Unpacking the CNH Premium
At the time, I did not pay much attention simply because these surges, accompanied typically by surging RMB HIBOR rates, happened every 3-6 months for the past 12-18 months. They would spike and fall back within a week.
However, this time the CNH has maintained a lengthy and very sizeable premium to the CNY. The CNH is currently trading at about a 600 pip premium to the CNY and over the past month has largely fluctuated between a premium of 400-600 pips. In FX markets where large changes are considered 0.5% in a day, a currency trading at a premium of nearly 1% is enormously anomalous. (Please see the update at the end of this piece as the discount disappeared today and I had written this piece before the discount has shrunk considerably.)
In any real market, and no Chinese FX markets are nothing more than Potemkin markets, a pricing arbitrage opportunity of this size would be arbitraged back to non-existent in the blink of an eye. However, given this ongoing differential we have to ask ourselves what exactly is happening and what does this imply going forward.
With any pricing discrepancy for identical assets, this opens up enormous arbitrage opportunities. An RMB in Hong Kong is fungible, relatively easily transportable, and interchangeable. Consequently, when the value of the CNH and CNY diverge by appreciable amounts, this will create arbitrage opportunities. So how do firms take advantage of the arbitrage opportunities and what does this tell us about the intended outcomes?
When the CNH is at a premium, this gives firms an incentive to repatriate USD from Hong Kong to the Mainland. Let me give you a simple example of how a physical trade like this might move. A Mainland parent company has a Hong Kong subsidiary. The Mainland parent company exports something, maybe a fictitious, overvalued, or perfectly legitimate trade, to the Hong Kong based subsidiary.
To pay for the import into Hong Kong from the Mainland parent, to take advantage of the CNH premium, the offshore subsidiary wants to send USD back to the Mainland. Because the Hong Kong subsidiary has offshore USD deposited, the subsidiary remits back to its Mainland parent USD to pay for the physical trade of goods.
Let’s assume the CNH is trading at a 1% premium to the CNY. On a $10 million USD transaction at approximate current exchange rates, this would result in a profit of nearly $100,000 if hard currency is remitted back to Hong Kong via an offsetting physical goods trade. Throw in various methods to boost the returns like adding leverage and the ability to make significant profits are obvious.
What should be happening is that USD is flowing from Hong Kong to the Mainland and RMB is moving from the Mainland to Hong Kong. We do not have recent enough data to know if this is happening but should know in the near future. The currency moves like this because it is cheaper to buy RMB on the Mainland with USD than in Hong Kong. Consequently, firms will try to send RMB to Hong Kong and USD from Hong Kong to the Mainland.
What makes this interesting is that Beijing is incredibly intent on stopping RMB outflows effectively limiting this arbitrage opportunity. French investment bank Nataxis estimates that RMB flows were balanced in December and new banking regulations require balancing the RMB flows with Beijing actually required to run a surplus in RMB flows. We see this in banking regulations requiring banks to balance their RMB flows and banks in Beijing actually required to run surpluses.
The net effect of the premium coupled with the limiting of RMB outflows is that Beijing is trying to suck in USD. As I have covered here previously, there is increasing suspicion that Beijing has been drafting in non-public entities to help prop up the RMB. If their ability to buy RMB with hard currency has been impaired to such a degree that they are straining, this may explain engineering a CNH premium to push USD back to the Mainland.
The other interesting point here is that when the CNH was at a discount from August 2015 to December 2016, this essentially created an incentive to move RMB onshore and take USD offshore, the reverse of what is happening now. What is interesting, as also previously noted here, is that there were large RMB net outflows from the Mainland to Hong Kong. This matters for two specific reasons. First, because the CNH was trading at a discount, that meant that it was actually more expensive to turn that RMB into USD in Hong Kong. This essentially runs counter to the price incentive. What that likely implies is that many simply could not obtain hard currency on the Mainland and consequently sent RMB to Hong Kong, even at a small loss, so they could buy hard currency. We have to assume that these were not major SOE’s who would likely have little trouble obtaining hard currency.
Second, what theoretically should have been a decrease in offshore RMB in 2016 actually was a sizeable decline despite the empirical reality of significant net RMB outflows for all of 2016 tapering as the year progressed. This implies that banks, either SOE’s or the PBOC, were buying up surplus RMB and repatriating it to China. This may explain the asymmetric push to now repatriate hard currency to China. If SOE banks were acting at the behest of the PBOC buying up surplus RMB to limit its fall using their own USD, they may be running short on the USD necessary to act as a buffer. It is worth remembering that the PBOC stopped reporting the bank holding of foreign currency about a year ago. By stopping net RMB outflows and encouraging USD net inflows via the CNH premium, the hope is to act as a type of off balance sheet FX reserve recapitalization.
Beijing in crafting its policies, despite the PR, create situations that are the standard “heads I win, tails you lose” scenarios. Most every currency policy released within the past year is designed to strengthen the one way movement. By that I mean, easing the ability to get capital into China while continually restricting the ability to capital out. Given the current premium, it appears that Beijing is trying to attract hard capital inflows counting on its ability to restrict RMB outflows.
UPDATE: I had written this over the days earlier this week. When I woke up this morning as I am currently in the US, I saw that most of the CNH premium has disappeared in one day. I am still posting this as it may come back and I think these concepts remain important.