RMB fall forces Chinese corporates to rethink hedges

For years, Chinese corporates assumed the renminbi would continue to appreciate, but following a surprise devaluation in August, many are now finding hedging a challenging experience

Unexpected: August's 4% devaluation of the renminbi

For years, corporate treasurers in China had it easy. The renminbi rate, controlled by the central bank, was either pegged or appreciated slowly against the dollar, making foreign exchange management a safe and predictable process – if indeed they bothered at all.

So, when the People's Bank of China (PBoC) unexpectedly devalued the onshore renminbi by 4% against the US dollar over two days in August, many treasurers were caught on the hop. The worst affected were unhedged importers and those with dollar-denominated loans – who saw their costs spike from a rising dollar – but exporters who had hedged assuming a rising Chinese currency were also caught off-guard, suffering losses as a result.

"Before the drop we were still relatively optimistic about the renminbi's trending, so we established large hedging positions through plain vanilla forwards, and investment positions through structured products, to bet on an upward trend of the renminbi. We suffered losses when it depreciated against the dollar on August 12," says Zhenyu Wei, head of group treasury at Chervon, a Nanjing-based manufacturer and exporter of power tools.

Difficulties of revisiting forex policies

What was once a certainty – that the renminbi would continue to rise against the dollar – is no longer, and many treasurers are revisiting their forex policies to take into account the two-way nature of the Chinese currency. For some corporates it is the first time they've had to hedge against a falling renminbi.

It has proved to be a difficult exercise, however. Liquidity for dollar/renminbi cross-currency swaps and forwards is thin, especially at longer tenors, and the lack of a Chinese netting opinion means banks cannot offset their exposures, making new trades more costly.

The PBoC released what I would say is a ridiculous policy, requiring banks to make a dollar deposit at zero yield for foreign currency products

A new regulation from the PBoC requiring banks to hold a 20% dollar reserve against new onshore renminbi forex swaps and forwards transactions has also made it an expensive exercise, with some treasurers reporting the cost of dollar/renminbi hedges has risen significantly, even before the rules came into force on October 15. For some, it has made what should be a prudent risk management tool unnecessarily burdensome.

"The PBoC released what I would say is a ridiculous policy, requiring banks to make a dollar deposit at zero yield for foreign currency products. This has pushed up the onshore cost for the buy side by 400 basis points at least," says the treasurer at the Shanghai subsidiary of a European chemicals company.

Steady appreciation

For the past five years, the story of the onshore renminbi, or CNY, has been one of steady appreciation against the dollar. After the peg was loosened in June 2010, the renminbi strengthened from 6.83 per dollar to 6.05 on January 1, 2014.

Given the predictability of the exchange rate, many corporates benefiting from the falling dollar, such as importers, chose not to hedge against a fall in the value of the Chinese currency. Those that did hedge, such as exporters exposed to a falling dollar, locked in exchange rates using forwards and dabbled in structured products that assumed the currency would continue to appreciate.

With interest rates in the US close to zero, compared to more than 5% in China, many also took on unhedged dollar-denominated loans or debt, hoping the rising renminbi would shrink its value.

Things changed though on February 18, 2014, when the PBoC started fixing the rate higher and spot soon followed suit, ending the month just short of 6.15. In March 2014 the PBoC doubled the daily range by which the yuan is allowed to rise or fall to 2%, leading to further depreciation; by April 24 it reached 6.25. The currency then strengthened to 6.12 before sitting at 6.20 for most of 2015.

Many, however, thought the brief depreciation was a way to put off corporate speculators, who had entered into structured products such as target redemption forwards assuming the currency would continue to lose value against the dollar. As a result, hedging against another renminbi depreciation was rare.

Surprise devaluation

The PBoC caught them by surprise though when it devalued the CNY against the dollar on August 11, causing the dollar/renminbi exchange rate to rise to 6.40 within two days. In the immediate aftermath of the shock, treasurers flocked to cover off their dollar exposures. Some rushed to stock up on dollars before they became more expensive, while others looked to enter new trades to cover previously unhedged dollar exposures.

"Many corporates were caught off-guard in the first few days after the devaluation. With the uncertainty, many clients came to us for advice to hedge their positions. Some came to us and bought US dollars, and many later started to hedge their dollar exposures, including some who had never hedged their position before because they expected further renminbi appreciation," says Zhou Cheng Gang, global head of renminbi sales at Standard Chartered in Hong Kong.

