When Rydex SGI filed for a new renminbi ETF in June, I wrote a
blog out of excitement for this groundbreaking product.
Now that the CurrencyShares Chinese Renminbi Trust
(NYSEArca:FXCH) is trading, I'm a little surprised at the lack of
investor reception it's received. Two months after launch, it only
trades a few hundred shares a day, and has just $7.8 million in
There may be several reasons why FXCH is off to a slow start.
But first, I think it's important to cover some important
structural differences between FXCH and the other renminbi currency
funds, which investors might be overlooking.
For starters, FXCH is the first currency exchange-traded product
to provide investors with direct exposure to the renminbi, without
using derivatives. Like all other CurrencyShares products, FXCH's
shares are backed by the underlying currency, held in deposit
accounts. This structure is similar to the popular SPDR Gold Shares
(NYSEArca:GLD) physical bullion fund.
Meanwhile, the WisdomTree Dreyfus Chinese Yuan Fund (NYSE
Arca:CYB) and the Market Vectors Chinese Renminbi ETN (NYSE
Arca:CNY) mostly use nondeliverable forward currency contracts to
gain exposure to the renminbi.
The issue that CYB and CNY have run into is that with a slow and
steadily appreciating currency like the renminbi, future
appreciation is already priced into the forward contracts. This
means that to make meaningful gains, the renminbi has to appreciate
faster than the forward markets expect.
This has muted the returns in both CYB and CNY since the summer
of 2010, when Chinese authorities relaxed their peg to the dollar
for the second time in six years.
While the renminbi has appreciated roughly 7 percent against the
dollar since last summer, CYB and CNY returned roughly 3 percent
and 2 percent, respectively.
Renminbi Onshore Vs. Offshore Market
The one caveat with FXCH is that it's based on Hong Kong's
"offshore" CNH market, not the mainland's "onshore" CNY market. (To
be clear, the CNY currency market shouldn't be confused with the
Market Vector's ETN, whose ticker is CNY. So, from here on out, any
reference made to CNY will mean the onshore currency market.)
As most investors are already aware, CNY is strictly controlled
by the Chinese government, which allows only a small
appreciationâor depreciationâwithin a tight daily band. The
relatively new CNH market is open to foreigner investors, but it
to be more volatile and vulnerable to shocks in the broad markets.
This sometimes causes a divergence in exchange rates between CNY
Naturally, one would assume that if there's a divergence in
exchange rates in the same currency, it would create an arbitrage
opportunity for investors to take advantage of the situation, which
would eventually bring the two exchange rates together again. But,
because CNY is restricted, there's currently no true arbitrage
mechanism in place.
However, as James King, a portfolio manager at Rydex SGI,
says:"There is a slow motion, or pseudo-arbitrage mechanism in
place, due to transactions taking place that can be settled in
either CNY or CNH in Hong Kong."
King adds that this "slow motion" arbitrage mechanism continues
to bring CNH close to CNY when there's a divergence. He also
expects this slow arbitrage mechanism to accelerate and become
faster over time as the interbank marketâthe currency trading
system between banksâmatures in China.
Regarding the two markets, King makes the analogy to two share
classes of the same company. Like different share classes, CNY and
CNH are parts of the same entity, but have separate pools of
liquidity and supply and demand.
"In that way, it's almost like the offshore trades like a
closed-end fund based on the onshore," explained King.
While CNH can periodically diverge from CNYâin October 2010
and September 2011, for exampleâit tends to crawl its way back to
CNY. You can also see the outperformance of CNHâagain that's what
FXCH holdsâcompared with CYB since summer of 2010, when CNH began
trading in Hong Kong.
So investors looking for renminbi exposure have some
With CYB, you're inherently playing the forwards market and
exposed to expectations for future movements that may already be
priced into the forward contracts. So far, as I said, this has
caused CYB to lag behind the actual returns of the currency.
