The Case For Renminbi And FXCH

December 20, 2011


Renminbi Onshore Vs. Offshore Market

The one caveat with FXCH is that it's based on Hong Kong's "offshore" CNH market, not the mainland's "onshore" CNY market. (To be clear, the CNY currency market shouldn't be confused with the Market Vector's ETN, whose ticker is CNY. So, from here on out, any reference made to CNY will mean the onshore currency market.)

As most investors are already aware, CNY is strictly controlled by the Chinese government, which allows only a small appreciation—or depreciation—within a tight daily band. The relatively new CNH market is open to foreigner investors, but it tends to be more volatile and vulnerable to shocks in the broad markets. This sometimes causes a divergence in exchange rates between CNY and CNH.

Naturally, one would assume that if there's a divergence in exchange rates in the same currency, it would create an arbitrage opportunity for investors to take advantage of the situation, which would eventually bring the two exchange rates together again. But, because CNY is restricted, there's currently no true arbitrage mechanism in place.

However, as James King, a portfolio manager at Rydex SGI, says: "There is a slow motion, or pseudo-arbitrage mechanism in place, due to transactions taking place that can be settled in either CNY or CNH in Hong Kong."

King adds that this "slow motion" arbitrage mechanism continues to bring CNH close to CNY when there's a divergence. He also expects this slow arbitrage mechanism to accelerate and become faster over time as the interbank market—the currency trading system between banks—matures in China.

Regarding the two markets, King makes the analogy to two share classes of the same company. Like different share classes, CNY and CNH are parts of the same entity, but have separate pools of liquidity and supply and demand.

"In that way, it's almost like the offshore trades like a closed-end fund based on the onshore," explained King.

While CNH can periodically diverge from CNY—in October 2010 and September 2011, for example—it tends to crawl its way back to CNY. You can also see the outperformance of CNH—again that's what FXCH holds—compared with CYB since summer of 2010, when CNH began trading in Hong Kong.


So investors looking for renminbi exposure have some choices.

With CYB, you're inherently playing the forwards market and exposed to expectations for future movements that may already be priced into the forward contracts. So far, as I said, this has caused CYB to lag behind the actual returns of the currency.

That being said, according to a recent prospectus supplement, CYB can now hold yuan-denominated money market securities—although as of this writing, only 17 percent of the fund looked to be holding such instruments.

CYB also has some tax advantages. According to its prospectus, if shares in CYB are held over a year, gains are taxed at the long-term gains rate of 15 percent. But gains on all CurrencyShares products are taxed as ordinary income, regardless of holding period.

But to me, there's a certain beauty about FXCH's simple structure. It's comforting to know that your shares are backed by the underlying currency and to understand how your shares move, depending on the CNH exchange rate.

Also, because each FXCH share is backed by 500 yuan, you can always simply take 500 and divide it by the share price to figure out whether you're paying a premium or discount to the current exchange rate, for both CNY and CNH.


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