Xi Wang. B. S. Business The Chinese University of Hong Kong, 2009

Transcription

1 / Offshore Renminbi Forward Market Development and Its Implication for the Currency Internationalization Process By Xi Wang B. S. Business The Chinese University of Hong Kong, 2009 ARCHIVES MASSACHUSETTS INSTITUTE OF TECHNOLOLGY JUN LIBRARIES SUBMITTED TO THE MIT SLOAN SCHOOL OF MANAGEMENT IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF SCIENCE IN MANAGEMENT STUDIES AT THE MASSACHUSETTS INSTITUTE OF TECHNOLOGY JUNE Xi Wang. All Rights Reserved. The author hereby grants to MIT permission to reproduce and to distribute publicly paper and electronic copies of this thesis document in whole or in part in any medium now known or hereafter created. Signature of Author: Certified By: Accepted By: Signature redacted Signature redacted IT Sloan School of Management May 8, 2015 Hui Chen Associate Professor of Finance Thesis supervisor Signature redacted- Michael A. Cusumano SMR Distinguished Professor of Management Faculty Director, M.S. in Management Studies Program MIT Sloan School of Management

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3 3 Offshore Renminbi Forward Market Development and Its Implication for the Currency Internationalization Process By Xi Wang Submitted to the MIT Sloan School of Management on May 8, 2015 in partial fulfillment of the requirements for the degree of Master of Science in Management Studies Abstract China has become the second-largest economy by nominal GDP and the world's largest economy after adjusting purchasing power by the end of Meanwhile, China is also the largest trading nation in the world. Since the late 2000s, the People's Bank of China (PBoC) has sought to internationalize the renminbi, the official currency of China, to improve the international use of the renminbi and in turn to stimulate monetary efficiency. The offshore renminbi market officially launched in Hong Kong SAR in July 2010 and the offshore deliverable forward market was established two months later. This paper aims to provide a detailed review of the renminbi internationalization process, particularly the foreign exchange market, including the deliverable forward market in the offshore setting. The review will test the correlations among the onshore deliverable forwards, the offshore deliverable forwards, and non-deliverable forwards by conducting time-series analyses. Moreover, interest rate parity theory is utilized to price the theoretical offshore deliverable forwards. Substantial deviations are observed and documented between the theoretical and actual offshore deliverable forward rates. Furthermore, regression analyses are adopted to provide empirical evidence to explain the possible reasons affecting the prices of the offshore renminbi deliverable forwards and the onshore deliverable forwards, also, the price differential between these two products. Among these reasons, exchange rate expectation, macroeconomic sentiment and market liquidity show statistically significant impact. Finally, the paper will discuss the possible implications of the preceding analyses for the development of the offshore deliverable forward market and the renminbi internationalization process. Thesis supervisor: Hui Chen Title: Associate Professor of Finance 1 Source: IMF

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5 5 TABLE OF CONTENTS INTRODUCTION 6 CURRENCY INTERNATIONALIZATION DEFINITION RENMINBI EXCHANGE RATE SYSTEM EVOLUTION RENMINBI INTERNATIONALIZATION PROCESS REASONS TO STIMULATE THE RENMINBI INTERNATIONALIZATION RENMINBI FORWARD MARKETS 9 FORWARD PRODUCT DEFINITION 9 RENMINBI FOREIGN EXCHANGE MARKET 10 RENMINBI FORWARD MARKET 10 EMPIRICAL ANALYSES 11 DATA COLLECTION AND METHODOLOGY 11 MAJOR FINDINGS 14 IMPLICATIONS FOR THE CURRENCY INTERNATIONALIZATION 19 CONTINUOUSLY EXPANDING FORWARD PRODUCT MARKET 19 MARKET IMPACT ON THE OFFSHORE RENMINBI MARKET 19 ESTABLISHED HEDGING FEATURE OF THE OFFSHORE RENMINBI DELIVERABLE FORWARDS 20 CONCLUSION 21

6 6 Introduction Currency Internationalization Definition By definition, a currency is internationalized when market participants - residents and non-residents alike - can conveniently use it to trade, to invest, to borrow, and to invoice in it outside the currency's home country ("offshore") 2. From a theoretical perspective, an international currency should serve the money function as a unit of account, a means of exchange, and a store of value not only within but also outside the borders of the issuing 3 country. It took the dollar 15 years to overtake sterling in official reserves and become a leading currency in mid-1920s after the passage of the Federal Reserve Act to promote the US dollar's challenge to sterling in global trade and finance 4. In the late 2 0 th century, in addition to the dominant role of US dollar, the Japanese yen, the Republic of Korea's won, the Singapore dollar, and the euro have played some role as international currencies. Renminbi Exchange Rate System Evolution In the pre-reform period before 1980, the renminbi was in a fixed exchange rate regime at an overvalued exchange rate to subsidize importers. In 1986, a dual exchange rate system was introduced to slightly loosen the rate control. Under this dual exchange rate system, domestic export firms had to exchange their foreign receipts into the renminbi at the official rate, whereas foreign companies were allowed to exchange at the market rate. Since the official rate was higher than the market rate in general, this policy put domestic exporters in a disadvantage situation-. In 1994, to stabilize the economy and moderate the risks of inflation and credit boom, a new fixed exchange-rate regime of 8.28 renminbi per dollar was in place. Along with the growing capital inflow into China, China's central bank intervened by exchanging the incoming dollars for renminbi at the fixed exchange rate and using the dollars to buy dollardenominated assets such as U.S. Treasuries. During this period, the major task for Chinese officials is to control and moderate inflationary pressure. By implementing a sterilization development policy including increased interest rates, reduced scale of commercial bank loans, and new issuance of renminbi-denominated bonds to absorb the extra liquidity and keep a relatively stable monetary base. However, at the same time, the maintenance of the fixed exchange rate under this scheme was also very costly. To intervene the fixed currency exchange rate, the central bank had to buy US dollars using the undervalued exchange rate. Moreover, to prevent the 2 R. McCauley Renminbi Internationalisation and China's Financial Development. BIS Quarterly Review 3 Zhang, L., and K. Tao The Benefits and Costs of Renminbi Internationalization. ADBI Working Paper 481. Tokyo: Asian Development Bank Institute. 4 Eichengreen and Flandreau L. Alfaro, and R. D. Tella China: To Float or Not To Float. Harvard Business School

