Routes other than ‘dim sum' bonds might make more sense for exposure to China's currency over the short term, suggests Hayden Briscoe
Some commentators predict that China's renminbi could overtake the US dollar as the world's principal reserve currency in the next decade or so. Only a few years ago such predictions would have been dismissed as fantasy, but the currency has come a long way since 2009 when Beijing made its initial steps to promote its use to settle trade transactions and opened up the renminbi bond market. A sign of the times: Argentina's soya bean crop is now already settled in renminbi.
Despite - or maybe because of - the global economic situation, most market analysts agree that great opportunities still lie ahead for China and its currency. Certainly, in our view, the Chinese government does not want to be forever forced to buy US Treasuries. Over the longer term, it would like to see borrowing and trades settlement in renminbi.
We have a positive long-term view on both China and its currency. Over the last two decades, when Asia has been the driving force behind the bigger role played by emerging markets in terms of global GDP, around half of the region's growth has come from China. In the short term, however, we think that investors should carefully consider what form their renminbi exposure should take.
Last year China took further steps to open its currency market by making it easier for banks originating and receiving payments on behalf of companies trading with China to gain access to the mainland's interbank bond market.
Supported by China's economic growth, the resulting pool of offshore RMB or CNH now accounts for around 7% of china's import and export trade - a staggering level, considering that it has only been around for about 12 months.
Investors have also taken a shine to the currency, converting out of predominately Hong Kong and US dollars into the renminbi. The deposit base in offshore RMB has grown from around RMB104bn (€12bn) in July 2010 to RMB572bn as of August 2011.
For now, the liberalisation primarily means investors have more freedom and opportunities to access Chinese markets and renminbi-denominated funds, mainly through ‘dim sum' offshore bonds available in Hong Kong. And this is just the beginning of a five-year plan to liberalise the currency market. Ultimately, the freeing up of capital flows could allow the country to develop into one of the largest bond markets in the world, in our view, rivalling Europe and the US.
Measured by purchasing power parity (PPP), the renminbi still looks around 20% undervalued against the currencies of China's trading partners, indicating that there is further appreciation to come. While the currency has thus far traded within a relatively restricted range, we anticipate some widening of the volatility bands. This suggests that there will be some twists and turns in the renminbi's path to becoming one of the world's main currencies.
The Chinese government's commitment to this path and the support of the Hong Kong market was recently confirmed by Chinese vice-premier Li Keqiang, who is tipped as successor to current premier Wen Jiabao. Comments made during Li Keqiang's visit to Hong Kong in August were aimed at promoting more international use of the currency. The vice-premier unveiled plans to allow foreign investors to buy mainland securities up to a quota of RMB20bn. No timing for this long-awaited scheme, known as mini-QFII (Qualified Foreign Institutional Investor) was given, but the move would give QFIIs a crucial new avenue for investment in the currency.
All this should make renminbi currency exposure through dim sum bonds appealing to investors in the long term. However, current off-shore yields are depressed by the demand and there is a lack of issuer and industry diversification: 70-80% of dim sum bonds are backed by government, banks or property.
So the current investment environment raises serious questions about whether the return justifies the risk. That's why investors are looking at alternative ways to get exposure to the renminbi. One option would be to find a way of benefiting from Asian bond yields, while hedging returns back to the renminbi.
Asia has traditionally been regarded as part of the emerging market category, yet its economic performance during the last 10 years has been such that it deserves consideration in its own right. Asian countries also score relatively highly in terms of creditworthiness, whether one is looking at their international reserve assets and sovereign credit-rating trends, or at macroeconomic measures such as debt, liquidity, growth, the overall political environment and policy. Similar comments can be made in respect of Asian investment-grade corporate bonds, which offer a yield premium to the Barclays Capital Global Aggregate Credit index, while their issuers generally having stronger balance sheets than their global counterparts. The average yield on Asian government bonds is significantly higher than on US, Japanese and German bonds.
So, China's economic importance and its moves towards currency liberalisation make us long-term bulls of both the renminbi and the opportunities offered by the dim sum market. However, the balance of short-term risk-adjusted benefits appear to lie with the bond markets of China's Asian neighbours.
Hayden Briscoe is director in Asia Pacific fixed income at AllianceBernstein