By Jonathan Shelon & Derek Yan of KraneShares and Jeffrey Qi from E Fund Management and portfolio manager for the KraneShares E Fund China Commercial Paper ETF

There is a famous quote stating that “it’s tough to make predictions, especially about the future”. This is especially true for the currency markets. Currencies are the largest, most liquid capital markets in the world, and impacted by just about everything. China’s currency the renminbi (RMB) has surprised many market participants with its year-to-date strength, which is being explained away by a surprisingly weak dollar. We believe that the fundamentals are part of the story, and that interest rates, economic growth and capital flows have all supported RMB strength this year. However, there has also been a steady policy transformation taking place over the last two years, that we believe will drive the relationship between the RMB and the USD going forward and change the way people view China’s currency and fixed income markets as part of a well-designed portfolio.

RATES

Let’s start by reviewing the key drivers of currency fluctuations, beginning with interest rates as of September 30. The first thing to note is that China’s yield curve¹ is not only attractive, but relatively flat when compared to US yields. China yields are 2% greater for one year maturities, and 1.25-1.75% greater for longer maturities².

This yield premium should provide currency support for the RMB, as yield-seeking investors around the world access China’s Interbank Bond Market. Historically, only 1-2% of onshore Chinese bonds were held by foreigners due to difficulty in accessing the Interbank Bond Market. However, this is slated to change going forward as the Bond Connect program, launched in July of this year, gives global investors access to the world’s 3rd largest bond market. According to the People’s Bank of China (PBOC), foreign investors only held $135 billion dollars in onshore bonds, but growth is rapid, with nearly $10 billion invested in second quarter of 2017 alone³.

At KraneShares, we’ve been providing access to China’s commercial paper market for nearly three years, through our KraneShares E Fund China Commercial Paper ETF (Ticker: KCNY). We chose to focus on commercial paper because the shortest maturities of the curve have the largest differentials between Chinese and US yields. Additionally, in a rising interest rate environment, commercial paper may benefit from an uptick in yield with less duration risk than longer maturities. We view KCNY as a compelling investment opportunity for those looking to enhance yield. Just this year, KCNY has gained 7.35% as of September 30, 2017. Click here for KCNY’s standard performance as of most recent month end.

Both Chinese and US yields have risen over the past year. China’s monetary tightening has lifted yields by 1-1.5% in the prior 12 months⁴. In the US, the increase has been more modest despite 3 rate hikes by the US Federal Reserve, over the same 12-month period. A disinflationary environment in the US has kept the yield curve contained, and could likely prevent the Fed from enacting the four widely anticipated rate increases this year. Because of these yield movements, China’s Interbank Bond yields are more attractive than one year ago, despite the US tightening cycle.

GROWTH

Similar to what we observe in yields, China has delivered a faster pace of economic growth over developed and emerging market averages.

China’s growth differential has been narrowing to other emerging countries as its economy matures, but has been 7% higher than the US over this millennium⁵. In the last 12-months ending September, the US economy grew at 2.3%, while the Chinese economy grew by 6.8%. According to the IMF, China and broad emerging markets may grow 4% faster than the US over the next 5 years⁵.

Unlike interest rates, which tend to have a more immediate effect on currencies, economic growth has a subtler impact, unless there is a sudden shift in the macro-economic environment.

FLOWS

One way to measure flows is to observe China’s foreign exchange (FX) reserves, or foreign assets held by the central bank.

In early 2016, FX reserves stood at over $3.2 trillion, but steadily declined throughout the year to end at $3 trillion⁶. While this was less than half the decline experienced in 2015, markets were extrapolating FX declines of $200-$500 billion per year, placing negative sentiment on China’s currency heading into 2017⁷. Many of the polices that China put in place including capital controls on both enterprise overseas investment and personal bank account transfers appear to have worked. As of September, FX reserves were back at $3.1 trillion, and have been steadily growing throughout the year⁸.

From a longer-term perspective, China’s globalization of its currency and capital markets could attract meaningful flows. There have been several milestones in just the past 12 months.

• October 2016, the RMB was the first emerging market currency to enter the IMF Special Drawing Rights Basket, estimated to bring $150 billion to $200 billion in currency flows over the next few years⁹.
• July 2017, MSCI announced China’s inclusion into MSCI Emerging Market and related indexes, estimated to bring $272 billion in equity flows over 5 years¹⁰.
• July 2017, Bond Connect established, allowing access to the $10 trillion Interbank Bond Market, the 3rd largest in the world, behind Japan and the US. Citigroup Inc. estimates inflows of $3 trillion dollars by 2025¹¹

PERFORMANCE

When comparing 10 major developed and emerging market currency returns against the US dollar, we find that half of them underperformed the US dollar last year, but all 10 outperformed this year. Prediction is hard indeed.

Specific to the RMB, which is up nearly 5% this year¹², our analysis on rates, growth and flows alone make a strong case for why the RMB was justified in its appreciation against the dollar this year, and why it should stay supported in years to come.

But there’s one area that we did not cover, that may be a better predictor of future currency behavior than fundamentals alone – policy. In its simplest form, China’s currency policy is based on a set of rules, sometimes transparent, sometimes implied, that influence RMB behavior, since it is not yet a fully convertible currency.

China’s currency policy has been evolving for decades, and we believe that the last two years represent a very important transition period to a new set of rules. These rules will help create currency stability while achieving the ultimate goal of internationalizing the RMB.

We start with a brief history of the RMB in order to understand currency policy, how it has changed over time and its impact on appreciation or depreciation.

