was able to arrange US dollar forward sales contracts, hedging its US dollar income against potential yuan appreciation, and at the same time strike some US dollar/renminbi non-deliverable forward contracts, gaining from a low-risk arbitrage.
This is how it works. Because of mainland capital controls, there is a huge gap in the price of the yuan between the restricted onshore and open offshore markets. In the case of a one-year forward contract, you get 7.3531 yuan for US$1 onshore and 6.708 yuan offshore.
Through the above-mentioned contracts, Shenzhou is buying yuan with dollars at the onshore rate and selling at the offshore rate. Even with a 30 per cent fee, one can still pocket a 4.5 yuan gain from every US$100 deal.
'It's a free-lunch arbitrage,' said the treasury head of an international bank.
If the gain sounds too small to you, consider the amount of money involved.
The size of Shenzhou's foreign exchange operations dwarfs its turnover. Turnover was 2.9 billion yuan last year and 1.5 billion yuan for the first six months of this year. Yet the total amount of its US dollar forward sales contracts and non-deliverable forward contract stood at US$736 million (about 5.44 billion yuan) and US$676 million (about 4.98 billion yuan) respectively at June 30, according to its interim report. That was six times the record reached in 2006.
To many of us in Hong Kong, this all sounds ordinary. Not so for the majority of people on the mainland.
I've casually browsed through the interim and annual reports of six privately-owned export-oriented companies. None of them enjoys Shenzhou's operations. In fact, most have suffered exchange losses as the yuan appreciated.
Why? The trick is in getting US dollar forward sales contracts - buying yuan with dollars - which is dominated by mainland banks and tightly controlled by the State Administration of Foreign Exchange. Approval is difficult to get.
How difficult? The financial controller of a Guangdong-based manufacturer has a very illuminating experience to tell.
Like Shenzhou, his firm produces for international brands. It recorded annual turnover of US$900 million. It, too, is listed in Hong Kong. Guess how large a US dollar forward sales contract it got after much hard work. US$3 million!
'Here we are only talking about ordinary hedging demand,' he said. 'To get a contract size that far exceeds your normal business; you have to be extremely well-connected.'
Why has Shenzhou has been able to make this juicy arrangement with predominantly domestic state-owned banks? I've asked the company but they haven't replied. Its interim report says it does not speculate and the amount to be hedged will depend upon expected revenue, purchases and capital expenditure requirements.
Without the 'charm' commanded by a few, the majority can resort only to the more expensive and risky option of hedging their dollar income.
First, increasingly popular non-deliverable forward contracts offered by not just international banks but also mainland ones. It's expensive because not many are betting on yuan depreciation. A 3 per cent premium is the minimum cost, according to several bankers.
Second, derivative instruments such as exchange rate-linked notes - more and more investment banks are pledging these and more and more companies have said they are considering them. But one Hong Kong-trained financial officer doubted many mainland managers genuinely understand the complexity and the risks.
Repaying renminbi loans with dollar borrowings, expanding domestic sales and increasing efficiency are the last three options suggested by many in their annual reports. But we all know how far-fetched those options are.
Now, you can understand what I mean by 'sitting ducks'.