Narrowing yuan spread puts brake on offshore deposit growth

HONG KONG - The narrowing spread of yuan foreign exchange rates in mainland China and Hong Kong has taken a toll on the expansion of the Chinese currency offshore and led to a slowdown in the growth of deposits.

Yuan deposits in the former British colony rose to 959.9 billion yuan ($153.5 billion) in April, up 15 billion yuan from a month earlier, the smallest monthly increase in eight months, data from the Hong Kong Monetary Authority (HKMA) showed.

It comes at a time when the onshore and offshore yuan/dollar gap has almost disappeared and offshore yuan even trades at a discount to its onshore counterpart, after commanding big premiums at the beginning of the year.

The difference between the two market rates usually offers arbitrage opportunities for corporates since they can choose a better rate to buy or sell dollars. The larger the spread, the more incentives companies have to find a more favorable market to conduct currency exchange.

Before the yuan's sharp fall earlier this year, its steady appreciation had made the offshore rate stronger than its onshore counterpart, leading to continuous outflows of yuan funds to Hong Kong and a rapid accumulation of yuan deposits offshore.

However, corporate enthusiasm to bring the yuan to markets abroad has been dampened since April, after sentiment toward the currency turned weaker and offshore yuan rates began to move in lock step with those onshore.

China's central bank engineered two phases of weakness in the yuan in February and April to deter speculative one-way appreciation bets on the currency. "In the near term, we could see a slowdown of offshore deposit accumulation due to a decline in CNH premium," said Becky Liu, a senior strategist at Standard Chartered Bank in Hong Kong.

The yuan is experiencing its most sustained depreciation since the 2005 landmark revaluation. It has lost 3.2 percent against the dollar year to date, wiping out all its gains in 2013 and becoming the worst performer in Asia.

The adverse impact of a weak yuan on the offshore pool is likely to be short-lived, however, as the Chinese currency is expected to regain strength later this year and more channels are set to be opened up to allow yuan outflows.

A pilot scheme called Shanghai-Hong Kong stock connect that allows investors in the two cities to invest in each other's stock markets and requires trade to be settled in yuan will be implemented in October.

Though analysts are divided on which of the two markets is more attractive in terms of valuation, the Hong Kong market's far better liquidity and transparent regulation will no doubt appeal to mainland investors and attract yuan funds.

Meanwhile, increasing use of the yuan by both Chinese and multinational companies in trade settlement also bodes well for long-term growth of yuan deposits overseas. "From our conversations with clients, we know that many multinational companies and most larger companies in the Greater China region are really past the understanding phase. They are asking 'how' rather than 'why' and are ready to take some real actions," said Michael Vrontamitis, regional head of product management at Standard Chartered Bank.