from Follow the Money

Will an (onshore) forward market for the RMB change the world?

August 10, 2005

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Dan Drezner and David Altig are waxing enthusiastic about China's decision to allow domestic banks to trade the RMB forward - a development that in theory will help Chinese firms to better "hedge" their currency risk. 

This no doubt is a part of China's overall plan to introduce - gradually - more flexibility into their exchange rate regime.  China wants its firms to be able to insure against a more volatile exchange rate before it allows a more volatile exchange rate.

But count me a continued skeptic about the real impact of this reform.

Here is why:

A market requires more than just the legal ability to sell a contract.   A real market - one that works without heavy central bank intervention -- requires both buyers and sellers on both sides of the contract.   One private party has to be willing to sell RMB forward for dollars (at a set price) and another has to be willing to buy the RMB forward at that price.

In many emerging economies, particularly emerging markets with fixed or heavily managed exchange rates, private demand for foreign currency is all on one side of the market.   As a result, hedging markets often only work because the government - whether the Treasury or the Central Bank - steps in and sells private firms the exchange rate insurance that they want.   And I suspect that will be the case in China as well.

Usually, private firms in emerging market economies have wanted more protection against the risk of currency depreciation than private actors in the market were willing to supply, so the government steps in to sell protection against the risk of a fall in the value of the local currency.   Think of the Mexico's finance ministry selling dollar-indexed debt - Tesobonos -- in 1994 (dollar-denominated debt offers insurance against the risk of depreciation, it has an embedded forward contract), the Bank of Thailand selling the baht forward in 1997, or Brazil selling dollar-indexed debt in 1998 and again in 2002.

In each of these case, the market worked because the government supplied the exchange rate insurance the private sector wanted - and in most cases, the government ended up taking large losses on the insurance it sold (See Roubini and Setser, 2004, Chapter 2).  Brazil avoided a private sector crisis in 1999 by selling its firms insurance in 1998 -- but that meant the government's own indebtedness went way up after Brazil's devaluation.

In China, there is, to put it mildly, little risk that the RMB will fall in value (depreciate) against the dollar -- or, more accurately, little risk that the RMB will depreciate against the dollar except as a result of changes in the euro/ dollar and the resulting mechanical operation of the basket peg.  

As a result, there is not likely to be much demand for protection against the risk that the RMB will fall in value against the dollar.  But there is likely to be a lot of demand for protection against the risk of RMB will rise in value (appreciate) against the dollar.  Remember, the same contract that allows firms to hedge also allows punters to speculate on the future value of the currency - I would buy RMB forward at 8 per dollar if I could ...

As a result, I suspect that the forward market will only clear if the PBoC itself provides most of the insurance against the risk of appreciation, or if private banks are so confident in the future direction of PBoC policy that they are willing to sell the insurance.    It will be just like Mexico in 1994 - only the private sector will be betting on an RMB appreciation in mass rather than on a peso depreciation in mass.

Think about it.  Would a Chinese firm that plans to import lots of goods priced in dollars in say 2006 or 2007 want to hedge?  There is very little risk that the RMB will collapse in the interim, and thus little risk that exchange rate moves will drive the price of the imported goods way up.  Indeed, there is a significant chance that the RMB will appreciate between now and 2006 or 2007, making the imported good cheaper.  Rather than selling RMB forward for dollars, I suspect the importer would stay out of the market.  Not hedging effectively is a bet on future RMB appreciation.   Even now, some think Chinese importers are delaying purchases in the expectation that the RMB will rise.

An exporter on the other hand presumably would be quite happy to hedge against the risk that the RMB will appreciate.   If they could sell their future dollar export earnings forward for say 8 RMB, they no doubt would.

The problem is matching supply and demand.  It seems like there would be a lot of demand for insurance against the risk of RMB appreciation, and very little demand for insurance against RMB depreciation.  The market could clear at a forward price that implies a very large future appreciation of the RMB - but that presumably would not please the central bank.   Alternatively, the market could clear if the PBoC - or a state owned bank acting on behalf of the PBoC - sold a ton of insurance.

I doubt a truly private bank would sell large amounts of protection against the risk of RMB appreciation to China's exporters.   It would be taking a huge bet, and be betting on future direction of Chinese policy far more than on the market-clearing price for the RMB.

After all, right now, market clearing price for the RMB is currently determined by the PBoC and no one else.  The foreign exchange spot market only clears because the PBoC spends $20 billion a month buying the spare dollars in the market.  $10 b of those spare dollars come from China's trade surplus, $5 b (roughly) from incoming FDI, and $5 b from other kinds of capital inflows.    The PBoC basically spends about $1 billion every trading day keeping the RMB from appreciating.  That is why I don't really think there is much doubt what would happen if the Chinese ever allowed the RMB to float.  It would appreciate until the RMB rose to the point there were as many sellers of RMB as there are buyers. 

As I understand it - and I certainly don't understand it perfectly -- the basket peg means that the RMB/ $ peg will change to reflect the dollar's moves against the euro, the yen and the Korean won (though not the Taiwanese dollar ... ).  But on any given day, once the reference rate is set, the PBoC effectively has to defend that day's dollar parity.   The market clearing exchange rate will always be at the point where the PBoC enters the market.    Now, though, that point can change.

But I don't think that changes the basic dynamics of the market much.  At anything close to the current RMB/ $ rate, there will be a large discrepancy between (private) dollar demand and (private) dollar supply in the spot market.   The market only clears because the central bank steps in and snaps up excess supply of dollars.  I don't see how the forward market would really work unless the PBoC also intervenes heavily, whether directly or indirectly, in that market as well.

My bottom line: I don't quite see how just allowing Chinese banks to sell the RMB (and the dollar) forward will create a real market, largely because I don't think there will be enough private sellers of protection against the risk of RMB appreciation to match private demand for protection .... I just don't see how the forward market can work properly until China lets the spot market move a bit closer to a market-clearing equilibrium.

What about the offshore futures market that already exists - the NDF (non deliverable forward) market.  I liked Jonathan Anderson's description of that market.   It is a place where hedge funds place bets among themselves about what they think the China's central bank will do, just as two British soccer fans can place a bet on the outcome of a Brazilian football match.

The onshore market should be very different.  Chinese firms cannot participate in the NDF market, but they can participate in the onshore market.

Finally, a point just for Dan Drezner. I would argue that the Funke and Rahn paper only demonstrates that Starbucks Lattes are even more overpriced in Beijing than they are in New York.  I find it hard to take a study that relies on a data set that ends in the fourth quarter of 2002 (I repeat 2002) all that seriously as a guide to the renminbi's fair value in 2005.  A lot has changed since 2002.  The dollar fell substantially, bringing the RMB down with it.  And Chinese exports absolutely took off - growing by more than 30% a year in 2003, 2004 and so far in 2005.  China exports about twice as much now as it did in 2002.  Its 2005 current account surplus is going to be well over twice the size of its 2002 current account surplus - it may well be three of even four times as big.   I want to see analysis that reflect the world as it is now, not as it was in 2002!

Two final caveats.

One, with lots of depreciations and appreciations and forward prices, I had lots of opportunities to get a sign wrong, so to speak.  Apologies in advance if I appreciated when i should have depreciated. 

Two,  I am most interested in how banks in emerging economies -- including the local operations of the big international banks -- hedge their currency risk.    If I am missing an obvious way a private financial institution in China could hedge its exposure if it sold insurance against a rising renminbi, do let me know.   If there are likely to be a meaningful number of private "sellers" of protection against the risk the RMB will appreciate, I would need to change my analysis.

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