How To Arbitrage The People's Bank Of China

Tyler Durden's picture

Since there are now numerous hard proofs that China’s export data (and to some extent import data as well) were significantly distorted recently, we naturally wonder the incentives behind the distortion and the detailed mechanism of these manipulations. As BofAML notes, there are four reasons why the distortions have risen so sharply since Q4 2012 but the various arbitrages (described in actionable detail below) between onshore and offshore currencies and interest rate differentials (and the role of gold in this) remain in place to make judging China's real trade growth as much art as science.


 

Via BofAML,

In the starting period of using RMB for trade settlement (2010-2011), people might not learn the trick on how to benefit from the differential between CNH and CNY exchange rates. And the differential was quite small before October 2012 when markets perceived a significant RMB/USD depreciation. Only since 4Q12 several preconditions were ripe for massively manipulating trade data.

  •  First, RMB/USD started appreciating again.
  • Second, the China’s economic growth started rebounding. These two preconditions made it attractive to bring in hot money via over-reporting exports.
  • Third, the differentials between CNH/USD and CNY/USD got widened in 4Q12 with CNH/USD becoming more expensive than CNY/USD, making it’s profitable to do arbitrage (more details below).
  • Fourth, people were experienced enough to use RMB trade settlement to carry out relatively complicated arbitrage.

Arbitrage the CNY-CNH exchange rate differentials

Demand for RMB assets in offshore markets has picked up since 4Q12 on a better growth outlook and the introduction of new investment tools such as RQFII, causing CNH/USD (RMB traded offshore) to be more expensive than CNY/USD (RMB traded onshore). At the peak in January, CNH was 0.6% more expensive than CNY. Consequently, arbitrage opportunities between CNY and CNH arise if people can manage to bring CNY to offshore RMB centers like Hong Kong. The trick is seemingly complicated, but actually the arbitrage is quite simple. Let’s use an example to reveal the mechanism of this arbitrage.

1. In mainland China, an arbitrager could borrow US$1.0mn and convert to CNY at exchange rate 6.20 (so he gets RMB6.2mn);

 

2. He could import something with minimum transportation costs such as gold from Hong Kong and settle the imports with the borrowed RMB6.2mn. In this way, this RMB6.2mn flows to Hong Kong and becomes CNH;

 

3. He then instructs his business partners (or his Hong Kong subsidiaries) to converts the RMB6.2mn to USD in HK. Assuming USD/CNH is 6.15, he gets US$1,008,130;

 

4. Finally he exports the previously imported gold which is settled in USD. In this way, US$1,008,130 flows into mainland China and the arbitrager completes the whole deal with a profit at US$8130 (perhaps less than that due to some transport and custom fees).

Arbitrage the differentials between CNH and CNY interest rates

Another arbitrage can gain purely from the interest rate differentials between CNH and CNY. Note interest rates for RMB are different onshore and off-shore. An arbitrager can gain by borrowing CNH at low rates, converting CNH to CNY and depositing CNY at higher rates. Currently the spread could be around 70bp. Here is an example on how to carry out this arbitrage.

1. In mainland China, an arbitrager borrows RMB1.0mn at a rate of 6% for two weeks (the time needed for getting CNH loans in Hong Kong), he then deposits RMB1.0mn in a bank with deposit rate at 3% and ask the bank to issue L/C for him;

 

2. With the L/C, his Hong Kong partners could get RMB1.0mn loans from HK bank for one year. The arbitrager then export something with minimum transportation costs to Hong Kong and the RMB1.0mn is sent to mainland China. He repays the RMB1.0mn.

 

3. His profit is calculated as follows. The revenue is the differential between the onshore RMB deposit rate and the offshore RMB financing costs. Currently the spread is around 70bp after deducting related costs, so the revenue is RMB7000. His cost for borrowing RMB1.0mn for one month is 2500. So his risk-free net return is RMB4500.

Arbitrage on interest rates differential and RMB appreciation

The most complicated arbitrage can gain from RMB appreciation, the interest rate differentials between onshore RMB and offshore USD, and the differential between CNH/USD and CNY/USD. Note that 1yr RMB deposit rate in China is now 3.0% but 1yr dollar lending rate in HK is lower than 2% (LIBOR +100bp). Here is an example on how to carry out this arbitrage.

1. In mainland China, an arbitrager borrows RMB1.0mn at a rate of 6% for two weeks, he then put RMB1.0mn as 1yr time deposits in a bank at 3% and ask the bank to issue L/C for him;

 

2. Assume USD/CNH is 6.15. With the L/C, his Hong Kong partners could get 1yr dollar loans of US$162,602 (=1000,000/6.15) at 2% from a HK bank.

 

3. The arbitrager then exports something with minimum transportation costs to Hong Kong and the US$162,602 is sent to mainland China. Assuming USD/CNY is at 6.2, he can get RMB1,008,132. He repays the original RMB loan at the amount of RMB1002,500 (RMB2,500 is interest payment) and obtain an immediate profit at RMB5632 which he will also put in 1yr deposit.

 

4. One year later, his time deposits will be valued at RMB1,035,801 (with interest payment). Assuming CNY/USD appreciated 2%, he can convert his this to US$171,774.