That being said, according to a recent prospectus supplement,
CYB can now hold yuan-denominated money market
securitiesâalthough as of this writing, only 17 percent of the
fund looked to be holding such instruments.
CYB also has some tax advantages. According to its prospectus,
if shares in CYB are held over a year, gains are taxed at the
long-term gains rate of 15 percent. But gains on all CurrencyShares
products are taxed as ordinary income, regardless of holding
But to me, there's a certain beauty about FXCH's simple
structure. It's comforting to know that your shares are backed by
the underlying currency and to understand how your shares move,
depending on the CNH exchange rate.
Also, because each FXCH share is backed by 500 yuan, you can
always simply take 500 and divide it by the share price to figure
out whether you're paying a premium or discount to the current
exchange rate, for both CNY and CNH.
So what's possibly behind the lack of investor interest in FXCH
For starters, the timing of the fund's launch might be a factor.
There's currently a negative vibe brewing with any Chinese asset,
due to weaker economic data coming out of China, signaling slower
"While we have heard and seen a lot of interest from advisors,
the assets have been slow to follow. We believe that this is due in
part to apprehension about the China government, and the 'true'
growth in the economy," Tony Davidow, managing director at Rydex,
said recently in a phone interview.
Indeed, export growth in China is slumping to levels not seen
since 2009, which might lessen any incentive for Chinese
authorities to accelerate currency appreciation.
Inflation has also recently slowed, taking some pressure off
Chinese authorities to use currency appreciation to fight
inflation. Adding to these fears is the European debt crisis and
the U.S. Senate recently passing a bill threatening to label China
as a currency manipulator and impose punishments.
Interestingly, the renminbi is recently showing some signs of
The Wall Street Journal published a story on this topic a few
days ago. In fact, the renminbi nondeliverable forward markets are
now pricing in a near-term depreciation in the currency, while CNH
is trading at a discount to CNY.
But even if China's growth significantly slows, does that mean
that we'll see a large depreciation in the renminbi against the
dollar? Perhaps, but not a certainty either.
The huge factor at play here is that China's currency is tightly
In fact, if you look at currency returns since the summer when
market volatility spiked, the renminbi has been one of the most
stable currencies, especially compared with currencies of emerging
and commodity-producing nations, which are highly affected by
shifts in the risk-on and risk-off trades.
Currency Returns Vs. The U.S. Dollar
Since Aug. 1, 2011
|Renminbi Onshore (
|Renminbi Offshore (
|As of 12/14/11
As the Wall Street Journal article pointed out, the general
consensus seems to be more of a neutral view on the renminbi in the
near future, instead of a downright depreciation.
As a reference, in 2008 during the financial crisis when Chinese
exports plunged, China simply halted the renminbi's appreciation
for a few years. But it didn't actually weaken its currency against
Fast-forward to the current economic crisis. If China were to
actually depreciate its currency against the dollar, could you
imagine the political friction that would cause with Washington?
While it's always possible, it's a scenario that both sides would
probably want to avoid.
Despite the negative tone of recent months, most economists and
investors still believe CNYâagain the onshore currency market,
not the Market Vectors ETNâto be undervalued relative to the
dollar over the long haul.
The internationalization of the renminbi is also accelerating,
and there's chatter about additional offshore renminbi markets in
London and Singapore possibly on the way. Expectations are also
growing for full-convertibility coming within the next several
While economic and political fears may be shunning many
investors away from Chinese equities, for those still bullish on
China, FXCH is another play to maintain exposure to China, perhaps
without having to take on all the volatility associated with
"We continue to believe that FXCH represents a great way of
playing the economic growth in China," Rydex's Davidow added.
FXCH may not be the slam dunk of being backed by onshore CNY,
but short of full-convertibility in that market, the CurrencyShares
ETF still offers investors the "purest" way to gain exposure to
China's currency out of the current mix of exchange-traded
Disclosure:I am currently long FXCH.
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