Nothing highlights China's problems better than the Yuan's onshore / offshore spread

Wednesday 6th January 2015

Nothing highlights China's problems better than the Yuan's onshore / offshore spread

 ref :- "Renminbi poses communication challenge" , the Financial Times, Markets and Investing p.30

All in all, it's been a pretty bloody start to 2016 and a good deal of the blame is being laid at China's door. Weak surveys of both manufacturing and service activity have added to fears that the slowdown in China's economic growth might be more severe than generally expected (or at least hoped) , and the effect on everything from global equity markets to the price of crude oil has been pretty painful. Once things had calmed down after last August's hiatus, the markets seemed happy enough to turn a strangely blind eye to China's issues but it would be fair to say that attention is squarely back on them now. The widespread concern about the immediate prospects for the Chinese economy is being particularly well reflected in the fortunes of its currency, the Yuan (or Renminbi), which is at its weakest for 5 years and for which the official, onshore rate against the US dollar has traded as high as 6.56 . Remember, the Yuan was trading at around 6.20 before August's devaluation, and still below 6.40 just after it.

A fair few traders have expressed some confusion over the actions of the People's Bank of China (PBoC) on this topic. In accordance with its stated intentions at the time of the devaluation, the PBoC has allowed the daily fixing rate to determined largely by market forces (i.e. progressively higher / weaker) and at times set the fix even higher than they were theoretically obliged to. At the same time, they have been intervening in foreign exchange markets in support of the Yuan. The two actions might seem contradictory, but in fact are not so hard to understand. The PBoC will not be unhappy to see a weaker currency  --  and the beneficial effects it brings to exports and the economy  --  but would not want to be seen to be actively encouraging it and thus open themselves to accusations of conducting a currency war by the back door. Voluble US politicians are always particularly keen to level this charge, especially in election year. The intervention is also intended to smooth and control market movements rather than reverse them  --  what the PBoC would definitely NOT want is an uncontrolled and panicky sell-off that would encourage the sort of capital outflows it desperately wants to avoid.

So what about this onshore / offshore thing ? For newcomers (and perhaps not so new), it might be useful to remind ourselves of how the offshore Yuan / Renminbi came about  and of the difference between the two. In the early noughties, China began the long process of internationalising its currency. To quote the Business Insider : "As China began to open up its economy, it wanted its currency to be used in the international market to settle trade and financial transactions without, however, fully opening up its capital account". Hence the establishment of an offshore currency that is not restricted to tight trading bands like its onshore equivalent and "is free of Beijing's control in that regard."   There are a number of financial centres with offshore Yuan markets, but naturally enough Hong Kong is by far the largest and most important.

The two can trade at parity (well, why not ?) and we have in the past seen the onshore version mildly weaker than its offshore counterpart (when China was still riding the wave, so to speak). More recently, we have become used to the offshore unit being a touch weaker, say 200 - 300 pips. Now look at the current numbers : US$ / CNY (Onshore) 6.5540 ,  US$ / CNH (Offshore) 6.7100 , a differential of over 1500 pips and a record in itself. Since it's the offshore unit that is free of artificial restraints and therefore the more definitive view of the market's view of things, it's plain that not too many are overly optimistic of China's performance for the near future.

Virtually everyone has been predicting a weaker Yuan over 2016, but some of the less radical forecasts have already been reached. It'll be interesting to see how many targets are revised, even if doing so in the first week of January is a touch embarrassing.

LOOK OUT FOR THE FED MINUTES TONIGHT .....

Just a heads-up that the minutes of the FOMC meeting in mid-December that preceded the announcement of the first rate hike will be released tonight. We know that the vote to hike was unanimous, but that's not the same thing as all members being of the same mind with regard to the larger picture. The markets will be desperate to sniff out any particularly hawkish or doveish revelations that might offer a pointer to the committee's thinking on the future for rates, inflation etc. No doubt they'll find something to get excited about, but not for the first time we'd urge a little caution : it's only been a few weeks, but already the landscape is looking a bit different to the one that the Fed was surveying on Dec 16th ..... and not in a good way.