perceived risk of using the offshore currency, which led offshore investors to reduce renminbi holding These deposits represent a pool of renminbi liquidity in Hong Kong Sar that can be redeployed to support the expansion of offshore financial markets and products. The pool remained significantly larger than the stock of renminbi financial Figure 4. Renminbi Liquidity Pool in Hong Kong SAR products despite its contraction and, thus, did (RMB bn) not constrain their growth. But, going 000 Share of renminbi deposits(incl. CDs) in HK forward, offshore renminbi liquidity will need to expand in parallel with assets to Corporate customers 600■ Personal ensure progress in renminbi internationalization. In theory, the pool will be replenished by flows of onshore renminbi 20 into offshore renminbi deposits in response o LImIT to market incentives for arbitrage. However, Jul Jan Jul Jan the scale of these flows and hence the 0092010 potential for arbitrage, are constrained by Source: HKMA capital controls. This suggests that an analysis of the effectiveness of arbitrage can shed light on how these controls are limiting progress in renminbi internationalization I. ASSESSING RENMINBI INTERNATIONALIZATION BY ANALYZING ARBITRAGE A. Defining progress in renminbi internationalization Progress in internationalizing the renminbi can be evaluated based on how well the offshore market functions as a substitute for the onshore market To tell whether the two markets are integrated, we assess whether there are no unexploited arbitrage opportunities between them This will be the case when the difference between the cny and cnh exchange rates with the dollar(the basis")is small enough to remain in a"no-arbitrage band, within which arbitrage is not profitable owing to transaction costs such as the bid-ask spread. A metric of the integration of the offshore and onshore markets can be derived by estimating no-arbitrage band and then assessing the extent that the CNY-CNH basis stays within this 9 Estimation shows that the no-arbitrage band is quite wide. Moreover, the basis is outside the band for extended periods, indicating that the offshore renminbi is an imperfect substitute for the onshore renminbi. The differential is often large, indicating that investors and firms face ignificant basis risk the risk that by using CNH in place of CNY could incur significant losses owing to volatility in the basis. An increase in the perceived basis risk makes investors and firms more reluctant to use CNH as a substitute for the CNY, holding back development of an international role for the renminbi They either try to use the cny itself--which is difficult due to capital controls- or the dollar where risks can be better hedge
5 perceived risk of using the offshore currency, which led offshore investors to reduce renminbi holding. These deposits represent a pool of renminbi liquidity in Hong Kong SAR that can be redeployed to support the expansion of offshore financial markets and products. The pool remained significantly larger than the stock of renminbi financial products despite its contraction and, thus, did not constrain their growth. But, going forward, offshore renminbi liquidity will need to expand in parallel with assets to ensure progress in renminbi internationalization. In theory, the pool will be replenished by flows of onshore renminbi into offshore renminbi deposits in response to market incentives for arbitrage. However, the scale of these flows and, hence, the potential for arbitrage, are constrained by capital controls. This suggests that an analysis of the effectiveness of arbitrage can shed light on how these controls are limiting progress in renminbi internationalization. III. ASSESSING RENMINBI INTERNATIONALIZATION BY ANALYZING ARBITRAGE A. Defining Progress in Renminbi Internationalization Progress in internationalizing the renminbi can be evaluated based on how well the offshore market functions as a substitute for the onshore market. To tell whether the two markets are integrated, we assess whether there are no unexploited arbitrage opportunities between them. This will be the case when the difference between the CNY and CNH exchange rates with the dollar (the “basis”) is small enough to remain in a “no-arbitrage” band, within which arbitrage is not profitable owing to transaction costs such as the bid-ask spread. A metric of the integration of the offshore and onshore markets can be derived by estimating a no-arbitrage band and then assessing the extent that the CNY-CNH basis stays within this band. Estimation shows that the no-arbitrage band is quite wide. Moreover, the basis is outside the band for extended periods, indicating that the offshore renminbi is an imperfect substitute for the onshore renminbi. The differential is often large, indicating that investors and firms face significant “basis risk:” the risk that by using CNH in place of CNY could incur significant losses owing to volatility in the basis. An increase in the perceived basis risk makes investors and firms more reluctant to use CNH as a substitute for the CNY, holding back development of an international role for the renminbi. They either try to use the CNY itself—which is difficult due to capital controls—or the dollar where risks can be better hedged. Figure 4. Renminbi Liquidity Pool in Hong Kong SAR 0 2 4 6 8 10 12 14 0 100 200 300 400 500 600 700 800 900 1000 Jul Jan Jul Jan Jul Jan Jul Jan (RMB bn) Certificate of deposits Corporate customers Personal customers 2009 2010 2011 2012 2009 2010 2011 2012 2013 (%) Share of renminbi deposits (incl. CDs) in HK total deposits (right scale) Source: HKMA
