Vibrant dragon, golden snake?

While China''s entry into WTO is expected to attract vital capital inflow, Frank Gong, vice president of the global markets group at Bank of America, warns that it will bring short-term risk to the currency market.

Frank Gong, a currency strategist at Bank of America, expects robust growth to continue in the year of the snake. Setting the scene at the recent Eurofinance Cash and Treasury Management conference in Singapore, Gong reports that China reported the highest growth rate in Asia during the first quarter. Despite the global slowdown, it recorded first quarter growth of 8.1% year-on-year.

Factors that are expected to support this growth are a continuing flow of foreign investment and a less export-dependent economy due to rising domestic demand. Foreign direct investment (FDI) is growing at a rate of 10% yoy and is expected to amount to nearly $50 billion in 2001. Already in the first quarter, FDI reached almost $10 billion. Domestic consumption, meanwhile, is growing at 10% yoy.  

Since 2000, China's domestic A-share and B-share markets rank as the world's best performing, with the B-share market index returning more than 100% in 2000 and another 110% year-to-date. Furthermore he says, China's state-owned companies have been able to raise more than $22 billion from the global equity markets through initial price offerings (IPOs) despite difficulties in stock markets worldwide. This figure is almost half of the total IPO's raised for Asia ex-Japan companies in 2000.

When China accedes to the WTO, Gong expects that more FDI will be attracted to China and help integrate the Chinese economy into a rule-based international economic system. This should accelerate reforms in the SOE (State Owed Enterprise) and banking sectors to improve efficiency and help cultivate a market-oriented domestic economy based on the rule of law.

Importantly, increasing FDI and a developing market-oriented domestic economy facilitates the transmission of new technology and management skills. In turn, Gong says that this will force a more flexible foreign exchange system and speed up the process of achieving full Chinese renminbi convertibility.

However, Gong warns that only a few of the benefits will show up immediately. WTO entry in the short run will have a deflationary effect. The huge trade surplus may be reduced as more imported goods compete in the domestic market. Pricing pressure will increase as tariffs and subsides fall and this may worsen the deflation and unemployment problems that China currently suffers. Further, China's still fragile banking and financial sector will face fierce competition from foreign banks. Bad assets held by banks could worsen if price cuts and increased competition make Chinese firms unprofitable.

The deflationary effect of WTO entry leaves no room for the Chinese renminbi to appreciate. Ideally, says Gong, the market must be allowed to play a greater role in determining the foreign exchange rate. Full renminbi convertibility will be necessary after China's economy becomes more integrated into the global economy and a free-floating system is the only feasible alternative, he argues. Bank of America expects that, should the band around the renminbi be widened, the onshore foreign exchange market will also be allowed.

Gong believes a risk of renminbi devaluation is higher under the Bush administration. One of the key factors that prevented a renminbi devaluation during the Asian crisis, says Gong, is the joint intervention by the US and Japan to support the yen. However, Gong believes that the Bush administration is less interested in market intervention, let alone intervention for the renminbi's sake. Therefore, there is likely to be a higher tolerance for a weaker yen from the US.

Currently, on-shore hedging of the renminbi can only be done through the Bank of China (BOC). The BOC offers renminbi forward contracts to onshore entities for current account-related hedging purposes. Tenors are only up to six months.

Both foreign investment entities and local trade companies can do onshore hedging but there is no competition in terms of pricing. As the renminbi is not convertible under the capital account and foreign exchange, forward transactions are regarded as capital account transactions, a natural renminbi forward market does not exist.

However, a non-deliverable forward (NDF) market has developed and participants are all offshore entities located outside mainland China. This NDF market is not very liquid, says Gong - average daily volume has been $50 to $100 million in 2001. The minimum size is $5 million. Gong says the current level of six month at 8.34 renminbi and one year at 8.42 renminbi is "still cheap".

One alternative to the hedging of the renminbi is the Hong Kong dollar (HKD) forward. Gong recommends two strategies. Firstly, to hedge against the possibility of a wider renminbi band, Gong, advises taking long positionson HKD interest rates. If the renminbi is more volatile and trades weaker, the HKD Hibor premium over Libor should be higher, although the peg may still stay as the market demands a higher risk premium for the peg. Therefore, HKD forwards can be gained in such a hedge if the renminbi is weaker. The HKD forward market is very liquid and there is no problem trading a position up to $50 million to $100 million at one time.

The second strategy involves taking short positions in renminbi NDF, but long corresponding HKD forwards to catch the expected narrowing spread between the NDF curve and HKD curve. Gong expects the NDF curve to move down while the HKD curve to move up in the event of a wider renminbi band.