7 7 booming monetary policy and credit availability, China's central bank largely invested in low-yield dollar assets such as U.S. Treasuries. Furthermore, the central bank also needed to issue sterilization paper and require the state banks to purchase it at high prices and low interest rates. As a result, the overall asset qualities of the state banks were questioned, and this led to a more serious concern about China's financial stability. Therefore, beginning in 2003, the undervalued renminbi became a popular topic and was under significant revaluation pressure. The accumulated foreign reserve and trading surplus especially motivated the calls for yuan flexibility from the U.S., Europe, Japan, and Latin America. Since 2005, a series of renminbi foreign exchange mechanism reforms has been broadly started. China was undergoing stable growth and low inflation, which provided an appropriate entry point for gradual currency liberalization. Several steps have been adopted since then, including that China's capital account has been gradually opened, major state banks have been listed, and more importantly, the renminbi has been de-pegged against the U.S. dollar and revalued at a more flexible exchange rate. Renminbi internationalization Process The renminbi has made significant progress in currency liberalization and internationalization in the past decade and more. An even more substantial move began in July 2005 when the People's Bank of China (PBoC), the central bank of China, announced that "China will implement a managed floating exchange rate system based on market supply and demand and in reference to a basket of currencies, instead of pegging to the US dollar 6 ". Since then, the renminbi has started to appreciate against the U.S. dollar. By 2008, the appreciation had reached 21% against the USD, and by the end of February 2013, the renminbi nominal exchange rate to the USD appreciated by more than 32%, and the real effective exchange rate (REER) of the renminbi appreciated by more than 36%7. As an indication of exchange rate flexibility, the daily trading band in the onshore market against the US dollar has been widened several times from 0.3% at the beginning to 2% from March More importantly, the establishment of an offshore market is a noticeable development, which has substantially facilitated the international use of the renminbi. In July 2009, the restrictions on the use of the renminbi in current account transactions were completely removed. A pilot offshore renminbi program covering trade among 358 companies from five Chinese cities and Hong Kong and Macau was also established. Furthermore, cross-border renminbi settlement has been introduced and expanded to all 6 Chang Shu, Dong He, and Xiaoqiang Cheng One Currency, Two Markets: The Renminbi's Growing Influence in Asia-Pacific. BIS Working Papers No Gang Yi Exchange Rate Arrangement: Flexible and Fixed Exchange Rate Debate Revisited. People's Bank of China.

8 8 foreign countries to accelerate the offshore market liquidity. Regarding capital accounts, the funding sources have been broadened as well. The actual utilized foreign direct investment in China has grown rapidly from USD billion in 2002 to USD billion in 20148, which meant China overtaking the US and becoming the top destination for foreign direct investment in Moreover, onshore interbank lending and bond markets have been opened for offshore financial institutions with easier access, and the renminbi Qualified Foreign Institutional Investor (R-QFII) scheme has allowed onshore renminbi investment products to be offered to non-chinese residents. The sources and scales of offshore funds have been expanded as well. The China Development Bank issued the first Dim Sum bond that issued outside China but denominated in renminbi in In 2010, the regulatory requirements for both investing and issuing Dim Sum bonds were eased. As a result, the total issuance of Dim Sum bonds reached RMB one trillion with more than RMB 400 billion (or USD 65 billion) new issues in Meanwhile, the PBoC started to set up bilateral currency swap facilities with overseas central banks to secure the short-short Renminbi liquidity in offshore market. By April 2015, the total deal amounts have reached RMB 2.67 trillion (USD 431 billion) with 29 countries 0 with 7 years' development. On the technical side, a set of official rates has been established gradually. In June 2011, Treasury Markets Association (TMA) officially launched spot fixing for the offshore renminbi exchange rate. In June 2013, the interbank interest rate fixing for the renminbi was introduced by TMA to facilitate the offshore lending related products, such as loans and cross-currency swaps. Consequently, the renminbi offshore market scale has grown substantially. For instance, the renminbi customer deposits in Hong Kong SAR had skyrocketed from RMB 895 million in Feb 2004 to RMB 1 trillion in Dec 2014". The progress can also be shown from the daily average turnover growth from the renminbi spot and outright forward transactions, where the daily average renminbi spot transaction turnover had increased from USD 8,981 million in April 2007 to USD 33,950 million in April 2013, and that of outright forward transaction turnover had also grew from USD 4,572 million to USD 28,104 million during the same period'. Reasons to Stimulate the Renminbi Internationalization It should be said that the market condition supplied the right timing for the renminbi to internationalize. The governmental measurements and schemes did activate and stimulate 8 Source: Ministry of Commerce of People's Republic of China 9 Invesco PowerShares Capital Management LLC Dim Sum Bond Primer. White Paper. 10 Source: People's Bank of China (PBoC) " Source: Hong Kong Monetary Authority (HKMA) 12 Source: Monetary and Economic Department, Bank for International Settlements