B. Estimating integration of onshore and offshore renminbi markets This research differs from other papers in the literature in that it assesses the integration of renminbi offshore and onshore markets in that it applies a Threshold Autoregession model (TAR)model to estimate the no-arbitrage band and checks how much the basis is outside the band. Other studies, for example HKMA (2012); Ding, Tse, and williams(2012); Maziad and Kang(2012); and Wu and Pei(2012), assess renminbi onshore/offshore market linkages using Granger causality test or GARCH models. They focus on price discovery directions that within the band the basis follows a random walk as transaction costs make arbitrage and volatility spillovers between the two markets. Estimation in this paper exploits the fact unprofitable. In contrast, outside the band it follows an autoregressive process as arbitrage is profitable and moves the basis back towards the band. The estimated parameters of the autoregressive process indicate the speed of this convergence back to the band and will depend on the volume of the arbitraging capital flows between onshore and offshore markets possible under existing capital controls The data are differentials between the daily Cny and CNh(onshore and Figure 5. CNY and CNH Spot Exchange Rate Differentials offshore)dollar spot exchange rates The estimated width of the band - Spot exchange rate difference(CNY-CNH) 253 pips, roughly one quarter of a percentage point(Figure 5). Statistical tests confirm that the basis follows random walk within the band and an 500 autoregressive process outside it (Annex Table 3). The data start in nber 2010 when CNH first began to trade actively. Despite over Sources: Bloomberg LP, and IMF staff estimations. 600 observations the sample is 1 Band is estimated with the TAR model on the sample of 1 September 2010-31 January 2013. Around 56 percent of observations are within the band. relatively short and the estimated width of the band could be different for different sample periods, either for statistical easons or because transaction costs can change with institutional market reforms. An example of how differences in market infrastructure can lead to different band widths comes rom applying the TAr model to other onshore-off-shore exchange rate Table 1. tar model estimation results s. as is done for the differentials ependent Variable: CNY-CNH Results between the onshore three-month CNY weaker than CNH (pos basis) L5 percent of time forward rate and (i) the offshore Autoregressive coefficient three-month nondeliverable forward Implied "half life 25 days rate(NDF)and (ii) three-month CNY-CNH basis trades within band 56 percent of time deliverable forward rate in hong CNY stronger than CNH(neg basis) 29 percent of time Kong SAr, respectively, as shown in the annex Implied"half life Note: *** indicates significance at the l percent level. The technical ar The estimation results find limited provides full estimation results
6 B. Estimating Integration of Onshore and Offshore Renminbi Markets This research differs from other papers in the literature in that it assesses the integration of renminbi offshore and onshore markets in that it applies a Threshold Autoregession model (TAR) model to estimate the no-arbitrage band and checks how much the basis is outside the band. Other studies, for example HKMA (2012); Ding, Tse, and Williams (2012); Maziad and Kang (2012); and Wu and Pei (2012), assess renminbi onshore/offshore market linkages using Granger causality test or GARCH models. They focus on price discovery directions and volatility spillovers between the two markets. Estimation in this paper exploits the fact that within the band the basis follows a random walk as transaction costs make arbitrage unprofitable. In contrast, outside the band it follows an autoregressive process as arbitrage is profitable and moves the basis back towards the band. The estimated parameters of the autoregressive process indicate the speed of this convergence back to the band and will depend on the volume of the arbitraging capital flows between onshore and offshore markets possible under existing capital controls. The data are differentials between the daily CNY and CNH (onshore and offshore) dollar spot exchange rates. The estimated width of the band is 253 pips, roughly one quarter of a percentage point (Figure 5). Statistical tests confirm that the basis follows a random walk within the band and an autoregressive process outside it (Annex Table 3). The data start in September 2010 when CNH first began to trade actively. Despite over 600 observations, the sample is relatively short and the estimated width of the band could be different for different sample periods, either