Last August, the Chinese currency (Renminbi or Yuan), experienced a major devaluation. The Central Bank of China removed the limits to currency price fluctuations and cut interest rates. A big effort to stimulate the economy by encouraging exports and corporate finance.
So, why this extraordinary and unexpected intervention by the Central Bank of China?
1. THE STOCK MARKET COLLAPSE
Last summer, the Chinese stock market suffered a sudden collapse, recording the worst performance ever seen in the past four years with the suspension of almost half of the securities. The collapse of the Chinese stock market has followed the panic in European markets. The fear who related to minor Chinese growth. Over the past thirty years China’s average real growth was 10%, today the IMF – International Monetary Fund, estimates 6.8% in 2015, but some analysts believe that the growth will be lower, probably closer to 5%.
A weaker Yuan has important consequences:
1. A weaker currency boosts exports, but also leads to capital outflows.
2. A weaker Yuan makes exports more competitive, but makes imports more expensive. The negative impact extends to countries exporting to China, there including Italy.
3. The currency weakness’ impact on China debt. Chinese companies have debts denominated in Dollar for about 529 billion, most of which is not hedged against fluctuations in exchange rates. The devaluation will weigh on their accounts. And now the real estate sector are more exposed to foreign debt. Setbacks in this area would have serious repercussions on the entire Chinese economy, since the real estate bubble has so far supported the growth inside China.
The goal of the Chinese government is to make the Yuan currency competitive against the Dollar, at least in Asia. Today it is the fourth most widely used currency in the world after the US Dollar, the Euro and the British Pound.
Then, what are the operating decisions to be faced by a European company that has business relations – import or exports – with China?
International trade can be denominated in any currency, this is a choice made by the trade partners. In the case of import from China, the company may consider to settle and pay for supplies in Renminbi. Conversely, the exporter can decide whether to cash in Chinese currency.
2. PROS AND CONS OF TRANSACTIONS DENOMINATED IN CHINESE CURRENCY
What are the benefits of using the Chinese currency?
2.1.1 More payment extensions
In China, foreign currency commercial payments may not be deferred for more than 90 days. Payments in Chinese currency may instead qualify for automatic extensions up to 360 days.
2.1.2 Accounting and banking system less intricated
Chinese enterprises generally have higher costs when they collect foreign currency. The hedging costs are higher, the financial and administrative management is more complex and extra costs can occur.
In the case of settlement and payments in the Chinese currency, favorable terms might be obtained from the supplier, as Chinese partner might prefer to use its domestic currency.
From the above, it would seem that the best solution is to renominate all the price list in the Chinese currency, but it is not always the best solution.
The primary issue is to understand how to determine who should bear the risk of exchange rate risk. If the prices are fixed and settled in the Chinese currency, the risk arising from changes in exchange rates is in charge of the European company. So what are the drawbacks?
2.2.1 Higher costs for banking fees
Companies pay commissions to financial intermediaries for currency management that are directly related to the liquidity or the easiness of transaction exchange for each currency. Not all currencies are equal. The liquidity of the Euro or the US Dollar is not remotely comparable to that of the Chinese currency. Despite all the progress made in recent years by the Chinese financial market, Western markets are still light years ahead in terms of transparency, volumes and investor protection.
To evaluate concretely how the conditions are different for each currency. Let us have a look at the exchange rate price list, as that provided by Investing.com (Figure 5).
The “bid” is the price that the seller can get, the “letter” is the price for those who want to buy. The difference between the bid and the ask price represents the intermediation costs.
Scrolling through the list, you’ll notice that the costs of intermediation for the Euro against the Dollar is very low, in the order of 0.009%. Much higher costs for transactions with the Russian ruble and Turkish lira (0.2%). Soaring costs for trading against the yuan: as much as 3%.
2.2.2 Higher volatility
Volatility is a crucial indicator in the markets. It ‘an index of the degree of risk that expresses the price fluctuation potential. Well, the volatility of the Chinese currency is much higher than that of the US Dollar, the Canadian Dollar and the Pound. More volatility means higher costs because is greater the risks of value fluctuations. A currency with a high risk of volatility is not considered a hard currency.
The risk measurement that undergoes a European company exposed to the Chinese currency has been made with the eKuota proprietary methodology. Thanks to the scenario generation engine, that is a mathematical-statistical model with a high degree of reliability, it is possible to precisely measure the risks. The instrument used is the Cash Flow at Risk (CF@R). CF@R quantify the potential cash flow losses. In the example showed in Figure 6, we have to pay an invoice of 7,220 Yuan expiring at the end of 2015, which corresponds to € 1,000 at the current exchange rates. That invoice can cost in the worst case scenario up to 1,114 Euros, i.e. 11% more!
A prudent approach for European companies who trade in different currencies is always to properly evaluate the risks involved in currency prices, the financial risks.
Recently many banks offer companies trading services for transactions in the Chinese currency. Before you rely on the advice of banking institutions, it is necessary to know in advance, which are the implicit costs that financial intermediaries do not always show.
Explicit commissions and interest rates are not the only element of cost to evaluate, we have seen how important is the evaluation of risk exposure related to the volatility of financial markets.
When the price difference between the transaction set in the Chinese currency and the price fixed in hard currency (the US Dollar is commonly used) is not at least 10% in your favour, evaluated with extreme caution the offer of your Chinese partner.
The Renminbi is still a low liquid currency with high costs and high risks. Renominating all your cash flows in the Chinese currency can cost a lot to the company’s income statement. For many companies that have transactions with Chinese partners, the optimal solution would be to diversify exposures, take some transactions in US dollars and others in Renminbi.