9 9 the internationalization process during the last decade; however, fundamental reasons behind the rapid development are more market-driven 13 Hong Kong, as the global hub for trade settlement in renminbi, has handled impressively rising trade volume. In the first ten months of 2014, the renminbi trade settlement grew by 70% compared to the first ten months in 2013 to total RMB 5.1 trillion 1 4 and by more than ten-fold since the implementation of the renminbi trade settlement pilot scheme in Thanks to these increasing trades between China and the rest of the Asia and the world, there is an increasing call to use the renminbi as a settlement currency to lower the currency risks in these transactions. At the same time, the speculation for the renminbi appreciation attracted more exporters than importers to settle their bills in renminbi to maintain the trade surplus. As a result, the trade situation is sustainable and beneficial for the renminbi internationalization in a longer term. Moreover, China has accumulated a large amount of foreign exchange reserve to keep the undervalued renminbi exchange rate during the last decade. However, the substantial trade surplus is largely criticized by other countries, and therefore, these countries have called for renminbi appreciation and driven the currency liberalization process. In addition to the substantial foreign currency reserve, the global financial instability also indirectly stimulated the international availability of the renminbi by encouraging more central banks to sign currency swap agreements with the PBoC to counter the potential liquidity problems under this undesirable financial circumstances. Last but not least, the existence of Hong Kong, as a special administrative region, serves as an ideal first offshore centre. The arrangement to liberalize renminbi in Hong Kong can effectively help Hong Kong to sustain its role as an international financial centre. Meanwhile, China has started to play an essential political role while maintaining this prosperous financial sector in Hong Kong. Renminbi Forward Markets Forward Product Definition Forward product is a customized contract between two parties to buy or sell an asset at a specified price on a future date. And renminbi forward product refers to a product that the buyer (seller) agrees to buy (sell) a certain amount of US dollars against renminbi at a specific value and at a specific date in the future. These contracts are customized to any commodity, amount and delivery date, so it is more flexible to cater particular business needs. For instance, if an American importer came into a contract to pay a Chinese exporter in renminbi 6 months later, then the importer can enter into a forward contract and fix the 6- month renminbi purchase rate today. However, since forward contracts do not trade on a 1 Zhang, L., and K. Tao The Benefits and Costs of Renminbi Internationalization. ADBI Working Paper 481. Tokyo: Asian Development Bank Institute. " Source: Hong Kong Monetary Authority (HKMA)

10 10 centralized exchange, they are harder for retail customers to access. Therefore, the major customer groups for forward products are financial institutions and corporate clients. It is largely used for hedging or speculation purposes. For hedging purpose, the involved parties can be protected against uncertain exchange rates in the future, which may adversely affect the profitability of the company. Renminbi Foreign Exchange Market The renminbi first entered the top ten most traded currency list in In April 2013, the renminbi daily average trading turnover soared to USD 120 billion from USD 34 billion in April 2010, which made renminbi the ninth most traded currency in terms of daily average turnover and raised renminbi's share in global FX market to 2.2%. Among this USD 120 billion turnover, currency pair of the USD versus renminbi occupied around USD 113 billion, 94% of the total turnover. There are five main product segments under foreign exchange market, namely, spot, outright forward, foreign exchange swaps, currency swaps and FX options, where daily average turnover of renminbi outright forward amounted to USD 28.1 billion, capturing 23.5% of the total turnover. The renminbi outright forward was the third most traded foreign exchange product, following USD 39.9 billion for foreign exchange swaps, and USD 34.0 billion for spot transactions in Although there have been gradual reforms during the last several years to open the market, the onshore market, including onshore foreign exchange market is still under certain restrictions. Only domestic banks and domestic subsidiaries of foreign banks can access the local wholesale market' 6. Moreover, the daily spot fixing rate is set by the central bank with a daily trading band of 2%. As a result, the foreign exchange transaction in onshore market is still under a certain level of limitations. In contrast, the renniinbi in offshore markets is freely traded. Any institution can access the renminbi offshore market with no restrictions on transaction amount or trading purpose, which means any entity can enter into the renminbi contracts for either hedging or speculation purpose. The exchange rates are completely determined by the market supplies and demands. Renminbi Forward Market An onshore renminbi deliverable forward (DF) market has been introduced since October 2005, shortly after the announcement of the renminbi managed float exchange rate regime in July 2005, to serve the domestic hedging and speculation demands. However, the Chinese authority has not officially allowed non-residents or foreign participants to access to the onshore forward market without restrictions. In April 2013, the onshore renminbi deliverable forwards had an average daily turnover of USD 2.44 billion, which took up 18% of the total renminbi outright forward transaction volume, and 2% of the total renminbi foreign exchange volume in terms of daily turnover. 15 BIS Monetary and Economic Department Triennial Central Bank Survey, Global Foreign Exchange Market Turnover in M Funke, C Shu, X Cheng and S Eraslan Accessing The CNH-CNY Pricing Differential: Role of Fundamentals, Contagion and Policy