for statistical reasons or because transaction costs can change with institutional market reforms. An example of how differences in market infrastructure can lead to different band widths comes from applying the TAR model to other onshore-off-shore exchange rate pairs; as is done for the differentials between the onshore three-month forward rate and (i) the offshore three-month nondeliverable forward rate (NDF) and (ii) three-month deliverable forward rate in Hong Kong SAR, respectively, as shown in the Annex. The estimation results find limited -1500 -1000 -500 0 500 1000 1500 2000 -1500 -1000 -500 0 500 1000 1500 2000 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Spot exchange rate difference (CNY-CNH) Band: (-32, 221) 1/ Sources: Bloomberg L.P.; and IMF staff estimations. 1/ Band is estimated with the TAR model on the sample of 1 September 2010‒31 January 2013. Around 56 percent of observations are within the band. Figure 5. CNY and CNH Spot Exchange Rate Differentials Dependent Variable: CNY-CNH Results CNY weaker than CNH (pos. basis) 15 percent of time Autoregressive coefficient 0.97*** Implied "half life" 25 days CNY-CNH basis trades within band 56 percent of time CNY stronger than CNH (neg. basis) 29 percent of time Autoregressive coefficient 0.88*** Implied "half life" 6 days Table 1. TAR Model Estimation Results Note: *** indicates significance at the 1 percent level. The technical annex provides full estimation results
integration between onshore and offshore markets they show that the basis trade within the no-arbitrage band only 56 percent of the time(Table 1). This fact, together with the large, absolute positive and negative values for the basis(peaking at 1, 795 and-1, 235 pips espectively), suggest users of offshore renminbi face relatively high basis risk, which serves to discourage them from using the CNh as a substitute for CNY. This awareness of basis risk may have increased with the sharp rise in the volatility in the basis in the second half of 2011, which may help explain the temporary stalling of CNH deposit growth as users became more cautious in holding CNH in place of CNY(Figure 4) C. Arbitrage between Onshore and offshore markets and the role of capital controls The estimation results confirm that arbitrage works to steadily narrow the basis when shocks air processes followed by the basis when outside the band. The coefficient on move it outside the no-arbitrage band. This is reflected in the highly significant coefficient estimates are fairly close to one, indicating that th e convergence process is relatively slow and may reflect limits on the scale of arbitraging capital flows owing to capital controls 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 201 1-October 2012 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 QFll that can be used to bring offshore renminbi funds onshore D. Sources of divergence of onshore and offshore renminbi exchange rates The movement in the basis outside the no-arbitrage band will be driven by a number of factors that, along with capital controls, contribute to limited integration of onshore and offshore markets. The literature points to a range of potential factors, including market expectations for the renminbi, market risk sentiment, capital controls and offshore renminbi liquidity. For example, arbitraging capital flows would lead to changes in offshore renminbi liquidity that would be negatively correlated with the basis. This appears to be the case, with
7 integration between onshore and offshore markets. They show that the basis trade within the no-arbitrage band only 56 percent of the time (Table 1). This fact, together with the large, absolute positive and negative values for the basis (peaking at 1,795 and -1,235 pips, respectively), suggest users of offshore renminbi face relatively high basis risk, which serves to discourage them from using the CNH as a substitute for CNY. This awareness of basis risk may have increased with the sharp rise in the volatility in the basis in the second half of 2011, which may help explain the temporary stalling of CNH deposit growth as users became more cautious in holding CNH in place of CNY (Figure 4). C. Arbitrage between Onshore and Offshore Markets and the Role of Capital Controls The estimation results confirm that arbitrage works to steadily narrow the basis when shocks move it outside the no-arbitrage band. This is reflected in the highly significant coefficient on the autoregressive processes followed by the basis when outside the band. The coefficient estimates are fairly close to one, indicating that the convergence process is relatively slow and may reflect limits on the scale of arbitraging capital flows owing to capital controls. 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. D. Sources of Divergence of Onshore and Offshore Renminbi Exchange Rates The movement in the basis outside the no-arbitrage band will be driven by a number of factors that, along with capital controls, contribute to limited integration of onshore and offshore markets. The literature points to a range of potential factors, including market expectations for the renminbi, market risk sentiment, capital controls and offshore renminbi liquidity. For example, arbitraging capital flows would lead to changes in offshore renminbi liquidity that would be negatively correlated with the basis. This appears to be the case, with
