20
Mar
2008

CNY ETNs: Hedging RMB Appreciation and Dollar Decline

UPDATE 4/11:  Also see my most recent post on RMB Appreciation on 4/11 when the RMB crossed the 7:1 exchange rate level.  Also related as a 3/30 post with more links on the RMB appreciation including Brad Setzer’s point that it hasn’t appreciated vs. the Euro.

I have been generally concerned about the decline of the dollar and specifically concerned about RMB appreciation. But the weekend collapse and the unprecendented Fed bailout of Bear Stearns prompted me to research it further.

The problem: dollar decline driven by US budget and trade deficits

John Mason at Seeking Alpha wrote a good analysis on dollar decline that explained that market participants expect there to be higher inflation in the US than in other countries. He explains that the US has acted as a “large country” with a reserve currency, not subject to market forces that would punish the country for running large Federal deficits and a loose monetary policy to prop up growth. When “small countries” do this, market participants sell off their currency. Well, it seems that the US is now subject to the same rules.

RMB notes

Meanwhile, Michael Pettis at Seeking Alpha reasoned that the fall of the dollar would put pressure on RMB revaluation:

To make matters worse, the fall of the dollar ($1.5580 to the euro, $2.0310 to the pound, and Y 99.77 to the dollar) is putting unbearable pressure on countries who peg their exchange rate to the dollar. Not only does this reduce the value of their currencies in international trade (and so put increasing upward pressure on their trade surpluses), but because the Fed is dropping interest rates and pumping liquidity into the system it can only increase hot money inflows into countries like China. Referring to Chinese Commerce Minister Chen Deming, the China Daily today said:

Chen’s ministry, which oversees foreign trade and domestic consumption, said that during the first two months, investments from the European Union countries rose a whopping 109 percent, while investments from the United States increased 44 percent. Wild expectations abroad that the yuan will continue to rise in value against major world currencies has led to money coming to China.

“When you bring US dollars to invest in China, you need to change it into the yuan. Naturally you would like your funds to enter China at an earlier date. Because, if you are late, the same amount of dollars will turn out to be less yuan bills,” Chen told reporters.

Chart: 5 year change in RMB to USD exchange rate

rmbusd5y

source: Yahoo! Finance

Well, Chen’s comment describes the situation that I’ve faced as we’ve been projecting our 2008 RMB denominated expenses for my company. We’ve elected to advance our payment to vendors so they can convert USD to RMB immediately so we can lock in the current exchange rate. But obviously, this solution is not great for most China vendor relationships! (Why? hint: trust issues)

After researching this, I started to feel that dollar decline was a potential risk to our own personal investments.

1. Limited Solution: establish RMB bank account and convert USD

China Merchants Bank logo

A limited solution is to set up an RMB bank account in China, wire in USD, and convert and hold RMB in that bank account. With Min’s help I set up an account at China Merchants Bank, which several other friends had recommended. This is only a limited solution because there is a USD $50,000 limit to incoming USD per person per year, as I understand it.

2. Potential solution: hedging USD through exchange traded notes (ETNs) tied to foreign currency

Note: this blog post does not constitute investment advice nor a recommendation/endorsement as to any specific legal, tax, investment or other matter. Do not blame me if you invest and lose your shirt.

MarketVectors logo

This week, March 17, Morgan Stanley and Van Eck Global announced the launch of a new Chinese RMB/USD Exchange Traded Note (ETN) and a new Indian Rupee/USD ETN (BusinessWire, discussion at SeekingAlpha). Detailed information is at their MarketVectorsETNs website.

ETNs tied to foreign currency has been in the market for a while. CurrencyShares from Rydex Investments has FXA (Australian Dollar), FXB (British Pounds), FXC (Canadian Dollar), FXE (Euro), FXY (Japanese Yen), FXM (Mexican Peso) FXS (Swedish Krona), and FXF (Swiss Franc). But this is the first time I’ve seen a Chinese RMB/USD ETN.

There is a FAQ on the official MarketVectors website but here are a few that help frame what this is:

What is an ETN?

An ETN is an Exchange Traded Note, senior, unsecured debt issued by a bank or other financial institution. In this case, they are issued by Morgan Stanley. There is credit risk associated with purchasing these notes.

How does the value of the note relate to RMB?

Notes do not pay interest. Instead, the issuer promises to redeem the notes based on the performance of the S&P Chinese RMB Total Return Index (ticker:SPCBCNY), which tries to stay as close as possible to the Chinese RMB Spot Market. More about S&P’s indices here and here .

What are the risks?

  • ETN is debt, and as such is subject to the solvency of the issuer, in this case Morgan Stanley.
  • The IRS requires investors to calculate gains or losses on ETNs each tax year, and pay tax on the “notional interest” even though the ETN does not pay out any gains until you sell the note. So this is bad for cash flow (and your net return).
  • The net return is also reduced by the fees related to the instrument. There are lots of examples on their Website.
  • Many other risks. Read the risk factors in the prospectus.

So is it a good investment? Not sure. But I’ll be considering this and other options while trying to hedge out my USD risk either via going long on RMB or other foreign currencies. Anyone else out there worried about the dollar? or worried about RMB appreciation? Is the ETN a good option for hedging?

