The Case For Renminbi And FXCH
December 20, 2011
FXCH seems like it might be the best-kept secret in ETF land. It's time to get the word out.
When Rydex SGI filed for a new renminbi ETF in June, I wrote a blog out of excitement for this groundbreaking product.
Now that the CurrencyShares Chinese Renminbi Trust (NYSEArca: FXCH) is trading, I'm a little surprised at the lack of investor reception it's received. Two months after launch, it only trades a few hundred shares a day, and has just $7.8 million in assets.
There may be several reasons why FXCH is off to a slow start. But first, I think it's important to cover some important structural differences between FXCH and the other renminbi currency funds, which investors might be overlooking.
For starters, FXCH is the first currency exchange-traded product to provide investors with direct exposure to the renminbi, without using derivatives. Like all other CurrencyShares products, FXCH's shares are backed by the underlying currency, held in deposit accounts. This structure is similar to the popular SPDR Gold Shares (NYSEArca: GLD) physical bullion fund.
Meanwhile, the WisdomTree Dreyfus Chinese Yuan Fund (NYSE Arca: CYB) and the Market Vectors Chinese Renminbi ETN (NYSE Arca: CNY) mostly use nondeliverable forward currency contracts to gain exposure to the renminbi.
The issue that CYB and CNY have run into is that with a slow and steadily appreciating currency like the renminbi, future appreciation is already priced into the forward contracts. This means that to make meaningful gains, the renminbi has to appreciate faster than the forward markets expect.
This has muted the returns in both CYB and CNY since the summer of 2010, when Chinese authorities relaxed their peg to the dollar for the second time in six years. While the renminbi has appreciated roughly 7 percent against the dollar since last summer, CYB and CNY returned roughly 3 percent and 2 percent, respectively.
Renminbi Onshore Vs. Offshore Market
The one caveat with FXCH is that it's based on Hong Kong's "offshore" CNH market, not the mainland's "onshore" CNY market. (To be clear, the CNY currency market shouldn't be confused with the Market Vector's ETN, whose ticker is CNY. So, from here on out, any reference made to CNY will mean the onshore currency market.)
As most investors are already aware, CNY is strictly controlled by the Chinese government, which allows only a small appreciation—or depreciation—within a tight daily band. The relatively new CNH market is open to foreigner investors, but it tends to be more volatile and vulnerable to shocks in the broad markets. This sometimes causes a divergence in exchange rates between CNY and CNH.
Naturally, one would assume that if there's a divergence in exchange rates in the same currency, it would create an arbitrage opportunity for investors to take advantage of the situation, which would eventually bring the two exchange rates together again. But, because CNY is restricted, there's currently no true arbitrage mechanism in place.
However, as James King, a portfolio manager at Rydex SGI, says: "There is a slow motion, or pseudo-arbitrage mechanism in place, due to transactions taking place that can be settled in either CNY or CNH in Hong Kong."
King adds that this "slow motion" arbitrage mechanism continues to bring CNH close to CNY when there's a divergence. He also expects this slow arbitrage mechanism to accelerate and become faster over time as the interbank market—the currency trading system between banks—matures in China.
Regarding the two markets, King makes the analogy to two share classes of the same company. Like different share classes, CNY and CNH are parts of the same entity, but have separate pools of liquidity and supply and demand.
"In that way, it's almost like the offshore trades like a closed-end fund based on the onshore," explained King.
While CNH can periodically diverge from CNY—in October 2010 and September 2011, for example—it tends to crawl its way back to CNY. You can also see the outperformance of CNH—again that's what FXCH holds—compared with CYB since summer of 2010, when CNH began trading in Hong Kong.
So investors looking for renminbi exposure have some choices.
With CYB, you're inherently playing the forwards market and exposed to expectations for future movements that may already be priced into the forward contracts. So far, as I said, this has caused CYB to lag behind the actual returns of the currency.
