FX AND REPATRIATION
Structuring an FX Program with NDFs: Managing Risks of Currency Appreciation
April 30, 2007
Mark Frey, Custom House Ltd.

"In a market where everyone is trying to get their foot in the door or consolidate the market position they've already achieved, the structure of your FX program can be a component of your competitive advantage...." ARTICLE TOOLS Print Version Reprints RECENT ARTICLES Different cities, same customers China is the region's top stop for exporting Improving wire transfers Quantifying your banks' performance

Doing business in China is an attractive but risky proposition, and although the timetable and scale of further CNY appreciation versus the greenback is unclear, the risks certainly seem to point to continued valuation increases for the yuan.  Mark Frey, head foreign exchange trader at Custom House Ltd., explains how non-deliverable forwards can be used in an effective hedging strategy.

The U.S. Commerce Department announced tough new measures on March 30, which will introduce countervailing duties on coated paper imports from China.  In doing so, the U.S. has reversed a two-decade-old policy of not imposing duties on imports from non-market economies, due to the inherent difficulties in identifying and quantifying the value of economic subsidies in a managed economy such as that in China.

Such a dramatic change in the implementation of policy comes as somewhat of a surprise even though the rhetoric coming from U.S. policy makers has been quite aggressive in its condemnation of the Unites States' trade deficit with China, which hit an eye-popping record of $233 billion in 2006.  Undoubtedly, this move on the part of the Commerce Department will spur renewed debate with respect to whether or not similar measures should be applied to other sectors.  In light of these developments, it makes sense to ask whether this latest volley from U.S. legislators will result in an increased trajectory for the Yuan's continual ascent, and if so, how does one protect against such a risk to a business exposed to a CNY appreciation?

Many Western market pundits believe the yuan could be undervalued by as much as 30 to 40% against the greenback.  Chinese officials on the other hand would be the first to point out that this is based purely on speculation.  Therefore, the first step in evaluating the merits of any CNY hedging program should be to attempt to quantify the risks of not doing anything.

While it seems to be overwhelmingly clear that the Chinese will not simply bow to U.S. pressure and throw their timetable for economic reforms out the window, the pace of change may begin to quicken.  If allowing for more flexibility in their currency will stave off an all-out trade war with the U.S., Chinese officials may be more willing to accelerate their reforms aimed at preparing their economy for a free-floating currency and less centralized management.  After all, there certainly is a rather compelling case for the notion that the CNY is significantly undervalued.

Since the implementation of the managed floating exchange rate system in July 2005, the CNY has risen approximately 7.1% in total, including the initial 2.1% at revaluation (yielding an approximate annualized rate of 4.2%).  By comparison to the broader market, the CNY looks to have under-performed in that the U.S. Dollar Index has fallen from 89.64 to 82.93 over that same time period, an 8.1% decline.  As further evidence, one has to look no further than the Malaysian ringit, which was revalued at the same point as the CNY.  After trading just under 3.8 MYR to $1 in July 2005, the Malaysian unit has appreciated to 3.45 per greenback, a move up of slightly less than 10% since revaluation.  I'm not sure about you, but I don't have many colleagues in the trading world who believe Malaysia's economic prospects to be brighter than those of China in the next decade or so.  After all, although it has been widely forecast that the pace of economic growth in China will moderate somewhat this year from just over 10.7% in 2006, not many are predicting GDP growth to be in the single digits.

Perhaps more important to a currency's long-term valuation than its economic prospects, however, are the general level of interest rates and the policy direction of a nation's central bank.  In short, it's hard to find a group of central bankers anywhere in the world with a more hawkish view than that of the People's Bank of China (PBoC).  Not only has the PBoC raised its one year lending rate by 27 basis points three times in less than a year, but it has increased the required reserve ratio (currently held at 10%) by 0.5% on five separate occasions in the past nine months in an effort to restrict what it sees as runaway monetary growth via the domestic credit market.  Chinese interest rates are also on a much higher trajectory that those in Malaysia, once again calling into question the relatively modest level of appreciation of the yuan by comparison.

It could be argued that although the yuan's appreciation has come via a route that more closely resembles a straight line than any other instrument you will see in financial markets, it hasn't appreciated as quickly as some expected, given the current framework.  The move to a managed floating exchange rate regime in July 2005 came with a commitment to allow the remnimbi (RMB) to float within a daily operating band of 0.3%.  Technically speaking, that framework should have easily provided the flexibility required for a much faster rate of appreciation than what the market has witnessed. 

