The Informational Power of the Offshore Yuan Exchange Rate

In this video, there is discussion of the offshore and onshore renminbi and how a falling offshore yuan leads to an outflow of dollars. Chinese can exchange yuan for dollars on the Mainland at CNY and then go to HK and exchange them at the CNH rate. Either that or the PBOC steps in and defends the yuan as it did in 2011 and 2012, by buying yuan. The move in the yuan earlier this year was orchestrated by the PBOC: there wasn't a dip in forex accumulation and CNY led the market lower (higher in the chart below). The latest move is not being led by CNY, but by CNH.
CNY is the dog and CNH is the tail, but this tail can wag the dog. From earlier this year: An Introduction To How China's Offshore Renminbi Market Works
"The gap between onshore and offshore yuan spot is quickly narrowing — probably a result of Beijing trying to close the arbitrage window and deter capital inflows," says Robert Savage of Track Research. In settling trade in renminbi, many companies accept CNY payments from Chinese importers and change that into dollars at the more attractive offshore rate. And borrowing costs are much cheaper in the CNH bond market than in mainland China. "Fervent demand for renminbi from international investors has driven down rates in Hong Kong and thereby created incentives for companies considering using the renminbi for trade or financing," explains Financial Times correspondent Robert Cookson. "Foreign exporters have cottoned on to the fact that the renminbi-dollar exchange rate is at a premium in Hong Kong compared with the mainland. To arbitrage the two markets, these companies accept renminbi as payment from Chinese importers, then swap the cash into dollars at the more attractive offshore exchange rate." The expectation that the yuan will continue to appreciate has been a key factor driving demand for CNH.
Now it is again moving the other way, as it did in 2011 and 2012.
The crucial thing to understand about the offshore market is that the yuan floats freely and doesn't fluctuate within a tight band like in the onshore market, and is free of Beijing's control in that regard. This allows for different prices on a single currency and creates those arbitrage opportunities that the PBoC is now trying to squelch.
It is a given that the PBOC has a large war chest and can intervene, but it would be unwise to discount the value of a market price. The PBOC has total control over CNY, but the informational and psychological value of CNH is far greater than CNY. The PBOC can control CNY and it can intervene to influence CNH, but it cannot control CNH. It cannot unmake the offshore yuan market without reversing internationalization and thus, unless it does take a major policy step backwards, the CNH does potentially have the power to force the PBOC's hand in extreme cases. There's evidence to back this up. Here is an IMF report from 2012: RMB Internationalization: Onshore/Offshore Link
s. At the same time, the rapid expansion of RMB trade settlement and issuance of RMB-denominated bonds by the Chinese government and corporates in Hong Kong, SAR have created some feedback channels across onshore (CNY) and offshore (CNH) RMB markets. We employed a bivariate GARCH model to understand the inter-linkages between onshore and offshore markets and found that, while developments in the onshore spot market exert an influence on the offshore spot market, offshore forward rates have a predictive impact on onshore forward rates. We also find evidence of volatility spillovers between two markets. Overtime, those spillover channels would be expected to grow as the offshore market further develops.
Mainland traders value a market signal.
Empirical results suggest that (i) developments in the offshore spot market could influence the onshore spot market in terms of both level and volatility during a period of offshore market dislocation, and (ii) the onshore market drives price movement offshore under normal market conditions, while developments in the offshore market could still affect the volatility of price movement in the onshore market.
Normal conditions, aka when models work. What happens in the periods when markets experience great volatility, change their pattern of behavior and even move to new equilibriums?
We can also find evidence that, despite wide-raging capital controls on flows between onshore and offshore markets, developments in the offshore market could influence onshore markets through volatility channels. Given that volatility in the offshore market has been higher than that in the onshore market, these findings imply that offshore market developments should be monitored carefully, as it could impact exchange rate stability on the mainland. In addition, during a period of offshore market dislocation, developments in the offshore market could influence the onshore spot market in terms of both level and volatility possibly because market participants believe that price development offshore better reflect global market conditions.
Also worth considering in regards to renminbi depreciation from a 2013 paper: Development of the Renminbi Market in Hong Kong SAR: Assessing Onshore-Offshore Market Integration
The estimation results reveal an asymmetry in the speed with which capital inflow and outflow work to narrow divergences in the offshore and onshore exchange rates. Arbitrage is much slower when the CNH is stronger than the CNY than when it is weaker, specifically:

 When CNH trades at a premium to CNY, arbitrage takes an average of 25 days to close half the gap back to the band (the “half life”) (Table 1). Capital outflows from the mainland are needed for this arbitrage, and work to increases the supply of offshore renminbi liquidity. This was the case in the November 2010-May 2011 episode.

 When CNH trades at a discount to CNY, arbitrage takes an average of 6 days to close half the gap back to the band. This involves capital inflows to the mainland, reducing the supply of offshore renminbi liquidity. This was the case in September 2011-October 2012 period.

The faster rate of convergence in the latter case—when CNH trades at a discount to CNY—implies that capital controls are less restrictive with respect to arbitraging capital inflows to the mainland than outflows from the mainland. This difference may reflect the fact that recent liberalization measures have focused more on easing constraints on inflows than outflows (see section IV below), such as the opening of channels for renminbi denominated FDI and QFII that can be used to bring offshore renminbi funds onshore.
When CNH is weaker, Chinese exporters do not bring their dollars onshore. Exporters hoard dollars and wait to buy yuan at the cheaper CNH rate. The arbitrage can close rapidly because they're free to exchange at any time. Foreigners looking to buy offshore need to pay a premium to entice sellers during a yuan rally. This is caused by capital controls, but is also a feature of a multi-year bull market.

When the market is operating under normal conditions, everything seems to indicate yuan strength and China has tight controls on inflows to slow yuan appreciation. But if the market is not normal— if there are no bidders for yuan, but instead a growing demand to hold dollars both onshore and offshore— the offshore yuan is free to tumble. And if CNH tumbles and the financial system sees a dollar shortage, the PBOC has to follow CNH lower to bid the dollars back or it has to spend its dollars (or let them be spent by banks and citizens) to halt the decline in CNH.

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