That being said, according to a recent prospectus supplement, CYB can now hold yuan-denominated money market securities—although as of this writing, only 17 percent of the fund looked to be holding such instruments.
CYB also has some tax advantages. According to its prospectus, if shares in CYB are held over a year, gains are taxed at the long-term gains rate of 15 percent. But gains on all CurrencyShares products are taxed as ordinary income, regardless of holding period.
But to me, there's a certain beauty about FXCH's simple structure. It's comforting to know that your shares are backed by the underlying currency and to understand how your shares move, depending on the CNH exchange rate.
Also, because each FXCH share is backed by 500 yuan, you can always simply take 500 and divide it by the share price to figure out whether you're paying a premium or discount to the current exchange rate, for both CNY and CNH.
So what's possibly behind the lack of investor interest in FXCH so far?
For starters, the timing of the fund's launch might be a factor. There's currently a negative vibe brewing with any Chinese asset, due to weaker economic data coming out of China, signaling slower growth ahead.
"While we have heard and seen a lot of interest from advisors, the assets have been slow to follow. We believe that this is due in part to apprehension about the China government, and the 'true' growth in the economy," Tony Davidow, managing director at Rydex, said recently in a phone interview.
Indeed, export growth in China is slumping to levels not seen since 2009, which might lessen any incentive for Chinese authorities to accelerate currency appreciation.
Inflation has also recently slowed, taking some pressure off Chinese authorities to use currency appreciation to fight inflation. Adding to these fears is the European debt crisis and the U.S. Senate recently passing a bill threatening to label China as a currency manipulator and impose punishments.
Interestingly, the renminbi is recently showing some signs of weakness.
The Wall Street Journal published a story on this topic a few days ago. In fact, the renminbi nondeliverable forward markets are now pricing in a near-term depreciation in the currency, while CNH is trading at a discount to CNY.
But even if China's growth significantly slows, does that mean that we'll see a large depreciation in the renminbi against the dollar? Perhaps, but not a certainty either.
The huge factor at play here is that China's currency is tightly controlled.
In fact, if you look at currency returns since the summer when market volatility spiked, the renminbi has been one of the most stable currencies, especially compared with currencies of emerging and commodity-producing nations, which are highly affected by shifts in the risk-on and risk-off trades.
|Currency Returns Vs. The U.S. Dollar
Since Aug. 1, 2011
|Renminbi Onshore (CNY)||0.96%|
|Renminbi Offshore (CNH)||0.26%|
|As of 12/14/11|
As the Wall Street Journal article pointed out, the general consensus seems to be more of a neutral view on the renminbi in the near future, instead of a downright depreciation.
As a reference, in 2008 during the financial crisis when Chinese exports plunged, China simply halted the renminbi's appreciation for a few years. But it didn't actually weaken its currency against the greenback.
Fast-forward to the current economic crisis. If China were to actually depreciate its currency against the dollar, could you imagine the political friction that would cause with Washington? While it's always possible, it's a scenario that both sides would probably want to avoid.
Despite the negative tone of recent months, most economists and investors still believe CNY—again the onshore currency market, not the Market Vectors ETN—to be undervalued relative to the dollar over the long haul.
The internationalization of the renminbi is also accelerating, and there's chatter about additional offshore renminbi markets in London and Singapore possibly on the way. Expectations are also growing for full-convertibility coming within the next several years.
While economic and political fears may be shunning many investors away from Chinese equities, for those still bullish on China, FXCH is another play to maintain exposure to China, perhaps without having to take on all the volatility associated with Chinese equities.
"We continue to believe that FXCH represents a great way of playing the economic growth in China," Rydex's Davidow added.
FXCH may not be the slam dunk of being backed by onshore CNY, but short of full-convertibility in that market, the CurrencyShares ETF still offers investors the "purest" way to gain exposure to China's currency out of the current mix of exchange-traded products.
Disclosure: I am currently long FXCH.