Exporters, who should in theory benefit from a rising dollar, were also wrong-footed, and were forced to unwind forex forwards hedges and structured products (see box: Back to the drawing board for exporters).

Corporate sales heads at three banks say client demand has so far focused on plain vanilla hedging products, such as forwards and cross-currency swaps. These are not only some of the more liquid products in China's relatively undeveloped derivatives market, but their simplicity also appeals to less experienced corporate hedgers.

PBoC regulation

However, just as corporates looked to hedge their dollar exposures, the PBoC released a regulation designed to disincentivise them from doing so. The rule, released on August 31 and followed by a September 2 circular, required dealers to place a zero-interest, dollar-denominated deposit at the central bank against 20% of the notional value of all forex swaps and forwards referencing onshore renminbi for a year. No interest is paid on the deposit.

The PBoC said the regulation was designed to minimise speculative trading following the currency depreciation. It would apply to dealers for forex forwards, options, cross-currency swaps where the customer collects foreign currency at a future date with no exchange of the principal amount in the short term, forward and swap contracts involving buying or selling the renminbi, and any other business associated with customers buying foreign exchange on a forward basis. For options, only half of the notional principal amount is used for the basis of the calculation.

While the requirement only came into effect on October 15, the chemicals company treasurer says prices for forwards rose by around 400bp weeks before that date, while cross-currency swaps jumped by between 200bp and 400bp. Dealer sources suggest the extra charge has been around 300bp across all tenors as the reserve needs to be held for a year, regardless of the maturity of the trade.

'We have to work a lot harder'

"It means we have to work a lot harder to make sure the exposure calculations are accurate, because every deal means extra costs," says the treasurer.

Other corporate treasurers say they have not yet been sent pricing adjustments from their relationship banks. For those unable to hedge in the offshore renminbi market, where the dollar reserve requirement does not apply, there will be little option but to accept the increase.

"If they are going to raise prices, I'm afraid we will have to accept it – as our trading infrastructure is established onshore, most of our hedging activities are conducted domestically. We have hundreds of millions of renminbi cashflow every year, all of which is hedged with forwards and options. The hedging cost will potentially increase, depending on the degree of price adjustment from banks," says Xinpeng Wang, a trader at China-based commodity trading firm Huashi Group in Rizhao, Shandong province.

Bankers say the extra charge will vary by bank, as each one will have a different 12-month US dollar funding rate. "You may start to see some differentiation in the market based on banks' ability and the cost of funds for that US dollar requirement," says Shane Sampson, head of Asian corporate forex and commodity sales at Westpac Banking Corporation in Singapore.

Corporate treasurers face other hurdles when looking to hedge their dollar exposures. For instance, China does not have a netting opinion, which means international banks cannot offset amounts owed to and from clients for derivatives trades. This means a portfolio's exposure is higher than it otherwise would be, leading to higher regulatory costs, which are inevitably passed on to end-users.

"For forex hedging in China, primary liquidity comes from international banks. For them, derivatives trading is more expensive than in other jurisdictions because China is not a clean netting jurisdiction. This means exposures have to be calculated on a gross basis, which translates into higher capital charges and lower trading limits for corporate counterparties," says Patrick Phua, head of law firm Ashurst's China derivatives and structure finance practice in Beijing.

Search for liquidity

Liquidity can also be hard to find, especially beyond five years, making it tricky for corporates to hedge US dollar bond issuances. Some blame this on the one-way nature of flows. Prior to the devaluation, everyone was betting on a renminbi appreciation, but now they are doing the opposite, making it harder and costlier to find the other side of the trade.

"With a lot of these markets and products, two-way flow is important. If the whole market is one way it might push it to the point where it becomes too expensive," says Westpac's Sampson.

Alternatively, other dealers say two-way flows had picked up prior to the August devaluation, as last year's blip caused the market to anticipate greater liberalisation of the Chinese currency.

"Over the last year the renminbi has become a currency with more two-way volatility and we are seeing a more balanced flow, both from importers and exporters, to manage two-way flow," says Ivan Wong, head of Greater China corporate sales for HSBC in Hong Kong.

The opening of the onshore Chinese forex options market in 2011, and the subsequent decision by regulators last year to allow corporates to sell as well as buy the instruments, also encouraged companies to hedge prior to the August devaluation, says Wong.

"While in the past the offshore market has been quite liquid in terms of different options instruments, the onshore market has always been very vanilla, but starting in August last year, there has been greater liberalisation in the currency options market, so we've seen some pick-up in activity," he says.

