The recent improve in offshore renminbi (CNH) liquidity in the first few weeks of 2013 is unlikely to lead to a decline in offshore renminbi costs due to the strong ongoing demand for CNH funds.
The offshore renminbi funding pool has again entered a growth phase, with the pick-up in current account inflows more than offsetting ongoing capital account outflows.
The bout of flush of liquidity in the first few weeks of 2013 led to a collapse in the overnight deposit rate to 0.7% from 2.5% in December and the one-year cross currency swap (CCS) to 1.9% from 2.6%, according to Standard Chartered (StanChart) in a research report released on February 1.
The is due to the steady and relatively loose monetary conditions in the domestic market as a result of frequent People’s Bank of China (PBoC) open market operations (OMOs), said Becky Liu, China senior rates strategist at StanChart. “Corporates’ swift response to the reemergence of the sizeable CNH exchange rate premium over onshore Chinese renminbi [is also a factor].”
PBoC’s OMOs helped improve onshore liquidity, where the overnight repo rate declined to 2% in January from 2.3%-2.5% in December, notes StanChart.
The potential pullback in February, which will likely bring currently overshooting CNH rates back to their medium-term fair levels, is unlikely to derail the trend towards renewed growth in the offshore funding pool.
This is because current account inflows is expected to remain strong, especially as USD/CNH is likely to remain at a premium over USD/CNY due to renewed renminbi appreciation expectations, says StanChart.
“We believe this pickup will more than offset capital account flows,” said Liu. “However, a repeat of the ultra-strong inflows seen in 2010-11 is unlike since restrictions are already in place to prevent pure arbitrage activity.”
While the CNH market will see some improved levels of inflows this year given that offshore exchange rates are priced at a premium, capital outflows will still remain the dominant driving force in 2013, indicating that funding rates will still remain high. An estimated more than Rmb300 billion (US$48.2 billion) is expected to flow out of Hong Kong, notes StanChart.
“We expect more balanced measures to be introduced over time, but the direction of capital flows is unlikely to change in 2013,” said Liu. “One of the measures in the pipeline is a scheme QDII2 (Qualified Domestic Individual Investors) – a pilot programme allowing individuals on the mainland to invest overseas using onshore funding.”
Also, corporates could still obtain cheaper financing via offshore loans seeing that they are market-driven as opposed to onshore loan rates which are regulated.
For example, CNH loans more than doubled in the first 10 months of 2012 to Rmb70.1 billion from Rmb30.8 billion as of end-2011.
“We expect CNH loans to rise further, especially following the start of the Qianhai cross-border loan pilot programme,” adds Liu.
As a result of all this factors, which are likely to lead to liquidity outflows from the CNH market, StanChart sees limited upside for short-dated Chinese government bonds (CGBs) – three years or below – and expects their yield to stay around the current 2.25% due to sticky funding costs, which we expect to remain around 3%.
On the other hand, long-dated bonds – beyond five years – should be better supported, with the 10-year offshore CGB yield likely to decline to 2.8% by end of the first half of 2013 from the current 3%, adds the bank.
Because of this trend, StanChart recommends an overweightduration stance on offshore Chinese government bonds (CGBs) as the long-dated tenors of these instruments is likely to be supported by strong demand from foreign central banks’ reserve diversification and a limited supply of Rmb25-Rmb30 billion in 2013.
The supply of short-dated offshore CGBs is also likely to stay subdued.
“Short-dated offshore CGBs are likely to lag the overall uptrend in dim sum bond market as the cost of CNH funding stays sticky and demand from banks weakens…as the change in the HKMA’s [Hong Kong Monetary Authority] liquidity ratio calculation in mid-2012 removed CGBs’ unique status as the only eligible liquefiable asset,” said Liu.
The average yield of offshore CGBs was 2.89% at end-2012, rising 84 basis points from a year earlier, more than 57bp increase for broader high grade bonds.