It’s been an eventful week in the markets, capped by Standard & Poor’s shock downgrade of the US government from the top AAA credit rating. Add this to the ongoing slide in the US dollar and the question of how long the world economy will revolve around the greenback becomes more and more pressing.
We’ve always assumed that if influence is going to slide away from the dollar, it will be like the pound losing its primacy 100 years or so ago: a long, slow process with its replacement gradually gaining ground. But might we be too cautious here? Could the US trash its reputation and its currency faster than we expect?
Nobody knows the answer to this. But as the US remains the world’s leading economy I would be very cautious about writing it off. That said, investors would be wise to watch what’s going on elsewhere – particularly in Hong Kong.
An international renminbi is on the way
Over the last year or so, China has taken the first few steps towards making the renminbi an international currency. And it’s done this by taking advantage of the unique status of Hong Kong.
As most readers will know, the Hong Kong financial system is completely separate from the mainland one. It has its own currency, which is pegged to the US dollar, and its own central bank. It operates no currency controls and you can freely bring funds in and out of the territory.
In contrast, China imposes strict capital controls, restricting the ability of foreigners and locals to exchange foreign currencyfor renminbi and vice versa. This is mostly done to prevent large amounts of potentially volatile foreign capital flooding into and out of the Chinese market.
Nonetheless, some exchange of renminbi for foreign currency has to take place in the normal course of trade and investment. As a result, deposits of renminbi have been building up outside China.
The crucial point here is that this offshore renminbi cannot automatically be repatriated back to a bank account in China. Capital controls prevent that. Thus there are two separate and segregated pools of the same currency, one onshore in China and one offshore.
As a result, it’s possible to experiment with developing an offshore renminbi market that anyone can trade in, without having to throw open the mainland financial system to the whole world. And that’s what China is now doing, through the offshore Hong Kong renminbi market, which is known as the CNH market (since CNY is the currency code for the renminbi).
A year of rapid change
Foreign companies have been officially allowed to hold some renminbi in Hong Kong bank accounts since 2004 for business purposes. But the market for this was very limited and not very developed. All banks could do with the deposits was park them at Bank of China Hong Kong, the designated renminbi clearing bank and sole official link between the renminbi pool in Hong Kong and the mainland market.
The first steps to broaden what could be done began in 2007. At that point, the Chinese government began allowing domestic financial institutions to issue renminbi-denominated bonds in Hong Kong. This meant that offshore renminbi could finally go somewhere else other than low-yielding deposits.
Then in 2009 and 2010, they took some much bigger steps. First, they introduced a system to allow some trade between China and the outside world to be settled in renminbi, meaning a greater flow of renminbi between offshore and onshore. This has developed faster than expected: About 7% of China’s international trade was settled in renminbi in the first quarter, up from 0.5% a year ago.
Second, the Hong Kong Monetary Authority announced new rules on renminbi banking in the territory. This allowed both individuals and companies to open renminbi banks for any purpose and funds to flow between accounts much more easily. Essentially, most limits on offshore renminbi banking were removed, except for the restriction on money going back to China, which could still only be done via Bank of China Hong Kong.
Third, more and more renminbi bonds have been issued in Hong Kong, including some from foreign issuers such as MacDonald’s. The market for renminbi bonds – now known as the dim sum bond market – has grown substantially, as shown by the chart below.
Fourth, certain foreign financial institutions are now allowed to reinvest their renminbi holdings into the Chinese interbank bond market. This means that banks will be able to do more with the renminbi deposits they take in.
The result of this is that renminbi deposits in Hong Kong banks have soared in the last year, as the chart below shows.
Three ways to buy renminbi
What are the consequences of this? First, it makes it much easier for foreigners to hold renminbi or renminbi assets. For a long time, the main way of getting exposure to the renminbi was through non-deliverable forwards (NDFs).
