Arbitrage from pledging RMB for USD funding has disappeared

The opportunity for corporates to place higher yielding renminbi as collateral in exchange for cheaper US dollar financing has vanished, signalling the rapid convergence between onshore and offshore rates.

  • 15 Oct 2012
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The easier access to the renminbi has prompted companies to look for ways to leverage on holding the renminbi. One of them being: pledging your renminbi as a guarantee in return for US dollars. But Standard Chartered notes that this window of opportunity has already disappeared.

Nei bao wai dai’ as it is known in Chinese stands for ‘onshore guaranteeing, offshore credit’. This is a practice where a corporate would have to provide the issuing Chinese bank with a guarantee, which could be deposits or even standby letters of credit (LCs) pledged as security with a bank, in return for a US dollar loan.

The benefit is the savings made between the differences in interest rates between the two currencies.

It is believed that corporates were able to save approximately 300 basis points (bp) to 400bp two years ago, but now the spreads have tightened to around 100bp-150bp due to the increase in demand for such products.

However, based on recent figures generated after taking into consideration renminbi depreciation expectations and the decline in onshore interest rates, the breakeven cost that banks will charge their clients for US dollar funding has narrowed from Libor+300bp a year ago to Libor+55bp, which essentially means that the arbitrage opportunity has vanished.

Referring to the calculations above, the total cost that banks would charge their clients for US dollar loans, excluding margin, is 1.58% (adding one-year Libor rate and breakeven rate). If financial institutions were to add a margin they would essentially have to charge more than 1.58%, which is a disadvantage for corporates.

If banks were to charge a cost of 1%, they will be making a loss and corporates will be benefitting from this with a 55bp saving. But, this is of course unlikely to occur.

“For the last 12 months, we haven’t seen many arbitrage opportunities because the margins are not there anymore and really, it’s not worth reducing your funding costs for a few basis points because you effectively blow-up your balance sheet as a corporate,” said Michael Vrontamitis, regional head of product management for Northeast Asia at Standard Chartered (StanChart) for Asiamoney PLUS in a telephone interview on October 12.

The corporate would be artificially inflating the size of its balance sheet as it places deposits in a higher yielding currency and pledging it to obtain a loan in another location at a lower yield. This essentially is a foreign exchange (FX) mismatch.

There are two elements that influence this arbitrage model: the interest disparity and exchange rate expectations, highlights Standard Chartered.

In order to make it work, renminbi appreciation expectations should persist and upward adjustments in interest rates should continue. This trend has, however, changed over the last few months as China continues to face headwinds in sustaining its growth and as the European sovereign crisis remains unresolved.

“Effectively what has happened over the last 12 months is that the expectations of appreciation has gone away and there is now a depreciation expectation for renminbi particularly from the offshore perspective,” declared Vrontamitis. “The second aspect that has happened over the last six to nine months is that the difference in interest rates between offshore and onshore has narrowed.”

The renminbi has fallen 1% against the US dollar since the start of 2012. Some banks have even readjusted their expectations.

Société Générale has also lowered its forecast for the Chinese currency. It now forecasts a 1% depreciation against the dollar instead of expecting the currency to be flat, and says the dollar/renminbi exchange rate is likely to reach 6.3500 by the end of this year, compared with 6.2940 late last year.

Additionally, the recent cut in policy rates has also led to this dwindling in arbitrage opportunity.

“In June and July this year, the PBoC (People’s Bank of China) actually cut the renminbi benchmark rate. This makes the one-year deposit rate drop by at least 50 basis points or more,” said Frankie Au, director for product management transaction banking for StanChart.

The PBoC surprised the market by announcing its decision to cut its one-year lending and one-year deposit rates by 31bp and 25bp respectively to 6% and 3% on July 5. This follows a cut on June 7, the first since 2008.

While arguments remain about how renminbi depreciation expectations is anticipated to reduce the pace of corporates redenominating their trade transactions into the Chinese currency, the market has finally come to terms that this is not only a one-way bet.

The use of the renminbi as a trade settlement currency is generally on the rise around the world.

For example, from July to August, 12.3% of China’s trade was settled in renminbi, up from 10.7% in the first half of the year. This is being driven by real corporate need rather than arbitrage opportunities.

Additionally, this was a rebound from the fourth quarter of last year, post-NDF (non-deliverable forward) shift to depreciation mode, when redenomination of the Chinese currency by companies deteriorated to 8.9% from 10% in the second and third quarter.

“Effectively what has happened over the last 12 months is that the expectations of appreciation has gone away and now is a depreciation expectation for renminbi particularly from the offshore perspective,” declared Vrontamitis. “The second aspect that has happened over the last six to nine months is that the difference in interest rates between offshore and onshore has narrowed.”

  • 15 Oct 2012

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