11 I I The renminbi non-deliverable forward (NDF) in Hong Kong has been traded since December , long before the market liberalization, allowing investors to circumvent the renminbi currency risks outside the home market or speculate the currency rate movements. In April 2013, the renminbi non-deliverable forward daily turnover amounted to USD billion' 8, around 61% of the total renminbi outright forward volume, and 14% of the total renminbi foreign exchange transactions in terms of daily turnover. According to the memorandum of co-operation on renminbi business signed on 19 July 2010, there would no longer be restrictions in establishing renminbi accounts and providing related services in Hong Kong' 9. Subsequently an offshore forward market, where Hong Kong, Singapore and London act as the leading centres, has been established and operated simultaneously with onshore market since September Unlike the onshore market, in offshore markets the renminbi forward can be freely traded by any market participants and the renminbi can be physically delivered at the settlement day. Sometimes, people refer the offshore market as CNH market. The CNH market initially represented the renminbi transactions taking place in Hong Kong SAR, but later on, CNH market has become a reference term representing renminbi offshore markets, including Hong Kong and all other markets geographically outside mainland China. It is worth mentioning that the offshore renminbi (CNH) deliverable forward market has become more actively transacted gradually. In April 2013, the daily turnover of the offshore renminbi deliverable forwards amounted to USD 7.10 billion, almost triple the size of that in the onshore market. A three-way split of the renminbi forward market currently exists. They are onshore deliverable forward (CNY DF), offshore deliverable forward (CNH DF), and non-deliverable forward (NDF). The main difference between deliverable forward and non-deliverable forward is whether the contract principals have been delivered or not at the delivery date in the future. Under a deliverable forward contract, the buyer actually exchanges the designated US dollars to purchase the renminbi and takes the delivery of the renminbi. Under a nondeliverable forward contract, at the contract expiration date, the buyer receives (or pays) the gain (or loss) in US dollars that measures the difference between the contract price and the benchmark price. No physical delivery of the renminbi happens in the process of the nondeliverable forward settlement. Empirical Analyses Data Collection and Methodology The development of the offshore renminbi deliverable forward products within the last 4.5 years has been tremendous. The daily transaction volume had reached USD 7.1 billion by April 2013 and it continues growing. This section aims to test the potential 7 Y. D. Wang Anomaly in China's Dollar-RMB Forward Market. 1 R McCauley, C Shu, and G Ma Non-deliverable Forwards and Beyond. BIS Quarterly Review. 19 Source: Hong Kong Monetary Authority (HKMA)

12 12 correlations among the offshore renminbi deliverable forward prices, onshore renminbi deliverable forward prices, and non-deliverable forward prices, the gap between the theoretical offshore deliverable forward prices using interest rate parity and the actual trading forward prices, and the possible causes that drive the offshore renminbi deliverable forward price movements, the onshore renminbi deliverable forward price movements, and their price differential. Interest rate parity represents a zero-arbitrage condition where it should be indifferent to invest in different interest rate markets in two countries. According to the covered interest rate parity formula, forward contracts are theoretically priced based on the interest rates of the two underlying currencies and the exchange rate. If market anticipates a major currency revaluation, such as the renminbi appreciation, forward contract prices should react in a positively correlated direction accordingly. In addition, interest rate changes should also influence the forward rate, where in the USD versus renminbi currency pair with USD as a base currency, the USD interest rate should have a negative correlation whereas the renminbi interest rate should have a positive correlation with the forward rate. Moreover, with the consideration of the over-the-counter transaction feature of forward products, counterparty risks and transaction costs should also affect the prices. In addition, since underlying currencies of the offshore deliverable forwards and nondeliverable forwards are in general under convertibility controls or capital flow restriction in their respective onshore market, where offshore investors have limited access to it, therefore, regulatory changes that potentially affects trading flexibility and market liquidity in the offshore renminbi market, particularly in Hong Kong SAR market, have been taken into considerations to assess their market impact on price fluctuation as well. Since the renminbi market has been undergoing the process of relaxation of capital control policies, the policies that regulate the segmentation of the two markets, as well as the flows between these two markets, can be potentially critical to the new renminbi market liquidity and capital flows, which will in turn has also anticipated impacts on forward product prices. Therefore, daily bid and offer spreads of the 12-month offshore deliverable forward points were collected to measure the market liquidity status. A tighter bid-offer spread indicates a more liquid market condition. In general, the renminbi financial product prices including forward product prices are influenced by fundamental macroeconomic conditions in mainland China as well as global market. To capture the macroeconomic status in mainland China, two indirect representatives derived from Shanghai/Shenzhen stock indices and Hang Seng China enterprises index are adopted. Besides the domestic market, global risk appetite as well as the risk assessment towards China, can also influence the prices of the offshore renminbi forward market. VIX, the Chicago Board Options Exchange Market Volatility Index, is referenced as a measure to future global economy volatility. The Chinese government's five-year credit default swap price is selected to assess the investors' risk appetite towards the country and the 12-month future volatility of onshore renminbi exchange rate is used to assess the risk sentiment towards the Chinese currency.

