September 2016

Domestic considerations and global uncertainty have ushered in a period of increased foreign exchange risk for institutional investors and multinational corporations with interests in China. Adam Williams speaks to Deutsche Bank’s Managing Director and Global Head of Renminbi Solutions, Evan Goldstein, to find out what is happening and how this can be managed.

It’s a time of great change for China’s economy and the internationalisation of its currency, the renminbi (RMB), as it contends with domestic economic pressures, a slowdown in global trade and increasing two-way swings in the value of the RMB.

The approval by the National People’s Congress of the 13th Five Year Plan for 2016-2020 ushered in a new phase in the development of China’s economy – a more ‘normal’ range of growth in GDP from between 6% and 6.5% over the next few years will lead to a ‘moderately’ prosperous society.  This will occur as the government seeks to simultaneously shift the economy away from its reliance on real estate investment and low cost exports to one driven by domestic consumption and investment in new industries such as clean energy, biotechnology and ‘smart’ manufacturing through home-grown advancements and the acquisition of foreign know-how.

The efforts behind this strategic policy and the continuation of RMB internationalisation, the increasing use of the currency in cross-border transactions, will be symbolically recognised by the international community on October 1, 2016 when the RMB is to be added to the basket of currencies that make up the International Monetary Fund’s Special Drawing Right, commonly known as SDR.  The SDR currently comprises the US dollar, the euro, Japanese yen and pound sterling and the addition of the RMB.

The very successes of past reforms and its impact on the global economy have made China and its currency an indispensible component of multinational corporations’ strategic plans.  However, the past ten months have seen an increase in the level of complexity and concern by investors as they consider their exposure to China and the RMB.

Mixed messages

Evan Goldstein, Managing Director and Global Head of Renminbi Solutions at Deutsche Bank, believes that mixed messages from the government and wider global issues have proved problematic in the short term for further internationalisation of the RMB and raised the issue of currency risk to the front of most investors’ minds.

"Until early 2015, the renminbi was seen as an appreciating currency with very little volatility in terms of movement. Many people, whether individuals, institutional investors or multinational corporates, were counting on that appreciation continuing,” he says.

But by the summer of 2015, leverage in China had risen to its highest ever level. The government’s response – a set of market cooling initiatives including a newly designed circuit breaker system intended to stabilise equity markets – was ultimately thought to have exacerbated investors’ concerns.

A circuit breaker system was designed to halt market trading for 15 minutes if the index fell by 5%, or to suspend trading for the remainder of the day if losses topped 7%.

However, this policy had to be abandoned in January 2016 after trading was suspended twice within a week, with the second instance occurring just 30 minutes after the opening bell.

“The government and regulators were caught out on the failure of the circuit breaker system.” adds Goldstein. “They didn't have a firm grasp on the tiller when it came to communicating their intent to the market and understanding the potential for a ripple-effect across international markets.”

Less than two months later the government announced a change to the methodology used to establish the daily fixing of the renminbi against the USD and effectively devalued the currency by nearly 3% .

This move surprised international markets and sparked the beginning of a rapid selling of renminbi for a variety of reasons.  From June 2015 to March of this year China’s FX reserves declined by about USD480bn.  As well, capital outflows over the same period totalled more than USD452bn – representing a desire by corporates to retire foreign currency debt, invest in overseas assets and protect cash from further devaluation onshore in China.

Pressure diverted

This pressure on foreign exchange reserves has now abated. This is partially due to more transparent and better understood FX policy, a cocktail of macro prudential measures and USD sales by the authorities, and a more gradual and controlled depreciation move than in the past.

Goldstein says a lot of institutional investors are looking to China for positive yields and credit diversification: “If you’re an institutional investor and you’re not perceived as a short-term player, then the regulators have made it much easier to invest into China in both the equities market and, more substantially, the interbank bond market.”

For China’s much-heralded dim sum and panda bonds, the outlook remains mixed. The recent increase in onshore liquidity by the PBoC has vastly reduced the appeal of borrowing offshore using dim sum bonds. Meanwhile, the panda bond market continues to make progress. The government has committed to opening up the market for RMB denominated debt to multinational corporations with plans to recognise international accounting standards and foreign audits.

However, MSCI inclusion – which would have seen Chinese mainland equities added to the firm’s global indices – was rejected earlier this year. This was against the expectations of many analysts but Goldstein remains bullish and believes approval is still ‘on the horizon’.

Structural change

Looking at the wider Chinese economy, the country is expected to continue its move away from cheap labour industries towards services and other industries. Investors in these affected areas must be prepared for this structural change, while those operating in industries such as pharmaceuticals, clean energy and technology are expected to flourish.

“Our clients are having to reassess their business models and the type of investments they make in China,” says Goldstein. “They have to evaluate where they stand with their financing plans. For example, if you’re a large manufacturer who is dependent on cheap labour, or you're in the steel industry or car business, then you're going to see some major pressures in terms of growth in China.

“If you’re in pharma, chemicals or green energy then you really will benefit significantly and firms are revising growth plans upwards because they’re seeing that change and that commitment of China to become much more of an R&D centre and a globally competitive marketplace.”

For foreign investors some long-standing risks – such as technology theft and the need for joint ventures – still remain an issue. Goldstein believes there is also lack of clarity from Chinese policymakers on the country’s future plans.

“The last eight to 10 months have been marked by a high degree of uncertainty and there is lots to consider,” he says.

“It feels like everything has been leading up to this point; the slowdown in the global economy, China opening up, the RMB seeing two-way volatility instead of just appreciating plus recent macro-prudential policy measures spooking markets.

“This has caused a lot of awareness and conservatism within the policymaking apparatus and among the regulators. Nobody wants to slip up with memories of last summer still fresh so things are moving very slowly.”

“While the complexity is still there, China is committed to market reforms.  The macro economic challenges they face simply mean that reforms will progress in a non-linear manner.  Rather, China’s economic integration with international markets will occur where they can, when they can.”

“Its important for our clients to hear from us frequently – not just to report on the latest regulatory announcement in China, but to help them evaluate the importance of that announcement to their business model and manage the ensuing risks accordingly.” 

- After the RMB devaluation, Deutsche Bank experienced a sharp increase in demand for FX risk management solutions by multinational corporations. To address this new area of FX flow business, a major investor education effort was launched to market Deutsche Bank as the go-to bank for innovative and structured solutions. Some examples of recent risk management tools devised by Deutsche include:

USDCNH Cancellable Call Spread Cross: allowing clients to manage their exposure to CNH in a cost-efficient manner via adjusting the magnitude of protection required. Additionally, the cancel-feature positioned our clients in a flexible stance to: i) be protected against CNH depreciation, and ii) reduce costs in a market reversal by cancelling the call spread CCS.

FX and Rates Risk Management Solution to Manage Foreign Currency Debt: Deutsche Bank assisted a listed Chinese corporate client (market cap. circa USD8 billion) to develop a risk management program that minimised the FX mismatch between its USD debt and RMB functional currency. The program consisted of a portfolio of committed and uncommitted solutions, with the aim of achieving hedging delta at or above 70% (for CNH depreciation), achieving a lower hedging cost compared to pure vanilla hedges.

- Bespoke cross-border FX offering for MNCs:  Leveraging our onshore RMB clearing capability and offshore RMB centre processing expertise, our unique business model enables clients across our global network to tap into the onshore market and achieve cost savings in their payment obligations.

Evan Goldstein

Head of Global Renminbi Solutions, Global Transaction Banking

Evan Goldstein

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