Interest rate strategy

CNH: The evolution of importer strategy July 25, 2011

CNH: The evolution of importer strategy

DBS Group Research 25 July 2011

The much cheaper offshore funding costs (relative to onshore) resulting from the divergence between Chinese and Hong Kong (/US) interest rates has driven a surge of offshore USD borrowings by mainland borrowers over the past year. Strengthening demand for USD funding drives up the costs of USD borrowing significantly. The arbitrage of importer strategy on USD loan thus becomes less attractive. As a result, enterprises are beginning to favor borrowing CNH offshore recently through discounting renminbi letters of credit (LC).

Cross-border renminbi trade settlements heavily skewed towards imports

Previously, when trade was denominated in USD, multinational companies could only benefit from lower loan interest rates through offshore affiliated firms. After the launching of the cross-border renminbi trade settlement, these companies have been able to reap the benefits of arbitraging from both exchange rates and interest rates. This partially explains why most of the cross-border RMB trade settlements have been import-related rather than export-related. Around RMB 1 trillion of trade has been settled under the program since July 2009, and some 90% of the settlement was mainland importers payments for offshore products; export-related settlements only amounted to 10%. Among the import-related cases, most of the offshore exporters are affiliated firms of onshore importers (Chart 1).

Chart 1: CNY cross-border trade settlements heavily skewed towards imports

CNY bn 160 140 120 100 80 60 40 20 0 May-10 Feb-10 Sep-10 Mar-10 Nov-10 Dec-10 Feb-11 Jan-10 Jan-11 Aug-10 Mar-11
1

Inflows

Outflows

Total

Apr-10

Jul-10

Enterprises are shifting away from USD loans to CNH loans

To conduct arbitrage trade, the so-called importer strategy works the following way. An onshore company generally deposits a specific amount in an onshore bank and applies for a one-year time LC or other bank credit guarantee endorsements.

Nathan Chow (852) 3668 5693 nathanchow@dbs.com

Oct-10

Jun-10

CNH: The evolution of importer strategy July 25, 2011

The offshore affiliated firm will then apply for a low-interest USD loan backed by a LC with an onshore renminbi account receivable as collaterals, and sells non-deliverable forward (NDF) CNY to repay the USD loan in a years time (Chart 2).

Chart 2: Importer Strategy

Onshore Bank

4. Pay RMB one year later

Offshore Bank

2. Place deposits and apply for LC

3. Apply for USD loan and enter into NDF

5. Settle NDF and repay USD loan one year later

1. Contract to trade in RMB China Importer

Overseas Exporter (affiliated firms)

This arbitrage has led to a rapid growth in demand for USD loans; causing a significant increase in the interest rates for USD loans in Hong Kong. To our knowledge, the interest rate for one-year USD loan is now as high as 3%, compared to less than 2% earlier this year. While the mainlands one-year onshore deposit rate is 3.5 %, the surge in USD funding cost makes the arbitrage of importer strategy on USD loan less profitable. Consequently, we are seeing a shift from these companies tapping the CNH market since interest rates for CNH loans are lower (around 2.6%). (Chart 3)

Chart 3: Enterprises are shifting away from USD loans to CNH loans

Overseas Exporter (affiliated firms)

USD loans interest rates 3%

CNH loans interest rates 2.6%

Interest rate spreads between USD and CNH loans to narrow

In order to curb speculation on currency gains, the PBoC has tightened regulations on RMB transactions in Hong Kong since June 2011. For instance, offshore banks must make sure their clients RMB transactions are supported by trade settlements, and settlements must occur within three months after the transaction has been

CNH: The evolution of importer strategy July 25, 2011

made (see Time to re-engage in the CNH-NDF basis trade, 27Jun11). Nonetheless, we believe that the onshore funding cost is likely to remain high given that the authorities are fighting inflation. Hence, lending interest rate differentials (around 300 basis points for one-year loans) between the onshore and offshore markets will thus keep the importer strategy in play. In addition, the NDF market will probably price in a faster renminbi appreciation once the transitory soft patch in the global economy passes and that will bring greater opportunities for settlement arbitrage. Meanwhile, strengthening demand for CNH will likely raise the CNH loan-to-deposit ratio. That could, in turn, cause banks to tighten borrowing requirements. As a result, interest rates for CNH loans may rise subsequently and spreads between USD and CNH funding cost would narrow accordingly.

CNH: The evolution of importer strategy July 25, 2011

Recent research
SG: Sticky inflation TH: Investment is the priority CNH: Decoupling of CNY/CNH bond yields to continue ID: Subsidy saved, subsidy earned JP: Recovery gathers steam VN: Growing pains CNH: Time to re-engage in the CNH-NDF basis trade CN: How likely is a hard landing? PH: Weathering headwinds Tactical Regional Asset Allocation 25 Jul 11 21 Jul 11 18 Jul 11 CN: The roller coaster ride continues CN: Offshore CNY progress check 2Q11 Tactical Regional Asset Allocation SG: A well-calibrated budget 5 Jul 11 CN: Inflation and labor productivity 1 Jul 11 28 Jun 11 27 Jun 11 CN: CNY capital account liberalisation -recent developments and implications ID: Interest Rate Outlook & Strategy TW: Appreciation impact 27 Jun 11 IN: Food inflation demand-driven 24 Jun 11 SG: Budget to tackle the gap 15 Jun 11 US: Interest Rate Outlook & Strategy ID: Indonesia FDI: more coming, more needed 14 Jun 11 SG: Singapore attempts the impossible Asia: Food prices and income inequality in Asia CN: A case study of price control on electricity CN: Good value in CNY forwards US: Interest Rate Outlook & Strategy CN: Latent risks facing China SG: Election effect on policy HK: Mild tightening at work KR: Interest Rate Outlook & Strategy ID: The balance of payments outlook FX: The CNH & its role in yuan reforms CN: The formation of Chinese wealth CN: Interest Rate Outlook & Strategy 6 Jun 11 SG: 2011: Above expectations 20 May 11 KR: Interest Rate Outlook & Strategy EUR: One for the bulls 18 May 11 KRW: Stronger than consensus 11 May 11 ID: 2011 budget preview 9 May 11 Asia: Interest Rate Outlook & Strategy 9 May 11 IN: Higher rates or higher inflation 15 Apr 11 Asia: The six ways to absorb capital inflow 11 Apr 11 MY: A step towards Vision 2020 8 Apr 11 IN: Rising growth potential 7 Apr 11 ID: Inflows & monetary policy 1 Apr 11 SG: Its payback time 31 Mar 11 11 Oct 10 13 Oct 10 13 Oct 10 18 Oct 10 26 Oct 10 26 Oct 10 28 Oct 10 1 Nov 10 3 Nov 10 29 Nov 10 11 Nov 10 11 Nov 10 6 Dec 10 11 Jan 11 17 Jan 11 24 Jan 11 8 Feb 11 21 Feb 11 28 Mar 11 24 Mar 11 23 Mar 11 21 Feb 11

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