23 October 2018
The offshore renminbi interest rate has been climbing, but the currency's exchange rate has been falling. Photo: Bloomberg
The offshore renminbi interest rate has been climbing, but the currency's exchange rate has been falling. Photo: Bloomberg

Market sometimes departs from theory in foreign exchange trading

After the People’s Bank of China (PBoC) launched its currency reform in August, the renminbi exchange rate has been declining.

The market had expected the inclusion of the currency in the International Monetary Fund’s Special Drawing Rights basket to boost its exchange rate.

Unfortunately, the latest Chinese economic data still reflects a weakening trend, putting downward pressure on the renminbi.

Sources said the PBoC temporarily closed some cross-border renminbi financing channels to increase the financing costs for overseas short sellers of the currency, cutting an importance source of capital for Hong Kong’s interbank renminbi market and reducing interbank renminbi liquidity.

But the expected deterrent influence on the renminbi short sellers has not been as big as expected.

In spot foreign exchange (FX) trading, traders will lend out currencies in which they hold long positions and borrow those in which they have short positions (usually through short-term swaps) until they reach a closed position.

For example, for those who are short renminbi/long US dollar, an increase in the renminbi short-term interest rate will lead to a higher financing cost to short the renminbi.

If the US dollar interest rate remains stable, the related FX carrying cost will increase as the renminbi financing cost climbs and therefore reduce demand.

But we should note that a rapid increase in the borrowing cost for the short currency will be offset by the influence of the forward market.

The forward currency price is theoretically decided by the interest rate differential.

However, in the real world, the forward price level will also reflect another factor — the outlook for currency trends.

This factor is influential in FX forward trading in small markets like USD/renminbi and USD/HKD, producing a chain reaction, starting from a spot rate rise, leading to a forward rate decrease, which then strengthens devaluation expectations, causing the interest rate to go up, and so on.

In the above example of a short renminbi/long US dollar trade, a rise in the short-term renminbi interest rate will be a deterrent for short sellers.

But on the other hand, the drop in the forward rate will strengthen market expectations for the renminbi to depreciate.

In the past weeks, the offshore renminbi interest rate has been climbing.

But the decreasing spot price shows that the move hasn’t effectively reduced the devaluation pressure on the offshore renminbi.

Of course, the technical factors mentioned may not be the only ones influencing policy efficacy.

But it is observable that market sentiment will sometimes go in an opposite direction from what is theoretically expected.

This article appeared in the Hong Kong Economic Journal on Dec. 16.

Translation by Myssie You

[Chinese version中文版]

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