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Voltaire once wrote that “uncertainty is an uncomfortable position, but certainty is absurd”. However, since 2005, investors in the renminbi have achieved a 25% return with minimal volatility [1] – a near certainty in the investment universe. The latter attribute is surely the most attractive, as other assets have outperformed in absolute terms, but have trailed the renminbi in risk-adjusted returns. Investors could not only expect low-volatility, but consistently positive returns as Chinese currency was guided lower (stronger) per official policy. Over the past five years or so, this has resulted in tremendous demand for the RMB. Unfortunately for investors, because of the strict and effective capital controls, the RMB was not accessible, and more importantly, not convertible. However, with the advent of the offshore RMB or CNH market, investors are able to take advantage of the so-called “one-way bet”. As we showed in a recent Policy Brief, it is this demand from foreign investors which has been the key factor in the growth of the offshore RMB market. But what happens when two-way volatility means the “one-way bet” is no longer so certain?
We don’t know the answer to that yet, as the RMB’s value is still determined in Beijing and not by market forces in Shanghai or Hong Kong. However, events over the last several months can give us some idea. As mentioned above, investors have enjoyed stable, consistently positive returns in the RMB which has outperformed most other asset classes in risk-adjusted return. Exhibit 1 shows that the RMB has been one of the most consistently positive assets since 2005, yielding a week-over-week positive return 66.1% of the time, compared with 56% of the time for the S&P 500. Exhibit 2 shows rough estimate of risk-adjusted return ratio [2]. Clearly the RMB has been a good bet for an inclined investor.
What has happened recently? Let’s look at YTD performance. In exhibit 3 and 4 we show similar charts, but based on daily returns instead of weekly (potential time zone distortions notwithstanding). Clearly the picture has changed. The RMB has been a poor performer in absolute and risk-adjusted space. But most importantly, volatility has increased and remained elevated (exhibit 5).
Exhibit 1: Percent positive week-over-week returns across selected assets, 2005-2013
Source: Datastream, author’s calculations
*Note: EM is a basket of emerging market currencies with the same weights as the MSCI EM equity basket
Exhibit 2: Risk-adjusted realized return measure, 2005-2013
Source: Datastream, author’s calculations
Exhibit 3: Percent positive daily returns across selected assets, YTD 2014
Source: Datastream, author’s calculations
Exhibit 4: Risk-adjusted realized return measure, YTD 2014
Source: Datastream, author’s calculations
Exhibit 5: 6-month rolling realized volatility
Source: Bloomberg, author’s calculations
As we’ve mentioned in previous posts, the sharp drop in the market value (the fixing rate has been more stable) of the RMB and the widened trading band are very likely an explicit policy choice by the PBoC to try to curb the illicit inflows which accelerated in Q4 2013 and the first part of the Q1 2014, as well as slowly marketize the currency. The unaccounted-for capital inflows (a.k.a. hot money) have actually been relatively important for the Chinese domestic financial system. Some estimate that hot money flows have accounted for approximately 25% of the growth in China’s monetary base over the last five or so years. Though these estimates seem optimistic to us especially given the uncertainty around the attribution of “hot money” (which we have also estimated in previous posts), but also because it seems unlikely that the monetary base would have not expanded via other means were these capital flows not to have occurred. The point remains, however, that foreign non-FDI capital has become an increasingly important source of liquidity in the Chinese domestic financial system. Savvy investors, who by a variety of balance-of-payments related schemes, have been chasing the aforementioned one-way bet. Given the uncertainty over not only the medium-term outlook for the RMB and the Chinese economy more broadly, but also the equilibrium outlook for the currency, the marginal foreign investor is now pricing in a higher risk premium, at the very least from currency (exhibit 6 shows 3-month option-implied volatility). This means higher external funding costs for Chinese firms with legal access to overseas capital markets, and perhaps a capital short-fall for Chinese firms who relied on illicit channels to gain access to cheap foreign financing.
Exhibit 6: 3-month option implied volatility of the RMB
Source: Bloomberg
Putting this in perspective, the Chinese authorities have ample means at their disposal to deal with any short-fall in liquidity, and have very recently been incrementally loosening policy in a targeted manner. At the same time, they continue to implement piecemeal reforms to the financial sector and the capital account. While we believe that the incremental reforms are certainly directionally positive, artificial injection of policy volatility into the currency market is not a long- or even medium-term solution to the problem of illicit capital flows. This policy is expensive, and ultimately runs counter to China’s longer-term objectives.
[1] Assuming a USD-based investor. We recognize that for much of this period, the RMB was not an investable asset for most investors (outside of QFII). However, we would argue that subsequent investors’ expectations built in the record of stability and policy-driven appreciation when the RMB became investable via the CNH market.
[2] Defined as the annualized return from 2005 through 2013, minus the annualized return of a designated risk-free asset, divided by the standard deviation of that same time period. We use the return on a 10-year US Treasury bond index as the ‘risk-free’ return here. All non-USD assets include currency effects. We do not consider carry (the difference between funding market and investing market rates) in returns.