Offshore RMB Market Sees Robust Growth

Thanks to China's continuedefforts in deepening financialreforms, the offshore RMBmarket has continued toexpand rapidly, as revealed by a recentreport by Deutsche Bank.

Five milestones of offshoreRMB market

According to the report, the yearof 2014 witnessed five key developmentmilestones in the offshore RMB marketin the following areas.

(e) Steady growth in the offshoreRMB liquidity pool and offshore RMBproducts.

CNH credits have underper-formed Asia IG USD bonds. The totalreturn of the CNH bonds tracked byS&P and DB's CNH Bond Index is3.07% in CNH and 0.79% in USD.In USD terms, the CNH bonds haveunderperformed the Asia IG bonds(which have returned 9.2% YTD); thereport notes this is attributable to theCNH depreciation against the USDand underperformance of CNH creditsby Chinese names (the credit sub-indexyield has risen 87bps YTD).

CNH credits have underperf-ormed Asia IG USD bonds. The totalreturn of the CNH bonds tracked by S&Pand DB's CNH Bond Index is 3.07% inCNH and 0.79% in USD. In USD terms,the CNH bonds have underperformedthe Asia IG bonds (which have returned9.2% YTD); the report notes that thisis attributable to the CNH depreciationagainst the USD and underperformance ofCNH credits by Chinese names (the creditsub-index yield has risen 87bps YTD).

Propect of continuous growth

In 2015, the report expects continuedrobust growth in the offshore RMB market,reaping the benefits of favorable policy andmarket infrastructure, and the consolidationof RMB as an increasingly internati-onalized currency.

Specifically, the report expects thefollowing developments and policies in2015.

To be sure, some of this weaknesscan be blamed on the negative spillovereffect from the change in the repocollateral rules, which has caused asharp squeeze on rates. But the authorsbelieve the move is more broadly areflection of l) slowing growth andbroadening disinflation; 2) a pick-up incapitaloutflows; 3) credit de-leveraging;and 4) valuations approaching expensiveextremes. On point 2, the authorsbelieve the outflows are being driven bya) hedge adjustments by corporates; andb) the repayment of outstanding foreigndebt.

Over the next few weeks thecrunch time for the PBoC's reaction tothe weakening in the RMB complexmight come. The RMB risk sentimentindex has been lifting off sharply (abearish RMB signal). In the absenceof any significant fiscal stimulus orintervention, onshore USD/CNYspot could reach the top ofits tradingband. The PBoC will have two choices:intervene and push spot lower, orgradually start fixing USD/CNYhigher. The authors' view is that FXpolicy will be more "hands off" thistime, and will act only to smooth RMBvolatility. If so, moreyweakness shouldbe seen to come for USD/CNH.

CNH vol spiked once more andcame close to recent highs. In theauthors' view, CNH vol will likelyremain elevated in lQ15. Given themore restricted regulatory environmentgoverning the recommendationof Target Profit Forwards (TPFs)products, particularly in Taiwan, andongoing RMB weakness, the authorsbelieve the appetite of corporates andprivate banking clients for TPFs will belower than in recent years.

Trading strategy: Although thereport authors are yet to initiate a longUSD/RMB trade, they have beenrecommending buying USD/TWDor USD/KRW as proxy trades on thisreversalin RMB fortunes.

On the CCS curve, the authorsthink the CNH CCS rates areincreasingly attractive and investorsshould consider receiving for thefollowing reasons: (a) CNH liquidityriskis manageable; (b) there is a limitedimpact from the expansion of theRQFII scheme; (c) CNH bond issuanceswapping into USD is more cost-efficient for corporate borrowers thanalternative USD financing; (d) payinginterest on the CNH CCS curve forhedging over long-term cross-borderRMB lending is likely to weaken;and (e) the CCS curve has priced ina significant risk premium for USDstrength and higher USD rates. Theauthors have recommended receivingCNH CCS 3Y at 3% with a target of2.4% and a stop loss of3.2%.