The “law of one price” dictates that identical goods should have one value – otherwise, prowling investors arbitrage away any differences. It is a law that China remains intent on breaking.
Mainland officials have allowed a pool of the currency to be deposited and traded “offshore” in Hong Kong. But that means the same currency has two prices: one more or less set by the government onshore, and one determined by market trading offshore. Beijing prevents the majority of arbitrage by maintaining tight restrictions on flows between the two markets, and Hong Kong and mainland regulators are thought to have done a decent job of unearthing “illegal renminbi transactions.”
However, some investors and companies find clever ways to slip currency through the cracks. Companies may record imports and exports at more or less than their real value, for example, sneaking money onshore or offshore. They may also choose to settle import bills in renminbi in Hong Kong, where the currency is usually stronger. They can then bring the money over to the mainland, where they convert the renminbi into US dollars at a better rate.
The difference between Hong Kong and mainland interest rates presents another opportunity for arbitrage. Chinese companies may deposit renminbi in a mainland bank, then apply for a “letter of credit” – essentially a short-term loan – ostensibly to pay for imports in Hong Kong. The company then uses the letter of credit as collateral to obtain a US dollar-denominated loan from a Hong Kong bank at a much cheaper rate than on the mainland.
The extent of this practice is reflected in Hong Kong bank claims on mainland banks, which had risen to over US$254 billion (RMB1.6 trillion) by October 2011, up from less than US$47.5 billion at the start of 2009, according to the Hong Kong Monetary Authority.
The Chinese financial media loves to play up these cat-and-mouse games of arbitrage. However, no one really knows how much of the US$93.3 billion (RMB588.5 billion) in yuan-denominated deposits in Hong Kong is the result of financial chicanery.
Critics point out that the vast majority of the trade settled in renminbi is conducted between Hong Kong and the mainland, not with markets like the US and EU that are the destination for many of China’s exports. That seems to indicate that arbitrage is the goal of most of these settlements, rather than trade. Yet that in itself is not necessarily a red flag because much of the mainland’s exports are first traded to Hong Kong, then sold abroad.
Moreover, evidence suggests that arbitrage is becoming a smaller proportion of total capital flows. Historically, Hong Kong’s renminbi deposits have grown when the spread between onshore and offshore exchange rates widens (suggesting that investors are diverting money to Hong Kong to skim the offshore premium). But in recent months this link has weakened. In December, for example, the offshore yuan spread was almost nothing, but deposits in Hong Kong dipped and cross-border trade leapt by almost a third.
This data indicates that most companies were tapping new programs to move their offshore renminbi into mainland markets, rather than seeking opportunities for arbitrage. “We’ve seen a lot of activity by foreign-invested enterprises that are making substantial renminbi-denominated investments into mainland China,” said Magnus Montan, head of international business at HSBC China, pointing out that the bank now does more cross-border yuan trade in a day than it would have in several weeks just a year ago.
This trade will continue to boom as more restrictions on capital flows are lifted. That will probably make preventing arbitrage more difficult in the years to come. For the time being, however, China is likely to continue evading the laws of economics.