Yuan remains key concern of investors, even after SDR inclusion
Initial inflow to China has been limited since joining the exclusive club of reserve currencies – but the country could attract more by pushing for onshore and offshore yuan convergence
Rising bond inflows triggered by the yuan officially becoming a reserved currency are still not strong enough to offset the outflows brought about by ongoing expectations of a stronger US dollar and overall uncertainties still hanging over China’s economy policy, according to analysts.
Claudio Piron, and Adarsh Sinha, foreign currency strategists with Bank of America Merrill Lynch, have ranked the yuan as one the three main concerns facing global investors, in a research report issued on Monday.
The other two are the US political cycle and its impact on Asian currencies, and doubts over the credibility of the monetary policies of the so-called G3 countries’ (US, Japanese and German) that could undermine a 14 per cent year-to-date total return in Asian local debt.
China’s currency was included for the first time in the International Monetary Fund (IMF)’s Special Drawing Rights (SDR) basket on October 1, giving the yuan the third largest weighting with 10.92 per cent within the exclusive club of reserve currencies, following 41.73 per cent for the US dollar, and 30.03 per cent for the euro. The Chinese currency is ahead of 8.33 per cent for the Japanese yen and 8.09 per cent for the British pound.
Strategists at BoA Merrill Lynch estimate in a new report that the yuan’s entry into the SDR will generate US$30 billion worth of purchases in China Government Bonds (CGBs) because on paper the SDR accounts for 3 per cent of global foreign reserves.
It says foreign holdings of CGBs in the China Interbank Bond Market (CIBM) rose by US$ 16 billion between September 2015 and August 2016, which it added “is consistent” with the official final second quarter’s reading of the country’s balance of payments, which showed there was a net inflow from portfolio investment of US$8 billion, driven by foreign purchases of debt – the first positive reading since 4Q 2014.
“But the fear of inherent vulnerabilities within China, remains stronger than the hope of stabilising flows from the RMB’s entry into the SDR,” it said.
Second quarter balance of payments data, released by the Chinese authorities, shows outflows from Chinese residents’ non-portfolio investment increased from US$29 billion to US$81 billion, the report shows.
An analysis of the data suggests 21 per cent of Chinese residents’ non-portfolio investment outflows since 2002 “were due to economic policy uncertainty, [movements in] the US dollar, and a desire for Chinese residents to diversify their assets, which averaged US$27 billion per quarter”.
“These three independent variables were particularly important in 2Q 2016.”
Aidan Yao, senior emerging Asia economist at AXA Investment Managers in Hong Kong, said besides the confirmed movement of around US$30 billion into China due to the IMF allocation, the inclusion of the yuan into the SDR basket was also a “soft guidance” to global central banks and reserve fund managers, who may develop stronger interest in buying Chinese government bonds.
He suggests the potential inflow could be even be larger in the wider private investment sector, given Chinese government bond yields remain considerably higher than, for instance, US Treasury bonds.
“But a key concern holding back international investors for now, apart from rules including repatriation restrictions, is a lack of tools to hedge risks stemming from onshore investment,” he said.
China opened up its onshore interbank bond market (CIBM) to both sovereign investors and foreign medium- and long-term investors this year.
But so far, only the former group of investors has been granted direct access to the onshore foreign exchange forward market.
Foreign medium- and long-term investors can only hedge their onshore bond exposures in the offshore market, and allowing them full access is probably the next priority for the Chinese authorities, according to analysts at HSBC.
“In our view, the next round of capital account/FX reform measures will likely address this issue, for example by granting onshore banks greater access to the offshore yuan market, and vice-versa,” the bank said in a report issued last week.
It added that by allowing access to both onshore and offshore investors to the CIBM bond market, the influence of Chinese banks in both domestic and offshore foreign exchange curves would be significantly enhanced.
“This would help prevent onshore and offshore FX curves from diverging significantly from each other and bring more flexibility to the onshore FX market,” the report HSBC said.
Heng Koon How, senior FX investment strategist at Credit Suisse, said it was way too early to contemplate merging both onshore and offshore yuan, which would essentially mean the free trade and full convertibility of the currency.
“For this to happen, there needs to be three pre-requisites: In addition to free trading of the yuan, authorities need to free up China’s capital account to allow for full convertibility, and there needs to be a large enough pool of offshore yuan (CNH) investments and trading assets,” he said.
“Unfortunately on that last count, any previous progress made has been reversed.
“The cross border use of CNH in trade for Hong Kong has decreased, similarly CNH offshore deposits and dim sum bond issuance has also dropped, probably the result of on-going market concerns over further depreciation,” said Heng.
“The focus now is to try to rejuvenate the global use of CNH.”