The RMB, the HKD and a flood of cash
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.