13 13 The purpose of the empirical analysis is to test the correlations among the renminbi offshore deliverable forwards, the renminbi onshore deliverable forwards and the renminbi non-deliverable forwards. Furthermore, covered interest rate parity is adopted to calculate the theoretical offshore deliverable forward prices. Finally, the paper aims to establish qualitative as well as quantitative connections to assess the potential causes affecting the renminbi offshore deliverable forward prices, the renminbi onshore deliverable forward prices, and the price differential between these two products. The market factors to be tested in the paper include interest rate and exchange rate components, microeconomic factors such as credit market indicators and volatility indices, and market liquidity indicators. The analysis is conducted in three steps. First, correlation analyses are conducted to expose the links among onshore deliverable forwards, offshore deliverable forwards and nondeliverable forward products. Second, covered interest rate parity formula is adopted to calculate the theoretical offshore deliverable forward prices. Third, regression model is adopted to exhibit possible causes that drive the renminbi offshore deliverable forward prices, the onshore deliverable forward prices, and the price differential between these two products. The major products tested in this paper are the 12-month renminbi non-deliverable forward points (Bloomberg code: CCN12M), the 12-month renminbi offshore deliverable forward points (Bloomberg code: CNHl2M), and the 12-month renminbi onshore deliverable forward points (Bloomberg code: CCSZ1Y). Forward points are the price gap between the forward rate of an outright forward contract and the spot rate at the time the deal is booked, which represents the interest differential between the two underlying currencies. The data involved are collected from September 2010 when the offshore deliverable forward products were introduced to the market to February 2015 from Bloomberg. The correlation function runs on both 100-day overlapping and non-overlapping window bases. Moreover, regression analyses are conducted from September 2012 to February 2015 excluding price noises at the early stage of the market development. A series of financial indicators including 1-year Shanghai interbank borrowing rates (SHIBORlY), 1-year CNH Hong Kong Interbank Offered Rate Fixing (CNH TMA 1 Y), 1-year USD London Interbank Offering Rates (USDLIBOR1Y), USDCNH spot rates (USDCNH), USDCNY spot rates (USDCNY), Shanghai Shenzhen A-share stock exchange index (SHSZ300), Hang Seng China Enterprises Index (HSCEI), 12-month future volatility of CNY exchange rate (USDCNH1Y Vol), Chicago Board Options Exchange Market Volatility Index (VIX), Chinese government's five-year credit default swap prices (CHINA CDS), and bid-offer spread of the offshore deliverable forwards (Market Liquidity) are utilized to estimate the potential influences from these variables to the offshore deliverable forward prices, the onshore deliverable forward prices, and the price differential between these two products. The covered interest rate parity formula takes the following form: cn= (1 + rcnh) Scn * (1 + rsd)

14 14 In these equations, FCnh refers to the twelve-month renminbi offshore deliverable forward points at day t, Senh refers to the offshore USDCNH spot rate at day t, rcnh refers to the one-year CNH Hong Kong Interbank Offered Rate Fixing (CNH TMA 1 Y), and rsd refers to the one-year USD London Interbank Offering Rates (USDLIBOR1 Y). The three regression functions of this paper take the following forms: scny g a 0 + a 1 * rcny + a 2 * rcnh + a3 * rusd + a4 * (cny + as *VIX + a 6 * CDS + a 7 * SHSZ300 + a 8 * HSCEI + ag * Spd + e (1) Fcnh /n -- ao + a1 * cny + a2 * rcnf + a3 * rusd + a4 * cny + as *VIX + a6* CDS + a 7 * SHSZ300 + a 8 * HSCEI + ag * Spd + E (2) (Fnv - FCnt) / /Scny (3) = ao + a 1 * (+C/ ) +a 2 * (rcny - rusd) + a 3 * (rcnh - rusd) + a 4 * Ceny + as * VIX + a 6 * CDS + a 7 * SHSZ300 + a 8 * HSCEI + a 9 * Spd + E In these equations, Fcnh refers to the 12-month renminbi offshore deliverable forward points at day t, Fny refers to the 12-month renminbi onshore deliverable forward points at day t, Scnh refers to the offshore USDCNH spot rate at day t, Scny refers to the onshore USDCNY spot rate at day t, rcnh refers to the one-year CNH Hong Kong Interbank Offered Rate Fixing (CNH TMA IY), rusd refers to the one-year USD London Interbank Offering Rates (USDLIBOR1 Y), and Ucny refers to the one-year USDCNY spot rate volatility. In addition, CDS, SHSZ300, HSCEI and Spd (market liquidity) are also to explain the potential causes influencing the respective dependent variables. a 1,a 2,a 3,a 4,a 5,a 6,a 7,a 8 represent quantified magnitudes of these independent variables on the estimated changes of the respective dependent variable. ao is the observed value of respective dependent variable. e is the error term that cannot be explained by the model. Major Findings 1. Although perfect positive correlations between the offshore deliverable forwards and the onshore deliverable forwards have not been observed till now, the correlations have generally exceeded that between the non-deliverable forwards and onshore deliverable forwards since January 2011.

