(Bloomberg) –
The Chinese renminbi’s rapid conversion of a sleepy background of the foreign exchange market into a currency suitable for competitive global counterparts leaves traders worried about how much further they can go without reforming and buying its rise.
In London – the world’s center of foreign exchange – more yuan is changing than ever before. Options in the Chinese currency exceed those referring to the Japanese yen, and buying or selling the yuan is now just as cheap as trading the British pound. Against this background, there are signs that Renminbi is playing an increasing role in influencing broad dollar movements, according to Wells Fargo & Co.
There have been many false adventures in China’s pursuit of the yuan to challenge other major currencies. But this time around, the explosion is fueled by a torrent of capital pouring into China’s markets, fueled by a frantic search for more than $ 14 billion in debt that pays less than 0% worldwide.
The appetite for some of the highest yielding government bonds in the Group of 20 countries has raised interest in China to fever and generated the demand for liquidity from investors who want to finance and hedge their investments. It also stimulates volatility and attracts speculators who have overlooked the market for years.
“It’s definitely a top currency in terms of the flow we see,” says Kevin Kimmel, global head of electronic FX at Citadel Securities, one of the world’s largest market makers in New York. “Trading activity in the yuan has increased significantly.”
The shift comes as China continues to relinquish – albeit slowly – its tightly managed currency, a key point of Beijing’s long-term plan to encourage greater global use. China is considering easing restrictions on citizens investing in securities outside its continent, a move that could facilitate two-way capital flows.
The so-called internationalization of the yuan is an important part of the government’s goal to relinquish dependence on the US dollar, and which some see as a geopolitical challenge to the supremacy of the greenback. The decline in China’s dependence on the dollar has become more important in recent years due to economic tensions with the US, a trend that is likely to continue under the Biden government.
For now, international investors are encouraged to use the foreign version of the currency, known by the CNH denomination in markets.
Although the foreign yuan is theoretically freely tradable – meaning that the price can fluctuate with demand, economic data and geopolitical developments – it usually stays fairly close to the domestic unit, abbreviated as CNY. And since it is allowed to stray only 2% above and below a daily rate set by the central bank, China keeps the exchange rate far beyond its borders – a peculiarity that could ultimately delay adoption.
Growth acceleration
Despite the limits, average yuan turnover in London rose to a record $ 84.5 billion a day in October, according to a central bank survey among the world’s largest FX trading center. In North America, daily volumes more than doubled compared to the same reporting period last year, to $ 7.8 billion a day. The EBS of exchange giant CME Group Inc. says that spot volumes on its platforms in London and New York increased by 90% and 131% respectively from 2015 to 2020.
Along with this growth in the spot market, there is also a huge demand from investors for instruments to hedge and trade their currency risk. The daily option volumes on the yuan in London rose to a record $ 11.7 billion in October, while on average nearly $ 12 billion in futures contracts changed hands every day, according to Bank of England data.
“It was intended to drive the currency freer in the market,” said James Hassett, co-head of Global Emerging Markets and G-10 Linear FX at Barclays Plc, in Singapore. “It gives people more confidence to trade it.”
At the heart of this metamorphosis is foreign funds that have gradually poured cash into China over the past year, contributing the best bonds in January to their bond holdings. Many are chasing higher yields – China’s 10-year bond yields 3.3%, compared to about 1.3% for equivalent US treasury and less than 0% for German bonds. Others add their contributions to increase exposure to the country’s assets, which have only recently been included in some of the world’s largest benchmark indices.
Amid this shifting landscape, market meters show that the projected fluctuations of the foreign yuan over a one-month horizon are now as wide as for the euro and the yen. While partly a function of the fluctuations for the major currencies declining in the face of unprecedented actions at the central bank, the yuan volatility attracts hedge funds and other fast money investors to make a profit.
The extra liquidity helped reduce the cost of transactions in the yuan to about $ 20 for every million dollars traded, according to Citadel Securities’ Kimmel. It is similar to the pound and compares to about $ 10 for the Euro-US dollar cross, the world’s most liquid pair. It is far below the spread on emerging market currencies, which ‘exceeds’ $ 100 per million,’ he said.
The question is whether all this interest in the yuan can last, especially as yields climb in developed markets such as the US, which ultimately reduces China’s relative attractiveness. Some of the largest banks in the world bet that demand will remain, with people like Deutsche Bank AG and Citigroup Global Markets Inc. which increases their China-dedicated staff in hubs such as London, New York and Singapore.
The movements reflect HSBC Holdings Plc’s call last year for the yuan to be included in the highest level of foreign exchange. Classic strategist Paul Mackel said the Group F-10’s classic FX label – which includes smaller Scandinavian currencies in addition to envelopes such as the dollar, euro and yen – is also ‘outdated and misleading’.
Despite its still small share in global trade – according to the latest data from the Bank for International Settlements – by 4.3% from 2019, the yuan recommends an extraordinary role in the foreign exchange market, as its daily movements serve as a key indicator of global investor sentiment. Wells Fargo strategists, including Erik Nelson, argue that the Chinese currency could even exert an influence on the broad dollar index.
‘Paradigm shift’
The foreign yuan may be gaining more weight in the fight for world currency domination, the strategists wrote in a note to clients this month. “If we continue to see signs that USD / CNH is having more influence on broad dollar movements, it could be a significant paradigm shift in the FX markets,” they wrote.
Yet Beijing’s ambitions to make the yuan a real global currency are still ahead of many challenges.
The share in the central bank reserves is about 2%, compared to almost 21% for the common currency and just over 60% for the US dollar. This is a pitifully low percentage given the size of China’s economic production. At less than 3%, Renminbi’s share in global payments is only a fraction of its larger competitors.
According to Bipan Rai, head of foreign exchange strategy at the Canadian Imperial Bank of Commerce in Toronto, it is the age-old issue of restrictions on the movement of capital across Chinese borders that is one of the biggest headwinds.
“China has made a lot of progress on this front, but it is still not quite at the level of free capital flow that you see in other developed markets,” Rai said. “It could be gone a few times.”
(Add details in paragraphs 6 and 7 to indicate China’s latest move to relax capital controls.)
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