 

5. He imports the goods from Hong Kong he exported a year ago by paying US$165854 (=162602*1.02). In this way he moves US$165854 to HK to repay his loans (principal plus interest payment).

 

6. His net profit (in one year) is US$5920.

Outright hot money inflow

In the above three cases of arbitrage, the person could even raise prices of exports which were previously imported to bring in hot money. When people believe the Chinese economy is safe (especially as growth recovers) and CNY/USD will appreciate, they have the incentive to take in hot money to benefit from higher interest rates in China (than USD rates) and CNY/USD appreciation.

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Billion Dollar Bonus's picture

China has helped establish a huge property bubble and hundreds if not thousands of empty cities. The Bank of China is mearly buying into the gold bubble and will lead to an even bigger collapse. 

oddjob's picture

...thousands of empty cities.

I heard that from at least a million people too.

Jack Napier's picture

They're not empty. They're full of space. I see dark matter.

Roandavid's picture

MDB's older ..... less talented brother.

knukles's picture

It is clear that when the PMB/CHN exceeds the marginal CHN/CNH's first moving derivative on about a 1 Chinese New Year's rolling partial average the CNY/USD and CYN/USD begin the IFY/KINDA maybe trend especially during years denominated in Tigers, Frog and Pestilences as was outlined in the Second Book of the Thoughts of Chairman Mao's Tongue.

I"m
sorry
Tyler
but
I
am
seriously
having
trouble
following
anything
any
more

Has John Galt gone Franz Kafka?

kaiserhoff's picture

That's the smartest thing I've seen on ZH for a week, or maybe it's just my

  Johnie Walker wisdom runnin' high.

TheFourthStooge-ing's picture

BofAML can't be taken seriously on arbing the Peoples Bank of Chinese Citizenism if they neglected to mention the Spiderman beach towel/river pig carry trade.

FinalCollapse's picture

There is also export subsidy that can go as high as 20%. When they export to HK they get this subsidy while converting back to RMB. This can be wildly profitable just constantly running export loops to HK.

Zero Govt's picture

All the politicos gibber about "systemic risk" yet none touch the real problem of their centralised (monopoly) institution, the biggest threat to society being a single centralised (monopoly) system, that if the core goes down trying to save, er, the core, it takes every poor sod with it

Now here we have a Korean central bwanker clinging to the US's central bwanker, none of whom are sane, none of whom are anything less than money history senile stupid and all without exception are global village idiots 

that's what you get when you are a monopoly insitution, you don't need intelligence to compete, you just need to suck your way up the pole like a good croney to the top office ...shit for brains, 100% guaranteed in every monopoly in history

you get what you deserve (design)

eigenvalue's picture

That's why goldbugs are totally screwed by putting their last hope on China.

Go to hell, gold and silver!

Die, gold and silver bugs!

lolmao500's picture

China's economic numbers are total bullshit...

http://www.ibtimes.com/china-has-been-inflating-its-exports-numbers-all-...

China Has Been Inflating Its Exports Numbers All Year, In Some Cases Doubling The Actual Figures

China has over-reported its exports for the last five months, inflating the apparent demand for its products overseas, according to a new research report.
Official customs data showed a surge in exports, but imports reported by trading partners don’t match up. Capital Economics, a research firm, estimated the actual exports expanded only half the 17 percent year-over-year rate reported by customs for the first four months of 2013.

I know China were cooking their numbers... but DOUBLING the real numbers... that's quite something!

MythicalFish's picture

"Assuming CNY/USD appreciated 2%" - is this momo or arbitrage?

q99x2's picture

I'm in enough trouble without your help.

When you see the obscene indignation standing where it should not be. Woe to the pregnant woman on the roof and the cow should not return from the field. For the end is near.

But I have heard that a metal band wrapped around my head can be used to shoot electrical signals through the hippocampus and that that will help.

logicalman's picture

I'm hoping to wake up in a world that makes sense!

Until then, there's ethanol.

IamtheREALmario's picture

So when did Goldman Sach take over Zerohedge? Just Curious.

Cashcollateral's picture

Doesn't work. This assumes that you can convince a bank to issue a standby letter of credit (the only trade instrument that fills the "L/C" criteria: any other would be either non transferable or non-collateralisable) for free. SBLCs are at the very minimum priced at cost of funds rate, otherwise the bank will lose money holding the cash. In an environment with 6% borrowing cost, good luck finding a bank that issues SBLCs at less than 70bp.

More intellectual wankery courtesy of investment bankers with no commercial bank experience who assume that just because the products exist they can be used any way they want.

Cashcollateral's picture

Doesn't work. This assumes that you can convince a bank to issue a standby letter of credit (the only trade instrument that fills the "L/C" criteria: any other would be either non transferable or non-collateralisable) for free. SBLCs are at the very minimum priced at cost of funds rate, otherwise the bank will lose money holding the cash. In an environment with 6% borrowing cost, good luck finding a bank that issues SBLCs at less than 70bp.

More intellectual wankery courtesy of investment bankers with no commercial bank experience who assume that just because the products exist they can be used any way they want.