15 15 From September 2010 to February 2015, there are 1161 daily prices collected for the 12-month non-deliverable forwards, 12-month onshore renminbi deliverable forwards and 12-month offshore renminbi deliverable forwards respectively. (See Figure 1) Also, the price differentials between the onshore deliverable forwards against either the offshore deliverable forwards or the non-deliverable forwards are calculated. (See Figure 2), It shows that the price differential using the 12-month renminbi offshore deliverable forward points minus the 12-month renminbi onshore deliverable forwards are generally above the x-axis especially after the first several months of the offshore deliverable forwards launch. In contrast, the price differential by using the 12-month renminbi non-deliverable forwards minus the 12- month onshore renminbi deliverable forwards shows less pattern, where 39% of the price differentials are above the x-axis and 61% are below the x-axis. Moreover, correlation analyses with 100-day overlapping and non-overlapping window are conducted to explore the links between the onshore deliverable forwards and either the offshore deliverable forwards or the non-deliverable forwards. (See Figure 3) The result shows that the correlations between the onshore and offshore deliverable forwards after January 2011, four months after the introduction of the offshore renminbi deliverable forwards, has generally exceeded the correlations between the onshore deliverable forwards and the non-deliverable forwards except the period from October 2013 to February It suggests that the offshore deliverable forwards may provide a more effective hedging opportunity for offshore investors for renminbi currency risks against the onshore forward markets with the presence of their access limitations. However, the perfect positive correlations have not been observed between the offshore and onshore deliverable forwards till now. 2. The offshore deliverable forwards have been more volatile than the non-deliverable forwards against the onshore deliverable forwards, but the volatility has been moderated along with improved market liquidity. The standard deviation of the correlations between the onshore and offshore deliverable forwards is higher than that between the onshore deliverable forwards and the non-deliverable forwards. It implies that prices of the offshore deliverable forwards are more volatile than those of the non-deliverable forwards. However, it has shown that with improved market liquidity, which is evidenced by the bid-offer spread of offshore renminbi deliverable forward points, price volatility of the offshore deliverable forwards has been effectively moderated. It is anticipated that the offshore deliverable forward prices will be more stabilized than the non-deliverable forward prices in the near future with further widening channels of capital flows between the onshore and offshore markets. Based on the 1161 samples collected from September 2010 to February 2015, the bidoffer spread of 12-month offshore renminbi deliverable forward points has been substantially tightened from 76 basis points on average in the first transaction year to 45 basis points on average in the second transaction year, and has been further stabilized at around 28 basis

16 . X. Wang 16 points since September (See Figure 4) Study shows that poor liquidity can directly result in a price discount of a financial asset 20, so I measured the price movements of offshore renminbi deliverable forward points against the policies imposed in the offshore market that affect the market liquidity and the policies announced by the onshore market that potentially widen the capital flows between onshore and offshore markets. Hong Kong SAR acts as the gateway to the offshore renminbi market, and a significant portion of the financial activities have been taking place in Hong Kong. As a result, Hong Kong has played the most important role in the area of China's capital account liberalization and market expansion especially at the early stage of the market development 1 At the same time, Hong Kong also acts as a testing ground where the mainland authorities can effectively monitor and facilitate the process. During the process, both regulations that are designed to limit the financial risks for the offshore use of the renminbi and policies that control the capital flow between onshore and offshore markets have been evolved as well. Observations show that these two categories of regulations had a substantial influence on the overall renminbi funding pool in the offshore market, which directly affects market liquidity and in turn affects the price volatility of the offshore renminbi deliverable forwards. When the offshore renminbi deliverable forward market was initially established in Hong Kong, companies who had a need to settle their imports by the renminbi in the future were incentivized to utilize the forward products to hedge the potential appreciation of the currency. (See Figure 5) As a result, most of the fmancial institutions were encouraged to hold the same renminbi positions - long renminbi and short US dollar. To manage the currency risk and limit the overwhelmingly large renminbi position, the Hong Kong Monetary Authority (HKMA) introduced a new measure on the renminbi net open position in December The renminbi net open position, which was defined as the difference between on-balance sheet renminbi assets and liabilities, excluding any renminbi structural position 2 2, had to be restricted to 10% of respective renminbi assets or liabilities, whichever was larger (1). This announcement immediately brought up the market awareness over the renminbi holdings and indirectly restricted the market liquidity, since authorized institutions could no longer expand their renminbi position without limit by executing a large amount of transactions. The renminbi prices, including the offshore forward points, were immediately affected: the spread between onshore and offshore renminbi forward points was broadened from 100bps to 470bps within one month after the net open position policy was launched. A series of policy changes to net open position have been announced since December In July 2011, HKMA allowed authorized institutions to take the net renminbi deliverable forward position in the opposite direction to offset the net open position (2). Moreover, in January 2012, HKMA introduced a new renminbi risk management limit, 2 0 Amihud, Y and H Mendelson Asset Pricing and The Bid-Ask Spread. 21 R. Sean Craig, Changchun Hua, Philip Ng and Raymond Yuen Development of the Renminbi market in Hong Kong SAR: assessing onshore-offshore market integration. 22Hong Kong Monetary Authority (HKMA) Renminbi (RMB) Cross-Bolder Trade Settlement and Net Open Position.

17 17 requiring that any institution should maintain its renminbi cash equivalent assets at no less than 25% of its renminbi customer deposits. Meanwhile, HKMA doubled the new open position limit from 10% to 20% of the net assets (3). In May 2012, the 20% standard net open position limit was replaced by a customized limit that can be set by individual institutions in consultation with HKMA (4). In June 2012, the renminbi liquidity ratio at no less than 25% was introduced and required by HKMA (5). Finally, in April 2013, both regulatory requirements of net open position and liquidity ratio were removed, because "the offshore renminbi market in Hong Kong has been growing healthily in the past two years both in terms of liquidity and new avenues of lending and investment", stated HKMA 23. The before and after policy announcement comparison suggests that early-stage regulatory policies considerably influenced the offshore renminbi deliverable forward prices. (See Figure 6) In general, soon after risk management policies were announced, it could be observed that abnormal price movements that were measured by the spread between onshore and offshore deliverable forwards were greatly steepened or tightened in response to the regulatory changes that affects the expected market liquidity. On top of these risk management control policies on the renminbi positions imposed in Hong Kong, many currency liberalization policies that aim to relax the capital flows between onshore and offshore markets also effectively foster the pool size of the offshore market and stimulate market liquidity. For instance, additional renminbi 310 billion quota of RQFII, the renminbi qualified foreign institutional investor policy, that allows qualified offshore investors to invest in onshore security markets with offshore raised funding was announced in October This policy was anticipated to widen the funding flow channels from offshore market to onshore market, which immediately incurred price volatility in the offshore deliverable forward market. Furthermore, it is worthy of note that measures that allow renminbi funds to flow across the border from onshore to offshore markets more easily have a more substantial influence on reducing price volatility and increasing market liquidity in the offshore market. Therefore, although the samples showed a more volatile pattern in the offshore deliverable market than in the non-deliverable market, it mainly happened in the initial period after the introduction of the product. It can be explained by inadequate market liquidity when both policy makers and market participants were inexperienced with the new product and market. Therefore, these new policy shocks could lead to market caution over the renminbi positions held by institutions or even financial losses sometimes in order to comply with these new risk management limits. It was understandable that these risk management measures at the early stage of the market development played an important role in balancing the overall market risks and the internationalization process of the currency. However, along with more matured regulation settings and customized risk management systems, it can be predicted that the price volatility in the offshore deliverable market due to regulatory shocks will be moderated, and the offshore deliverable forward prices will possibly become less volatile compared to the non-deliverable forward prices. 23 Source: Hong Kong Monetary Authority (HKMA)