Essentially, these are derivative contracts based on the expected future renminbi/US dollar exchange rate (that’s what the forwards part means). They are settled in US dollars and no transfer for renminbi takes place at any point (hence the non-deliverable, meaning no renminbi is delivered to either party involved in the contract). Most renminbi-based products – ETFs, renminbi funds, renminbi savings accounts at foreign banks – are structured on NDFs.
You could only get cash renminbi if you were buying for a permitted purpose – ie trade or an approved investment. In that case, you would transact with a Chinese bank at the official People’s Bank of China renminbi/US dollar exchange rate.
But with the build up of renminbi deposits outside China, it has become possible to swap foreign currency for renminbi. Technically, you could do this in any financial centre in which renminbi liquidity existed. But, only in Hong Kong is the market officially permitted and regulated and the liquidity at all significant.
That said, deposits now seem to be building in Singapore, which may get its own official renminbi clearing bank at some point. If that happens, it will be another step towards an international renminbi.
What’s holding back the dim sum market?
The other angle is that investors now have assets in which to invest renminbi funds: a growing pool of bonds and almost certainly more instruments to come. We saw the first renminbi-denominated initial public offering of a real estate investment trust in Hong Kong earlier this year.
There are still problems with the dim sum bond market. First, if a company is raising renminbi funds offshore, it needs permission to remit them back to the mainland. This effectively means that issuing dim sum bonds is only possible for firms that are going to be allowed to do this.
For example, property developers are generally not allowed to do so. (They get around this restriction to some extent by issuing synthetic dim sum bonds, which are denominated in renminbi but settled in US dollars.)
Getting approval to remit funds is still a fairly bureaucratic process. In addition, actually issuing bonds is not totally straightforward – firms need to use an offshore subsidiary that then makes a loan to or injects equity capital into the parent or a specific project on the mainland.
These restrictions mean that the pool of dim sum bonds is still growing more slowly than demand for them. This is turn means that yields on dim sum bonds are not very high – around 2-3% for three years seems to be typical. As the chart below shows, dim sum yields are much lower than the yields of comparable onshore renminbi bonds in mainland China.
And the shortage of bonds means there isn’t much active trading in the secondary market. Investors buy them when they are issued and lock them away.
Dim sum funds are growing fast
Nonetheless, this is a fast-growing market and one that should continue to grow quickly as investors clamour for access to the renminbi. Dim sum bond funds are already being issued and marketed outside Hong Kong.
Italian asset manager Azimut announced a European fund for institutional investors that will hold cash and dim sum bonds. And Barclays recently issued a retail investor fund in Singapore.
Meanwhile, Guinness Atkinson – whose China and Asia funds I profiled a while ago – launched a Renminbi Yuan and Bond Fund in the US at the end of June. This is not yet available to non-US investors, but could perhaps come to the UK and Europe at some point if there is demand for it. And US ETF manager Van Eck is reportedly planning a dim sum bond ETF.
For now, the only UK renminbi-based fund that I know of comes from Stratton Street Capital, managers of the Wealthy Nations Bond Fund that I’ve mentioned here before. This is currently a synthetic fund – it invests in higher yield US dollar international bonds and hedges currency exposure into renminbi using NDFs. As the CNH market grows and better yields becomes available, it is then likely to move the portfolio gradually into renminbi-denominated products. While potentially interesting, the minimum investment is currently US$100,000.
Personally, I’m not convinced that renminbi funds are the best option right now. I’d agree that the renminbi is likely to continue rising over the long term. But it is very much a consensus bet and dim sum bond funds are paying you a rather low yield for joining that crowded trade.
That goes double if you are not based in the US. The renminbi is priced off the US dollar, hence it could continue to rise against USD while falling against other currencies if the dollar continues to slide. I see better opportunities in other assets and currencies.
However, the rapid development of the dim sum market means they could become attractive in due course. And in any case, the CNH market is clearly worth watching as an indicator of how quickly – or not – the global currency system could change.