China’s currency: the RMB, CNY, CNH…

28 December 2011

China’s currency is officially called the renminbi. The yuan is the unit of account. The renminbi, denoted RMB, is thus the name for the currency traded onshore and offshore. There exists a separation between these two markets, as China institutes capital controls that prevent the currency from flowing abroad and vice versa.

If the RMB is traded onshore (in mainland China), it is referred to as CNY, whereas if the RMB is traded offshore (mainly in Hong Kong) it trades at the rate of USD/CNH, deliverable RMB located in Hong Kong. Thus, while the RMB is just one currency, it trades at two different exchange rates, depending on where it is traded.

As China is seeking to increase the role of its currency on the world stage (referred to as currency internationalization), foreign exchange reforms have led to the formation of the CNH currency. The CNH market is still relatively small and illiquid, especially to the USD and EUR market, but it is growing rapidly as restrictions on this market are gradually lifted. During 2010, reforms made it possible for RMB to leave the China mainland and move to Hong Kong for trade purposes. For example, a Chinese exporter receiving USD could convert USD to CNH in Hong Kong. Once moved to Hong Kong, the RMB is reclassified as CNH and (at the time of writing, as reforms proceed rapidly) it cannot easily flow back to China mainland, only under strict rules and for trade purposes.

Drivers of CNY vs. CNH dynamics

Currently, the onshore CNY and the offshore CNH are two separate markets. Apart from the technical differences, the main feature of CNY is that its exchange rate with the dollar is fixed by the Chinese central bank. Players on the CNY-market are among others onshore exporters, who demand CNY and sell US dollars. Onshore importers pay for US dollars with CNY. The PBoC also typically buys US dollars in line with its monetary policy the USD/CNY exchange rate fixing (see also China’s exchange rate policy).

The CNH exchange rate is driven by private demand and supply for CNH, although the supply of CNH is suppressed by government regulation. The result is that demand for CNH (for example by speculators anticipating on an increase in the value of the Chinese currency) generally exceeds supply. Therefore, the CNH is usually trading above the value of CNY.

Premium vs. discount CNH vs. CNY

However, at two moments in time, CHN was trading below the value of CNY (equivalently, USD/CHN was trading above USD/CNY). The first time was prior to the collapse of Lehman Brothers in August 2008. Tensions in the CNH market (a sudden decline in demand) led to a higher USD/CNH, which has been perceived as an indication that USD/CNY would be fixed higher by the PBoC in a response to financial market unrest.

The second moment has been during the escalating European debt crisis, as fears for a large adverse impact on Chinese exporters due to a sudden drop in demand from Europe led to comments by Chinese officials that the USD/CNY-rate would be kept relatively stable. In anticipation of a higher fixing for USD/CNY, and as a result lower demand for CNH, USD/CNH traded higher.

The future of the CNH market

There are two developments indicating that the CNH market will grow over time and become more important for exporters, importers and investors alike.

  • China is aiming to expand the international role of the CNH market by allowing foreign companies to issue bonds denominated in CNH. For example, during the course of 2010, the first ‘Dim Sum’ bonds were issued by McDonalds, Caterpillar, China Development Bank, the Asian Development Bank, some Hong Kong corporates, etc.
  • Also, the CNH market will proceed its expansion as current capital controls that impede CNH to flow back onto the mainland are lifted gradually. Thereby, the returns from offshore CNH investments are allowed to be directly invested in fixed capital projects in mainland China. Without possibilities to invest CNH, the CNH accounts in Hong Kong stand basically idle, while the return on such deposits is generally very low. This would prevent significant growth in the CNH market.

Non-Deliverable Forward Market

Before the CNH-market was established, the Non-deliverable forward (NDF) market already existed. This market was generally used to hedge against exchange rate fluctuations of the renminbi against the US dollar. Although the Chinese currency could not be delivered, exchange rate differences against which a player was hedged were paid out in US dollars. Therefore, the NDF CNY markets was actually based on future changes in the USD/CNY exchange rate. Players from mainland China could not participate in this market, although participation of onshore players in the CNH market is allowed.

For as long as the CNH market is relatively small and illiquid, the NDF market will in the short term be the main market in which investors can participate and take positions on China’s exchange rate. As the CNH market develops and restrictions on the offshore renminbi use of the are relaxed, most likely the CNH market will step by step overtake the NDF market.

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