18 18 3. Covered interest rate parity violation is observed between the theoretical and actual offshore deliverable forward prices. By using the covered interest rate parity formula, the theoretical offshore deliverable prices are calculated from September 2012 to February Substantial forward point discounts using actual forward points minus the theoretical forward points are documented. (See Figure 7) Accordingly, with the theoretical forward points, the renminbi interest rate discounts are also implied, where the actual renminbi interest rates are smaller than the theoretical interest rates. (See Figure 8) It implies that theoretically with a renminbi borrowing and a USD investing can bring arbitrage opportunity to the investors. One explanation is that the CNH Hong Kong interbank offering rate cannot accurately reflect the borrowing costs in the offshore market. The actual borrowing costs by investors can be much higher than the interbank offering rates due to the limited renminbi funding pool in the offshore market. 4. The renminbi exchange rate expectation, China's country risk and market liquidity mainly drives the price differential between the offshore and the onshore renminbi deliverable forwards. Regression formula (1) is run to test the offshore deliverable forward points that is normalized by the offshore USDCNH spot rate against nice independent variables. The results indicate that the offshore renminbi interest rates, USD interest rates, USDCNY volatility, VIX, the China government's CDS, Shanghai/Shenzhen index indicator and the offshore forward market liquidity are statistically significant to affect the offshore deliverable forward prices. (See Table 2) Regression formula (2) is calculated to measure the onshore deliverable forward points that is normalized by the onshore USDCNY spot rate against the same set of independent variables. The results show a very similar pattern except that the onshore renminbi interest rates are irrelevant to the forward price. (See Table 3) It is worth noting that an increase in the USD interest rate drives both the offshore and the onshore deliverable forward prices up, which disobey the interest rate parity where USD interest rates should have a negative impact on the renminbi forward rates. This implies that currently the interest rate parity doesn't dominate the deliverable forward pricing in both onshore and offshore settings. The expectation of the renminbi appreciation or transaction costs can be another critical factors to price the offshore deliverable forwards. In addition, although the market liquidity concerns attached to regulatory risks had been largely diminished, which was also signaled by the removal of the renminbi net open position limit and renminbi liquidity ratio requirement, market liquidity is still playing an important role especially to the offshore market. Regression analysis (3) is conducted to assess the price differential between the offshore and the onshore deliverable forwards. The results show that the onshore and the offshore spot rate differences, the onshore USD and the onshore renminbi interest rate differences, USDCNY spot volatility, the China government's CDS and market liquidity

19 19 have a statistically significant impact on the price differential. (See Table 4) Combining the CNH/CNY spot rate factor, the onshore interest rate differential factor, and USDCNY volatility component also supports that the changes in both exchange rates and exchange rate expectations influence the forward market pricings. Moreover, China's country risk tends to affect the price movements of the offshore renminbi deliverable forwards more significantly than that of the onshore deliverable forwards. Lastly, improving offshore deliverable market liquidity will tighten the price differential between the offshore and the onshore deliverable forwards. However, the R squares of these three regressions are only between 30% and 60%, which indicates that only a limited portion of the price differential can be explained by the current study. Implications for the Currency Internationalization Continuously expanding forward product market Market size is a critical indicator to measure the establishment and liquidity of a market. Although the market size of offshore deliverable forward products has been growing rapidly during the last several years, it still has large potentials for the future. For example, in April 2013, the total volume combining Japan's imports and exports was around one-third of that of China, but the daily turnover of the forward transactions in Japanese yen during the same period was more than four times that of the renminbi. During the last several years, not only was the offshore renminbi market relatively new to most corporate investors, but the renminbi appreciation expectation also limited the transaction volumes, with most of the investors choosing to hedge only their import positions against the renminbi receivables. However, since the renminbi has started to have two-directional exchange rate movements, it is expected that stronger hedging demands will come from merchants, especially exporters, in the foreseeable future. Market impact on the offshore renminbi market Based on the observations above, the price movements of the offshore renminbi forward market have become more market-driven than policy-driven after the first several months of market development. Before that, the renminbi deliverable forward price in the offshore market is deviated greatly from that in the onshore market because of the insufficient market liquidity. During the same period, arbitrage opportunities did exist through some channels. Since April 2013 when HKMA lifted a series of renminbi risk management controls, the regulatory risks have been largely moderated. Now market participants can set up and follow their own internal risk management policies to manage their renminbi positions. In other words, most of the transactions will be driven by customers' needs or market participants' views. Moreover, renminbi will be mainly used for China-related businesses, which means ultimately a large portion of the currency needs to be reconnected to mainland China to realize its currency value. As a result, the offshore renminbi deliverable forward prices will gradually follow the onshore deliverable forward

