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Currency Management: More than one way to play the renminbi

Theory and history suggest that China’s currency should appreciate along with its economic growth. But Charlotte Moore finds investors looking for other routes besides the fast-growing ‘dim-sum’ market

As a nation moves from an agrarian to industrialised economy and makes signifi-
 cant strides in productivity, theory – and empirical evidence – suggests that its currency will tend to appreciate steadily over time, reflecting the steady growth of the economy.
So it is no wonder that the currencies of emerging markets set to benefit from long-term macro-economic trends – and especially that of the biggest economy of all, China – are attracting attention from institutional investors.

“Despite near-term headwinds we believe in the medium term both income and productivity in China will continue to rise, which will increase the value of the currency over time,” says Jeremy Cunningham, senior portfolio manager for the bond team at AllianceBernstein. “The renminbi still represents a tiny proportion of total global transactions – which is out of line with the size of the economy. Over time, the currency will recalibrate to be a more accurate reflection of the importance of the Chinese economy.”

There is another major benefit to the Chinese currency – it is not volatile compared with other currencies. It is not a free-floating currency but instead pegged every day to a trade-weighted basket of other currencies. As the US dollar makes up the majority of that basket, and the currency is restricted to changing its value by more than one percentage point every day, it lacks volatility.

Value appreciation and lack of volatility, however, are not the only reasons to buy the renminbi; it is also a very safe asset with the potential to become one of the world’s reserve currencies.

There are currently two reserve currencies – the dollar and the euro. But neither of these look very safe. The US is running a high fiscal deficit, while the European sovereign-debt crisis is threatening to undermine the long-term strength of the euro.

James Kwok, head of currency management at Amundi, says: “Long-term investors need a third reserve currency. The most likely candidate is the Chinese renminbi, given the size and growth rate of this economy.”

The emergence of the renminbi as the third reserve currency might take less time than some anticipate. There is good historical precedent for new currencies to quickly surpass existing systems. The US dollar became a currency of international settlement in 1913 with the establishment of the US Federal Reserve System. Within 15 years, the dollar, rather than sterling, was the most favoured settlement currency.

Exposure to the Chinese renminbi also provides diversification for investors. Geoff Lunt, investment director of Asian currencies at HSBC Global Asset Management says: “The risks are skewed in the investors’ favour in a currency that will be a good diversification away from the more established currency markets.”

There’s one last benefit to investing in renminbi for pension funds, linked to its potential to act as a claim on China’s economic growth: it could provide a hedge against inflation. Cunningham says: “The Chinese currency is likely to appreciate more rapidly than inflation, which could provide important protection for pension funds.”

While it might not be as volatile as other currencies, the controls on the Chinese currency clearly make it more difficult for investors to benefit from its long-term appreciation. It is becoming easier, however, for foreign investors to buy the currency; the Chinese authorities recently launched an offshore currency market  in Hong Kong.

Andrew Seaman, partner and fund manager at Stratton Street Capital, says: “There are two ways of getting exposure to the currency – through non-deliverable renminbi forwards, which works for currencies that are not freely convertible. Or investors can buy the Hong Kong currency.”

There is another alternative. As well as an offshore currency, there is an offshore bond market in Hong Kong, known as the ‘dim sum’ market. There are a variety of issuers including sovereigns and both investment grade and high yield corporate bonds. This is the only source of Chinese corporate bonds for foreign investors.

“This market is very illiquid. The maximum bond issue size is $200m dollars. The benchmark size bond issue in the US would be at least $500m, if not $1bn,” says Seaman.

The popularity of the dim-sum market has meant that it has exhibited some unusual characteristics since its inception a year and a half ago – corporate offshore bonds have lower yields, of around 200 basis points, than Chinese government onshore bonds.

“It’s a particular quirk of the supply and demand dynamics of the offshore bond market that the financing costs for a corporate are less than for the Chinese government,” says Seaman. “In our view, that makes it a very expensive market for investors.”

Indeed, the spread between the yields on the dim-sum bonds have risen towards those on the local bonds, resulting in losses for offshore-bond investors.

“This narrowing in the yield spread can be explained by the recent concerns over the strength of the Chinese economy,” Seaman suggests. “Some investors may have lost confidence in the Chinese currency story and sold their offshore bonds. But other investors, like us, who think that Chinese currency appreciation is a long-term opportunity still consider these bonds to be too expensive, so have not bought those bonds and the price has fallen as a result.”

Last year there was a very strong expectation that the renminbi would appreciate, which drove demand for dim-sum bonds and this increased issuance. Towards the end of last year, however, the European sovereign-debt crisis in the autumn made investors risk adverse which, in turn, slowed down issuance in the dim-sum market. At the start of the year the dollar rebounded while the Chinese economy slowed down, causing both demand and issuance to drop.

But there has been a recovery in recent months. Sean Chang, head of Asian debt at Barings, says: “Over the last six months, there has been a doubling in monthly issuance to CNY20m (€2.5m). In 2011, total renminbi issuance was more than CNY200bn, almost triple the amount in 2010. This year, we expect issuance to be about the same as last year, [and we further expect] new issuance to almost be double next year, at approximately CNY400bn.”

Even though prospects for growth are good, the dim-sum bond market is still a fledgling market, so there is limited supply. “Over the longer term, the market will become a very attractive opportunity for investors to capture good risk-adjusted returns,” says Cunningham.

There is a way, however, for investors to benefit from the appreciation of the Chinese renminbi without relying on the dim-sum market. “Dim-sum bonds are too expensive, so instead we buy pan-Asian dollar-denominated sovereign and corporate bonds, then use non-deliverable forwards to gain exposure to the Chinese currency,” says Seaman.
Stratton Capital is not the only investor to take this route; this is also the strategy used by AllianceBernstein.

“We have the flexibility in our renminbi fund to invest 100% of the fund into the dim-sum market but we currently only have around 3% of those assets invested in that market,” says Cunningham.

Cunningham is wary of the dim-sum market for a number of reasons. “There are offshore deposits worth $600bn in Hong Kong, which is three times the size of the dim-sum market,” he says. “That means that demand far outstrips supply. In addition, these bonds are bought and held to maturity which, in turn, drastically reduces the liquidity of the dim-sum market.”

Cunningham also has concerns over the quality of some of the bonds available on the dim-sum market. “Some of the companies that issue are ones that we would not want to invest in,” he says.

Kwok concurs: “The high-yield dim-sum bonds do not give investors a very pure exposure to the Chinese renminbi. Investors are also taking on considerable levels of credit risk.”

In addition to buying dollar-denominated bonds and hedging the currency exposure, AllianceBernstein also carries out swaps between offshore and onshore renminbi. “There are sometimes dislocations between these two currencies which we can exploit,” says Cunningham.

Managing this type of portfolio takes considerable skill. “You need to ensure that on a particular day you will not be rolling your currency hedge for a significant proportion of your portfolio, as that could have a considerable impact on the returns of the fund,” he adds. The fund takes a ladder approach to minimise this risk.

The constraints on the Chinese currency market mean that pension funds have to take a lateral approach to this asset class. But the long-term growth potential of the renminbi is such a significant macro-economic trend that institutional investors could be well rewarded for moving outside of their comfort zone.

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