Longer term

Over the longer term, some treasurers are hoping to avoid the forex market altogether. Many Chinese companies took on foreign currency loans in the past due to the interest rate differential, but the hedging problems have led some to view the renminbi market in a new light.

"In the past, euros and dollars were very cheap offshore, so you had the advantage of borrowing offshore, but now you suffer a lot when you try to hedge your foreign currency loan. So I have heard a lot of companies plan to replace dollar and euro loans with renminbi loans, because people know hedging will mean higher costs," says the Shanghai-based treasurer at a European chemicals company.

The Chinese authorities have also moved to encourage corporates to take out more loans in the onshore currency. On October 23, the PBoC cut the country's benchmark loan rate by 25bp to 4.35% – the sixth cut since November. Meanwhile, the three-month CNY interbank lending rate has fallen from 4.18% in November 2014 to 3.18% as of October 15, 2015.

The moves could also make it cheaper to borrow in CNY than the offshore renminbi – the parallel currency market where Chinese subsidiaries of international companies have traditionally sourced their currency.

"The offshore pricing has actually increased significantly in comparison with onshore pricing. A few years ago, the pricing was as much as 3% cheaper offshore and then you would make an internal loan to your onshore entity, where the one-year benchmark rate was higher than 6%. Today that situation has changed. And then if you add in withholding taxes and business taxes, the offshore borrowing rate is actually even higher," says Jackson Xu, Singapore-based regional treasurer for French electricity and transport systems company Alstom.

While dollar-denominated borrowing has been largely curtailed, some say they are looking at funding in other low interest rate foreign currencies, such as the yen and the euro, as their respective quantitative easing programmes are expected to continue for some time.

"Apart from indispensable trade financing, we won't consider financing in dollars in the future as the dollar is appreciating against the renminbi. We may consider raising euro debt as we expect the euro to stay on a downward track in the foreseeable future," says Wenbo Hu, head of group treasury at Zhengzhou Yutong Bus, a bus-manufacturing company in Zhengzhou, Henan province.

Alstom's Xu says the firm has looked into changing its contracts to reference renminbi instead of dollars to shift the forex risk off its books.

"We receive cash in US dollars, for example, based on a contract with a foreign company. Before, we would have hedged that foreign currency exposure in China. However, today we are working to change contract structures so that, instead of paying in euros or dollars, the customer pays in renminbi and does the hedging on their side as it is cheaper," says Xu.

Back to the drawing board for exporters

Exporters should in theory be cheering a devaluation of the renminbi: they receive the stronger US dollar while their expenses are in the weakening onshore Chinese currency, known as the CNY. However, many locked in their foreign exchange rates using forwards and entered into structured derivatives trades that assumed the renminbi would continue to appreciate – when it fell, they were left with losses.

Zhenyu Wei, head of group treasury at Chervon, a Nanjing-based manufacturer and exporter of power tools, says the firm has had to abandon most of its forwards positions and is now increasingly using the spot market to convert flows.

"We expect the renminbi to drop further against the dollar in the near future, so we quit most of our forwards positions and simply convert our renminbi payables and dollar receivables in the spot market. We are currently executing a strategy where we lock in the exchange rate of 30% of our revenues – around $200 million – through short-term, mostly three-month, vanilla forwards. The remaining 70% we convert in the spot market," says Wei.

Chervon also had to take off structured products positions referencing the currency pair in the face of losses. "We retreated from trading most structured products as the dollar/CNY rate is still volatile and we cannot see a clear trend emerging in the near future. We will re-enter the market after the renminbi drops to 6.5 against the dollar," he says.

Other Chinese exporters have taken a bolder approach. "In the face of the strengthening dollar against the renminbi, we have slightly increased the proportion of our trading in structured products to try to potentially profit from the volatility. Previously, our trading structure consisted of 80% plain vanilla forwards and 20% structured products. That has been adjusted to 70% and 30% since August," says Wenbo Hu, head of group treasury at Zhengzhou Yutong Bus, a bus-manufacturing company based in Zhengzhou, Henan province.

Structured products referencing the dollar/renminbi rate, such as target redemption forwards, had already been under pressure during the brief renminbi depreciation in early 2014, which led the Taiwanese regulator to crack down on sales of the product.

Hu says Chervon has also looked to enter forex trades using the offshore renminbi rate, which diverged from the onshore rate after the August move – at one point the onshore rate was at 6.40 while offshore was 6.50. This allows them to lock in a higher rate to sell their dollars than they would otherwise get in the onshore market.