20 20 prices in the short term. Eventually such arbitrage opportunities will be gradually closed along with the growing market size and widening capital flow channels. When the offshore renminbi market becomes fully developed, and when a larger variety of products are freely traded and mechanisms of conducting transactions are more established, it is to be expected that the offshore renminbi forward market will be influenced by global macroeconomic conditions, as are other foreign exchange markets, especially those in emerging markets. For example, the offshore renminbi markets should be affected by the cyclical behavior of capital flows to emerging markets relative to the changes of the global economic outlook and risk appetites. On top of domestic economic conditions, with a broader use of the renminbi in international settings, the offshore renminbi market should be more responsive to the external environment and global shocks. Established hedging feature of the offshore renminbi deliverable forwards Globally, non-deliverable forwards grew rapidly from 2008 to From April 2008 to October 2013, the average daily volume of non-deliverable forwards increased from USD 23 billion to USD 43 billion, and its percentage over all kinds of forwards rose from 11.5% to 21%2. However, this trend has become uncertain since mid On the one hand, nondeliverable forwards for speculation purposes have been undergoing stricter regulatory controls, with regulatory institutions from both the United States and Europe calling for more transparent reporting systems. On the other hand, non-deliverable forwards for hedging purposes have been facing the challenges from a more freely traded deliverable forward product. Prior to the launch of the offshore renminbi deliverable forwards, offshore investors could not directly hedge the currency risks outside mainland China. Non-deliverable forwards as a substitute were widely adopted. However, the settlement of non-deliverable forwards may incur undesirable basis risk. Non-deliverable forwards' settlements are set with reference to the official spot-fixing rate against the US dollar at 9:30am every day by the China Foreign Exchange Trade System. But the actual trading rate on the same day can be within 2% bands of the fixing rate. There is a growing tendency that the actual trading happens near the edges of the bands. Therefore, the difference between the fixing rate and the actual trading rate leads to an unexpected volatility of the currency exchange rate, which is referred to as basis risk. For a company that prefers a direct hedging of its renminbi open position, non-deliverable forwards sometimes can cause unfavorable exchange losses. Moreover, since the investors cannot physically obtain the renminbi currency at the settlement day - they only receive (or pay) the gain (or loss) in US dollars that measures the difference between the contract price and the benchmark price - it is ineffective for the actual renminbi users to settle payments in renminbi. 24 Source: London Foreign Exchange Joint Standing Committee

21 21 In contrast, the offshore deliverable forwards provide a more flexible and costeffective alternative. No matter whether it is for hedging or speculation purposes, the physical delivery of the renminbi currency offers a higher flexibility so that investors can decide if they would like to exchange the renminbi currency back to USD on the same day or any day in the future, or they can use the renminbi directly for payments. In addition, because the fixing rate is set by reference as the current trading rate, the basis risk during deliverable forward settlements is very minimal. Therefore, in general, with a more liberalized offshore market where the renminbi deliverable forwards are widely available, the transaction volume of the renminbi non-deliverable forwards is expected to gradually decrease and more investors who are seeking hedging solutions will choose deliverable forwards instead of nondeliverable forwards to mitigate the potential basis risks. Currently, the Chinese government still restricts non-residents from accessing onshore market, including onshore forward market. Simultaneously a pool of renminbi circulates in the offshore market with widening capital flow channels. During the last several years, the accumulated transaction volume of the offshore deliverable forwards has already started to challenge the volume of non-deliverable forwards. Therefore, because of the flexibility and affordability, the offshore deliverable forwards may become the major hedging product for renminbi currency risks in the near future. Conclusion The offshore renminbi deliverable forward market has been growing substantially since September This study has collected more than 1100 samples from September 2010 to February 2015 to explore the correlations among the offshore deliverable forwards, the onshore deliverable forwards, and the non-deliverable forwards, and the possible causes driving the price differentials during the period. In the early period of the market development, the market liquidity was inadequate. Therefore, policies that regulate the renminbi positions in the offshore market significantly influence the market sentiment and in turn influence the product prices. The observations show that new policy announcements largely incurred recognizable price volatility. However, the policy-driven price movements have been moderated with a more sizable transaction volume and a more established market environment. The market liquidity has been largely improved along with the market development. This is evidenced by the bid-offer spread of offshore renminbi deliverable forward points. Consequently, the price changes of the offshore deliverable forwards have also become more market-driven. According to the correlation analyses, there has been established correlation between the onshore and offshore deliverable forward markets. However, the violations of covered interest rate parity still shows that inadequate funding pool, or potentially higher transaction costs affects the current market. Moreover, the interest rate factors and global volatility expectation also have a statistically significant impact on the offshore deliverable

22 22 forward price. It not only exhibits a more integrated connection between these two markets, but also demonstrates an increasing impact from a global macroeconomic perspective. During the past four and a half years, the progress of the offshore deliverable forward market has revealed a successful angle of the renminbi internationalization process. In the future, the goal to liberalize the renminbi will further foster the market size of the offshore deliverable forwards. In addition, the forward market volatility will be influenced by both domestic economic status and global risk appetite since market liquidity and regulatory concerns will be largely eliminated. Lastly, given its flexibility and effectiveness, the offshore deliverable forward product is estimated to challenge the utilization of nondeliverable forwards and become the major hedging product of the renminbi exchange rates in the offshore markets.