China Market Meddling Widens Rift in Onshore-Offshore Prices

John Mack: PBOC's Yuan Restriction Makes a Lot of Sense
  • Integrating with global markets requires more balanced opening
  • Mainland market still trading in world of its own, Bocom says

For all the talk in Beijing about integrating China with the global financial system, the disconnect between local markets and those in the rest of the world is only getting bigger.

From the yuan to stocks and interest rates, intervention by Chinese policy makers is pushing domestic valuations further away from those in freely-traded markets just across the border in Hong Kong. The offshore yuan’s discount to the mainland rate has quadrupled this year, while yuan borrowing costs in the two cities are drifting apart. Dual-listed shares are now 39 percent more expensive in Shanghai after trading at parity as recently as November 2014.

While China’s leaders have pledged to give markets greater sway and allow money to flow freely across the nation’s borders within five years, efforts to restrict capital outflows and prop up share prices in 2015 suggest the authorities are in no rush to loosen their grip. The pressure to exert control will only increase next year as China’s economic expansion slows to the weakest pace since 1990 and rising U.S. interest rates heighten the risk of destabilizing outflows, according to Bocom International Holdings Co.

“The mainland market is still trading in a world of its own,” said Hao Hong, chief China strategist at Bocom in Hong Kong who called both the boom and bust in mainland share prices. “With a divergence in monetary policy and already substantial capital outflows, I wouldn’t be surprised if policy makers become more cautious in this environment over opening up the capital account.”

The risk for China is that allowing increased two-way flows will cause onshore prices to drop to offshore levels. The yuan traded in Shanghai’s market has declined 4.4 percent this year, the most since 1994, and was last at 6.4902 a dollar. The spot rate in Hong Kong has plunged 5.4 percent to 6.5697. The Hang Seng China Enterprises Index is priced at 7.3 times earnings in Hong Kong, while the ratio for the Shanghai Composite Index is 18.8.

“They do want to internationalize the renminbi but whether they want too much capital flowing out of the onshore market to the offshore one is open to question,” said Pieter van der Schaft, a strategist at UBS Group AG in Singapore, using the yuan’s official name.

The People’s Bank of China has suspended at least two foreign lenders from conducting some cross-border yuan operations until late March, people with direct knowledge of the matter said Wednesday. The offshore yuan traded in Hong Kong erased a 0.5 percent daily decline, rebounding from a five-year low on suspected intervention by the central bank.

QuickTake China's Managed Markets

China’s defense of the yuan in Shanghai and Hong Kong contributed to the first-ever annual decline in the nation’s foreign-exchange reserves, which shrank $405 billion in the last 11 months to $3.4 trillion. In the stock market, the government spent 1.5 trillion yuan ($231 billion) to shore up prices after a rout that began in June, according to a Goldman Sachs Group Inc. estimate given in September. It also banned selling by major shareholders and told state-owned firms to buy equities.

While the Communist Party said in November that it aims to boost the yuan’s convertibility by 2020 and the foreign-exchange regulator pledged last week to push ahead with easing capital controls, the policy actions that China has taken suggest it is in no hurry to ease its grip.

Outflows Curbed

The bias against outflows is built into some programs hailed as major steps in capital-account liberalization, such as the Hong Kong-Shanghai Stock Connect. The initiative, which started in November 2014, allows 13 billion yuan of daily flows to China but just 10.5 billion yuan in the other direction.

In the fund management industry, it is easier to bring cash into China than take it out. While quotas for a program that facilitates investment of offshore yuan in domestic markets have expanded 46 percent this year to 436.5 billion yuan, the nation suspended new applications for a route that allows Chinese to invest abroad.

The PBOC last month quietly made it harder for lenders to take funds out of the nation by telling onshore banks not to offer cross-border financing to their offshore units and limiting their ability to borrow domestically using bond-repurchase agreements. The lack of access to mainland borrowing pushed up offshore yuan financing costs.

Market Development

“It’s very difficult to transact in the market if no one can effectively access liquid borrowing instruments,” said Logan Wright, Hong Kong-based director of China markets research at Rhodium Group Ltd. “They eventually want to point toward development of the onshore market but offshore is where most of the innovation has taken place in terms of the international use of the renminbi.”

Although the central bank has intervened to prop up the offshore yuan this quarter, the impact is limited because it’s harder to grasp how much the authority needs to buy to boost the currency in a market without capital controls, said Tse Kwok Leung, head of economic research at Bank of China (Hong Kong) Ltd.

“In Hong Kong you’re buying actual cash flow, but in China you’re buying a government guarantee,” said Patrick Chovanec, chief strategist at Silvercrest Asset Management Group in New York. “Obviously this makes capital account liberalization extremely difficult. When you introduce distortions, it becomes very hard and costly to maintain them.”

Some Optimistic

Some remain optimistic the decoupling is temporary. As China proceeds with capital-account liberalization, the two markets will converge again in the medium- to long-term, said Zhang Ming, director of international investment research at the Chinese Academy of Social Sciences in Beijing. The Communist Party leadership said last month it will boost the yuan’s convertibility in the next five years.

Shrinking liquidity and falling confidence have curbed business for offshore renminbi centers, which dot the globe from Taiwan to Luxembourg. Deposits of the currency shrank to 854.29 billion yuan in Hong Kong on Oct. 31 from a peak of 1 trillion yuan in 2014. Offshore yuan bond sales fell 45 percent this year to 169 billion yuan.

With more market-driven reforms, the yuan traded in Shanghai will probably decline to near Hong Kong’s levels, which are now setting expectations for the currency, said Bocom’s Hong, who turned positive on Chinese stocks in September 2014 and predicted a crash in June.

“The regulators really don’t want capital outflows, so the design of all these so-called capital-market reforms including the connect program is really to get money into the Chinese market rather than the other way round,” said Hong. “We need a complete opening of the capital market to make the two markets merge over the time.”

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