Although correct on the surface, that argument fails to address the drag on appreciation created by the alarmingly wide bid-ask spreads on funds in China, where USD and HKD deposits are capped well below free market interest rates.  It also fails to address the impact on the currency of the open market operations of the PBoC, which is flooding the market with CNY to purchase USD assets, and those denominated in other currencies, to accommodate China's burgeoning trade surpluses with the rest of the world.

For the average treasurer or business manager dealing in China, a conservative view would most likely take the form of an expectation where the CNY continues to appreciate at 4.2% a year, in a relatively straight-line fashion, as long as economic growth remains near current levels.  A more bullish view would be that the increased pressure and market signals being presented to Chinese officials at present will result in a slightly increased rate of appreciation in the coming year(s), perhaps even double the current rate of change. 

That being said, how many businesses feel as though they can pass on an effective annual price increase to customers in the range of 4.2 to 8.4% in North American economies where central banks employ inflation targets in the neighborhood of 2%?  It would seem prudent to employ a hedging strategy to mitigate the risk that results from the divergence of how quickly one can reasonably expect to increase prices to customers versus the potential increase in one's input costs.  The instruments of choice for mitigating that risk for the CNY are the non-deliverable forward (NDF) or non-deliverable option and other structured products that use these products as their key components.

NDFs work in the same manner as a regular currency forward contract, except that there is no physical exchange of funds at expiry.  The contracts are settled on a net cash basis and therefore provide a hedge to the appreciation of the CNY without requiring delivery of the notional amount, similar to a futures contract.  The key difference between an NDF and a futures contract --other than the fact that futures are only available in highly traded and liquid currencies-- is that an over-the-counter NDF can be structured for exact time frames and amounts as opposed to standard expiries and notional trade sizes.  Non-deliverable options are similar in structure, but as the term "option" would suggest, they are a right to initiate a hedge, at a pre-specified price, as opposed to an obligation.  Due to the fact that many brokers or banks offer relatively short terms on NDFs, they can usually be booked and rolled in succession in order to hedge exposures over a longer time horizon.

Although hedging with an NDF eliminates the risks associated with an unfavorable move in the CNY rate, that's really only half of the battle.  If you're paying too much to convert your hard currency into yuan, you may be losing a great deal of the value that you are attempting to protect by initiating a hedge.  Domestic institutions must transact all foreign exchange deals involving the CNY onshore.  Too many organizations, however, believe that they have no control over the rate of exchange that they obtain when paying invoices denominated in CNY.  Although USD must be delivered to the local institution that then converts it into the domestic currency, you can obtain greater control over the rate at which your funds are applied by using a broker or bank with a strong local correspondent relationship, thereby obtaining a higher rate of execution.

For example, you can purchase CNY from your broker or bank in the country of origin, who will in fact then deliver USD to the onshore beneficiary institution at the previously contracted rate of exchange.  Although the actual exchange is handled onshore, you can obtain a price ahead of sending your payment if you book a trade to buy CNY as opposed to simply sending USD directly to the beneficiary.  Brokerage houses and banks that have invested in their payment infrastructure will then use their correspondent relationships to secure the rate of exchange that you've agreed to, without any surprises at the other end.  Due to some inconsistencies amongst beneficiary banks in China, you can't always be guaranteed that your payment won't be applied minus administrative fees of some variety, but you certainly can reduce the chance of this occurrence.  Innovations in the FX market have also allowed for the creation of synthetic forwards and structured products that can combine the hedging benefits of non-deliverables with their capabilities in local markets via their correspondent relationships. 

Doing business in China is an attractive but risky proposition and although the timetable and scale of further CNY appreciation versus the greenback is unclear, the risks certainly seem to point to continued valuation increases for the yuan.  By employing hedging products to mitigate spot price fluctuations and working with a specialized broker that has developed strong correspondent relationships in the local market, it is possible to effectively manage the financial risks unique to the Chinese economy.  In a market where everyone is trying to get their foot in the door or consolidate the market position they've already achieved, the structure of your FX program can be a key component of your competitive advantage in dealing in the world's most attractive market for growth.

Mark Frey is the Head FX Trader and Cash Manager at Custom House Ltd., the largest independent foreign exchange provider in North America and one of the largest in the world, handling more than $18 billion in transactions each year through 154 currencies. 

See also: Non Deliverable Forwards Take Off

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