UPDATE 03/23/2008

Related analysis on RMB appreciation:

Michael Pettis, professor at Peking University’s Guanghua School of management, blogged about More, or Less, RMB appreciation. He argues that the Chinese government needs to allow the RMB to appreciate to fight inflation. But as it appreciates, more hot money will enter the country:

If Chinese inflation is a monetary problem, which I think it is, I it seems clear to me that the only way to reduce inflationary pressures is to reduce monetary growth, and that means of course reducing the net capital and current account inflows into China. A more rapid rise of the RMB is not only unlikely to reduce those inflows (at least until the RMB is much more expensive than it is now), but on the contrary it will actually increase net inflows by encouraging hot money faster than it reduces the trade surplus (and anyway so far the trade surplus hasn’t declined).

My conclusion is that either a slow, gradual appreciation of the RMB happens or a one-time large-magnitude RMB revaluation happens. Either way, it makes RMB a good investment for the individual investor.

Some other posts by Pettis include:

How do you turn this thing off?

5% revaluation of the RMB? Are you crazy?

More attention on the RMB

Section 988 Tax Issues related to ETNs

I’m still investigating the US Federal tax issues related to these ETNs. The default position of the IRS is that all gains and losses must be treated as Ordinary Income/Loss each tax year, unless a Section 988(A)(1)(b) election is taken, in which case some portion of the gains and losses can be treated as capital gains/losses. But I called MarketVectors and they couldn’t explain this provision even at a high level. The customer service rep asked me who I was with, concluded that I was a small-time individual investor (which I am), and then said “I’ll get back to you” with a tone of disregard. I’m now researching this with my accountant.

Everbank WorldCurrency Access Deposit

Via another SeekingAlpha review I discovered EverBank WorldCurrency Access Deposit Account. It provides for up to $100k in FDIC insured deposits at FDIC insured bank. No interest is provided for. However, this may be better than the drag of management fees with the ETN, and the tax questions highlighted above. I’ll be calling them to learn more about this product.

One downside to the EverBank product is the RMB account doesn’t provide any interest rate. To compare, current time deposit interest rates in China Merchants Bank are as follows: 3 months – 3.33% interest rate; 6 months – 3.78%; 1 year – 4.1%. Still, for the amount beyond the $50k convertible,the EverBank product may still be a reasonable option to hedge against dollar depreciation.

HSBC Renminbi Bank Services

HSBC also provides a variety of RMB related banking services. According to the footnotes on that page, “Renminbi Switching Service shares the same transaction limit of RMB20,000 per person per day with the Renminbi exchange services through HSBC accounts.” This doesn’t appear to provide a better option for large scale RMB exchange either.

ETRADE Global Trading

I’m also looking at the ETRADE Global Trading product that provides for trading into 6 currencies: Japanese Yen, Canadian Dollar, Swiss Franc, Euro, Hong Kong Dollar, British Pound.

UPDATE 03/24/2008

Found out more about the EverBank World Currency Deposit Access Account:

  • Basic account is a deposit account backed by $100,000 of FDIC bank insurance.
  • Value of principal is based on the spot market for RMB non-deliverable forward contracts.
  • Transaction cost: they take a “spread on wholesale spot rate of 75 bps going in and out” according to the EverBank sales rep.
  • Account has a $10,000 minimum to establish, and funds can be moved between currencies. Other currencies supported include: Austrailian dollar, British pound, Canadian dollar, Czech koruna, Danish krone, Euro, Hong Kong dollar, Japanese yen, Mexican peso, New Zealand dollar, Norweigian krone, Singapore dollar, South African rand, Swedish krona, Swiss franc.
  • For Chinese RMB, the account is non-interest bearing, vs. the 1 year time deposit rate of 4.1% at China Merchants Bank at this time.
    No 1099 will be issued because it is not an interest bearing account. Any gains or losses must be reported as capital gains or losses.

From my perspective, the advantages vs. the ETN are as follows:

  • ETN gains are treated as ordinary income unless a special Section 988 election is taken (which I don’t understand what that is right now). According to EverBank, Deposit gains are treated as capital gains. Need to confirm this with an accountant. But if this is the case, then the long term capital gains (LTCG) rate would be 5% for taxpayers in the 10% and 15% tax brackets and 15% for taxpayers in the 25%, 28%, 33%, and 35% tax brackets (source: about.com).
  • EverBank takes a 75 bps spread when the currency is bought, and again when the currency is sold. The ETN charges 40 bps asset management fee. So it looks like the ETN is better for a shorter term hold.
  • But with these 2 factors, it looks like with a 3 year hold, EverBank is better than the MarketVectors ETN by a slight amount.

Some more links:

  • Brookings Institution report dated July 2007 discussing the tradeoffs between currency appreciation and inflation. Written by Geng Xiao, Director, of Brookings-Tsinghua Center.
  • China Daily article stating that USD will stay the anchor of China’s foreign reserves and was at around 70% at the time of the article, dated November 2007.
  • China Daily article dated 3/24/08 stating that central bank advisor Fan Gang “opposes the use of another one-off revaluation of the Chinese currency, or yuan, according to the Shanghai Securities News. Widespread expectations that the yuan would register further sharp gains against the dollar have been encouraging inflows of speculative money into the country.”
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