New Chinese forex crackdown to hit corporate hedging

Despite new reserve requirement, dealers say ‘maturity’ in risk management is here to stay

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Dealers fear a move by the Chinese authorities to reinstate a deposit requirement on foreign currency derivatives could slow a recent pick-up in hedging from local corporates, despite warnings from regulators that firms need to do more to brace for future market volatility.

The People’s Bank of China announced on August 6 that banks must put up a zero-interest, US dollar-denominated deposit at the central bank representing 20% of the notional value of all new forex forwards, swaps and options trades referencing onshore renminbi for a year.

“Recently, due to factors such as trade frictions and changes in international exchange markets, there have been some signs of procyclical fluctuations in the foreign exchange market. In order to prevent macro financial risks and promote the sound operation of financial institutions, the PBoC decided to readjust the foreign exchange risk reserve ratio of forward sales from 0 to 20%,” said the central bank in a statement on its website translated into English.

The rule, which took immediate effect, reinstates a requirement that was in place from September 2015 to September 2017. This time, however, the deposit requirement for options is set at 20% instead of 10%.

Gunjan Kalra, head of the Asia corporate solutions group at Citi in Singapore, says reinstating the reserve requirement is likely to increase onshore hedging costs by around 400 basis points and slow what has been a fairly dramatic move to embrace risk management among China’s corporate community as volatility returned to the country’s currency (see figure 1).

“The renminbi (RMB) market has evolved into a two-way market and this volatility has led to corporate clients being more proactive about their hedging policies,” says Kalra.

She says Citi saw a 20–30% increase in corporate hedging over the past six months compared to the same period for the previous year. Wayne Hua, Shanghai-based head of advisory sales at DBS, says the Singaporean bank, which also has a large corporate franchise in China, saw its corporate sales volume for the first six months of this year hit almost 90% of the volume for the whole of 2017 – with no sign of this slowing down. Candy Ho, HSBC’s global head of RMB business development, also agrees there has been a rise in demand from Chinese firms.

Paradigm shift

Kalra says that despite the PBoC's move, there is now a “newfound maturity” in how Chinese firms approach risk management, which looks like it is here to stay. This sentiment is spreading beyond large, private conglomerates to smaller firms and even state-owned enterprises (SOEs), she adds. “There has been a paradigm shift in how hedging is perceived among the corporate community in China. In the past, losses incurred on hedges were potentially frowned upon by the board, whereas now, increasingly, there is an expectation of a prudent approach to risk management.”

Chinese firms have been forced to think about this since August 2015, following the unexpected depreciation of the RMB that marked the start of two-way currency volatility. But Kalra says this latest change in corporate culture is the result both of a greater awareness of the risks that firms face on the domestic market – something the Chinese authorities are keen to highlight – and of firms that have gone overseas and had to face risks beyond their own currency.

A return of volatility – the end of June saw the sharpest decline in the RMB since 2015, with the currency falling 3.6% over a two-week period – has prompted authorities to step up their warnings that firms need to do more to guard against risks. Both the State Administration of Foreign Exchange, which oversees foreign exchange market activities, and the PBoC have issued warnings that Chinese corporates need to brace for more volatility and should be prepared to do more hedging.

“When the Chinese government calls for corporates, particularly SOEs, to strengthen their risk management capability, then the mindset for some of these firms is perceived to change and skill sets to improve,” says DBS’s Hua.

Options in vogue

Options have increasingly been used by corporate hedgers with US dollar liabilities looking to retain upside exposure in case the trend reverses and moves in their favour – especially as the prior rules required only a 10% deposit compared to 20% for other instruments. Theoretically, this made options cheaper to use, depending on the nature of the hedge and the structure deployed.

According to Citi’s Kalra, corporates in Asia have tended to be more comfortable doing zero-cost structures such as capped forwards, since it is difficult internally to justify paying a premium, which is required in an options-based hedge. However, firms in China have been increasingly willing to pay a little more in return for the greater flexibility that options provide.

In the past, losses incurred on hedges were potentially frowned upon by the board, whereas now, increasingly, there is an expectation of a prudent approach to risk management
Gunjan Kalra, Citi

Traders at HSBC and DBS agree that interest in options has risen, although they note that the pool is still seen as relatively small, with spot and forwards markets the overwhelming hedging instruments of choice.

However, the PBoC’s new reserve requirements bring options into line with other forex instruments, and potentially remove the incentive to trade the product.

Despite the latest news from Beijing, bank sources believe the trend towards greater currency hedging by corporates is likely to continue, particularly in light of growing internationalisation of the RMB and the development of China’s global Belt and Road initiative.

Kalra says Citi is more concerned about the inability of corporates to hedge adequately on the fixed-income side, given the lack of cost-effective tools. “This market is really nascent in terms of what we can offer to our clients, and that is a huge challenge,” she says. “Corporates that issue bonds want to be able to hedge the forward-starting risk they have on upcoming issuances. Those solutions are not really there compared to what we see in developed markets.”

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