Since there are now numerous hard proofs [5]that China’s export data (and to some extent import data as well) were significantly distorted recently [6], 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.
[7]
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.