renminbi deposits and CDs in Hong Kong SaR surging when the Cnh trades at a premium to the CNY, and vice-versa(Figure 6). The influence of shifts in investor sentiment can also be seen in the correlation between the basis and the renminbi risk reversal- which is an index market sentiment(Figures 7) Figure 6. Correlation of Basis and Renminbi Figure 7. Correlation of Basis and Renminbi Risk Deposits and CDs in Hong Kong SAR Reversal RMB bn 1200 1000 arbitrage band arbitrage bi 642 400 600 Renminbi deposits and CDs in Hong Kong SAR Renminbi risk reversal index(3m)l/ CNY-CNH (left scale) CNY-CNH (left scale Sources: Bloomberg LP and IMF staff estimation. Sources: Bloomberg LP, and IMF staff estimation. 1/ Represents market view of the most likely direction of the spot movement over the next three months To confirm that the influence of these variables( Figures 6 and 7)on the basis is robust we estimate a VaR model to test their statistical significance and control for a range of other variables. The dependent variables in the VAR is the onshore-offshore renminbi differential with the following explanatory variables found to have a statistically significant impact, as reflected in VAR impulse-response functions(see the Annex for technical details) the change in renminbi liquidity as measured by deposits and CDs in Hong Kong SAr (Figure 6) the three-month renminbi risk reversal index(Figure 7) a dummy variable for the opening of new channels for renminbi cross-border flows (see Annex for detailed definitions) a dummy for when the quota is hit on the size of the aggregate net position that Hon Kong Sar banks can square with the clearing bank at onshore rates for trade-related renminbi payments The VaR results confirm that the basis is affected by changes in offshore renminbi liquidity This is the case even when controlling for the endogenity that results from the fact that the arbitrage narrowing the basis also affects offshore liquidity. The results also show that shift 2 The reversal index is defined as the implied volatility for call options minus the implied volatility for put options on the base currency with the same delta. It can be interpreted as the market view of the most likely direction of the spot movement over the next maturity date 8
8 renminbi deposits and CDs in Hong Kong SAR surging when the CNH trades at a premium to the CNY, and vice-versa (Figure 6). The influence of shifts in investor sentiment can also be seen in the correlation between the basis and the renminbi risk reversal,2 which is an index market sentiment (Figures 7). Figure 6. Correlation of Basis and Renminbi Deposits and CDs in Hong Kong SAR Figure 7. Correlation of Basis and Renminbi Risk Reversal -600 -400 -200 0 200 400 600 800 1000 1200 -40 -20 0 20 40 60 80 10/8 10/10 10/12 11/2 11/4 11/6 11/8 11/10 11/12 12/2 12/4 12/6 12/8 12/10 12/12 Renminbi deposits and CDs in Hong Kong SAR CNY-CNH (left scale) RMB bn pips Shaded area: outside of estimated noarbitrage band -600 -400 -200 0 200 400 600 800 1000 1200 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 10/8 10/10 10/12 11/2 11/4 11/6 11/8 11/10 11/12 12/2 12/4 12/6 12/8 12/10 12/12 Renminbi risk reversal index (3m) 1/ CNY-CNH (left scale) % pips Shaded area: outside of estimated noarbitrage band Sources: Bloomberg L.P., and IMF staff estimation. Sources: Bloomberg L.P., and IMF staff estimation. 1/ Represents market view of the most likely direction of the spot movement over the next three months. To confirm that the influence of these variables (Figures 6 and 7) on the basis is robust we estimate a VAR model to test their statistical significance and control for a range of other variables. The dependent variables in the VAR is the onshore-offshore renminbi differential; with the following explanatory variables found to have a statistically significant impact, as reflected in VAR impulse-response functions (see the Annex for technical details); the change in renminbi liquidity as measured by deposits and CDs in Hong Kong SAR (Figure 6); the three-month renminbi risk reversal index (Figure 7); A dummy variable for the opening of new channels for renminbi cross-border flows (see Annex for detailed definitions). A dummy for when the quota is hit on the size of the aggregate net position that Hong Kong SAR banks can square with the clearing bank at onshore rates for trade-related renminbi payments. The VAR results confirm that the basis is affected by changes in offshore renminbi liquidity. This is the case even when controlling for the endogenity that results from the fact that the arbitrage narrowing the basis also affects offshore liquidity. The results also show that shift 2 The reversal index is defined as the implied volatility for call options minus the implied volatility for put options on the base currency with the same delta. It can be interpreted as the market view of the most likely direction of the spot movement over the next maturity date