The RMB, the HKD and a flood of cash

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

If noth­ing else, Mon­day’s an­nounce­ment that China spent US$94 bln of its for­eign re­serves in Au­gust to pre­vent the ren­minbi from fall­ing against the US dol­lar should con­vince the doubters that China has no in­ten­tion of be­ing a mer­can­tilist “cur­rency war­rior”. As a re­sult, any bear­ish case against the ren­minbi should not rest on the gov­ern­ment’s in­ten­tions—in spend­ing its US$94 bln, the Peo­ple’s Bank of China has made it clear that it will hold a ‘line in the sand’, at least for the com­ing weeks and months—but in­stead must rely on the idea that we will con­tinue to see mas­sive cap­i­tal flight out of the ren­minbi into other cur­ren­cies.

Now for­eign­ers hold only a lim­ited amount of ren­minbi. Af­ter all, China has been run­ning size­able, and grow­ing, trade sur­pluses for the past two decades. Thus, any struc­turally bear­ish view on the ren­minbi has to be based on the idea that the Chi­nese them­selves will quit on their own cur­rency and move a siz­able por­tion of their pool of do­mes­tic sav­ings, most of which is sit­ting in cash at the bank, into for­eign cur­ren­cies.

To some ex­tent this is what has been hap­pen­ing in Hong Kong over the past four weeks. Since the launch of the off­shore ren­minbi, or CNH, mar­ket in mid-2010, Hong Kong res­i­dents have been ac­cu­mu­lat­ing bank de­posits, CDs and bonds in CNH. For Hong Kongers—whose lo­cal cur­rency, the Hong Hong dol­lar, is pegged to the US dol­lar— trans­fer­ring sav­ings into CNH was widely seen as: a) an easy way to cap­ture a few ex­tra points of yield, and b) a “free” call op­tion on the con­tin­ued ap­pre­ci­a­tion of the ren­minbi against the US dol­lar. But last month’s ill-timed and ill-ex­plained change in China’s for­eign ex­change pol­icy un­der­mined these premises. Since then, Hong Kong in­vestors hold­ing ren­minbi have been rush­ing for the exit, help­ing to open a record gap be­tween the off­shore CNH and the on­shore CNY ex­change rates (see the chart be­low).

The flows out of the CNH and into the Hong Kong dol­lar have been strong enough to force the Hong Kong Mon­e­tary Au­thor­ity to in­ter­vene on at least three sep­a­rate oc­ca­sions to pre­vent the Hong Kong dol­lar ap­pre­ci­at­ing be­yond its HKD 7.75 to the US dol­lar limit, spend­ing a to­tal of al­most HKD 18.6 bln (US$ 2.4 bln). The last time the HKMA in­ter­vened in the mar­ket was in April, when money was pour­ing into the Hong Kong stock mar­ket as lo­cally-listed H-shares be­gan to surge in em­u­la­tion of China’s soar­ing on­shore A-share mar­ket. Of course, this time around, the un­der­ly­ing flows are not driven by greed and hopes for a Hong Kong bull mar­ket, but by fear of ren­minbi de­pre­ci­a­tion. Still, the fact re­mains that liq­uid­ity is now flow­ing back into the Hong Kong dol­lar. As in­vestors, the ques­tion we should ask our­selves is: Where will all those new Hong Kong dol­lars end up? Will they:

1) Sit in cash, earn­ing no re­turn?

For the next few weeks, this is a dis­tinct pos­si­bil­ity. But it is not a likely long term out­come.

This is a pos­si­bil­ity if Chi­nese pol­i­cy­mak­ers man­age to con­vince in­vestors that their goal is not de­val­u­a­tion, but to es­tab­lish the ren­minbi as a re­serve cur­rency for Asia and the world. A few more months of in­ter­ven­tion, a sta­ble ren­minbi, and the prom­ise of in­clu­sion in the spe­cial draw­ing rights bas­ket may do the trick. If so, by year-end Hong Kong’s large sav­ings may start flow­ing back into ren­minbi again, trig­ger­ing a nar­row­ing of the CNH dis­count and a tight­en­ing of spreads.

Pos­si­ble, though as of now there are few signs of this. If Hong Kong sav­ings were re­ally mov­ing into US dol­lar as­sets, the HKMA would have to de­fend the Hong Kong dol­lar from weak­en­ing, not strength­en­ing.

2) Head back into CNH to cap­ture the ex­tra yield?

3) Chase yield in US dol­lar bonds?

4) Chase yield in Hong Kong-listed stocks?

This is a strong pos­si­bil­ity. Part of the at­trac­tion of the CNH mar­ket was that it of­fered a great “yield to volatil­ity” propo­si­tion. If re­tail in­vestors now con­clude the volatil­ity of the CNH trade has struc­turally changed, they may well switch to a high­eryield­ing as­set class, even at the cost of more volatil­ity. And few mar­kets of­fer a wider gap than Hong Kong be­tween short rates (ef­fec­tively zero) and div­i­dend yields (around 4.5%).

5) Plunge into do­mes­tic real es­tate?

This is Hong Kong we are talk­ing about so pour­ing more money into real es­tate is al­ways a pos­si­bil­ity! Hav­ing said that, cur­rent val­u­a­tions ap­pear es­pe­cially stretched, and the re­cent rise of the US dol­lar (and hence the Hong Kong dol­lar) means that real es­tate op­por­tu­ni­ties else­where may be more tempt­ing.

Putting it all to­gether, we be­lieve that it makes sense to con­tinue to mon­i­tor the Hong Kong dol­lar, the HKMA’s in­ter­ven­tions, and the CNH-CNY dis­count. The fact that yesterday’s HKMA in­ter­ven­tion, at around US$ 400 mln, was weaker than last week’s is an en­cour­ag­ing sign that the selling pres­sure on the CNH may be start­ing to abate. If this is the case, then the com­ing weeks are likely to see a sta­bil­i­sa­tion of Asian eq­uity, cur­rency and bond mar­kets.

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