BRIEF HISTORY

China’s economic planning cycle is measured in decades and not years, so to understand how the RMB will act in the future, we first cover the last 30+ years in the chart above.

1. The RMB steadily depreciated against the dollar for much of the 1980s and 1990s, as China gained its competitive export edge.
2. In 1997, a peg to the dollar was initiated at 8.3 RMB for every dollar, and this peg stayed in place until July 2005.
3. Once the peg was removed in 2005, the RMB appreciated by 37% to reach a high of 6 RMB per dollar, which remains the recent high to this day¹³.

The appreciation experienced after de-pegging was consistent with China’s plan to shift the economy away from exports and towards a consumer led economy. Consumer strength was seen as more important than export competitiveness, and this view remains today.

4. August of 2015 began a RMB depreciation cycle that lasted 1.5 years, with 2015 ending down 4.5% for the currency¹⁴.
5. 2016 saw concerns about capital flight, an economic hard landing, banking crisis and FX reserve depletion, leading to a 7% decline. Incidentally, only a brief period of FX reserve depletion was experienced, but none of the other concerns fully materialized¹¹.

While we began our discussion with the fundamental drivers of performance like rates, flows and growth, reviewing the RMB’s history shows just how important policy matters really are. Looking forward, we believe that China may be entering a new currency regime, one that is less dollar driven, and more internationalized. This is supported by President Xi Jinping’s recent statements at the 19th Party Congress regarding relaxation of market access for foreign investment and deepening market-oriented reform of the exchange rate and financial system.

A SINGLE CURRENCY THAT BEHAVES LIKE MANY

It should be clear from our analysis that predicting how any one currency behaves against another in the near-term, is very hard. 10 major currencies have all outperformed the US dollar this year while experts were predicting just the opposite. And unless you are a currency speculator, single currency predictions are not all that useful. Most individuals and institutions use a portfolio approach for owning equites and fixed income, and hold a broad basket of developed and emerging market country and currency exposures. This has led to the popularity of the US Dollar Index - DXY, that captures the performance of the US dollar against 6 major currencies and better gauges how currency strength or weakness impacts an overall portfolio.

A popular piece of advice is not to put your eggs in a single basket, and it’s fair to say that for a long time, China’s RMB was either entirely in the dollar basket when it was pegged to the dollar, or entirely outside of the basket when it experienced rapid appreciation, after the peg was removed.

What few people understand is that since 2015, China has been enhancing how the RMB is managed in order to internationalize the currency. This includes changing the managed float process to include a broad basket of currencies, gradually widening the bands, and updating the basket over time. This process is executed by the China Foreign Exchange Trade System (CFETS) which was established in 1994 to transmit the PBOC’s monetary policies, and we have had unprecedented transparency into the process over the last two years.

For example, in December of 2015, CFETS adopted a 13-currency basket for managing the RMB, called the CFETS RMB Index, similar to a basket approach like DXY. The CFETS basket was expanded to 24 currencies at the end 2016, reducing the US and many other developed market currencies. Of the 12 countries that were added, many of them were emerging economies, giving the basket a more global representation. A comparison of the countries and their changing weights are shown below. An important difference between the CFETS RMB Index and US Dollar index is that DXY is 70% concentrated in Euro and Yen, while CFETS only has 28% exposure¹⁵.

But the biggest distinction between the CFETS and DXY approaches is that DXY is a basket of 6 currencies that all float freely, whereas the CFETS RMB Index has been managed to a country basket of currencies over the last two years.

In order to compare the DXY and CFETS indexes historically, we created a CFETS Basket by using current basket weights and applying them to prior years, then linking results to the actual 2016 and 2017 CFETS RMB Index returns.

Two things become clear from this analysis. The first is that a 24 currency basket like the CFETS RMB Index is less volatile than the 6 currency DXY. Over this 17 year period, the RMB Basket would have been 40% less volatile than DXY¹⁶. If we sharpen our focus on the last 2 years when the RMB was actually being managed to the basket, we see that the movement of the CFETS RMB Index is even more steady, especially when compared to the performance of the US Dollar Index.

The implications of having a single currency track closely the behavior of a 24-country basket are important, particularly for those seeking enhanced yields by investing globally. Lower currency volatility, or risk, makes higher yields in China’s fixed income market that much more attractive, especially at the shorter end of the yield curve where the yield differences between the US and China are greatest, and interest rate risk is lowest. This is clear from looking at the 3.39% yield and lower than 6-month effective maturity of our KCNY ETF¹⁷.

Final thoughts

When China made a rule change in 2005 and de-pegged its currency, the RMB appreciated nearly 40%. We believe that the currency basket approach that was adopted in 2015 promotes stability, rather than large scale appreciation or depreciation. That said, there are plenty of supporting items for the RMB that are worth mentioning:

• Attractive interest rates in China’s Interbank Bond Market, more accessible now than ever before
• MSCI’s inclusion decision supporting the view that China’s equity market should be viewed as an asset class
• Fixed income inclusion decisions being reviewed by major bond index providers like Citigroup and Bloomberg
• Capitulation of many RMB short positions during this year’s appreciation

This leads us to believe that now is the time to invest in China’s fixed income market to secure higher yields without sacrificing portfolio risk management. There will always be those making short-term predictions on one currency vs. another, and sometimes, they will even be right.

Our focus will remain on delivering access to China’s deep capital markets by providing compelling investment opportunities that improve overall investor results. Whether considering fundamentals or policy, accessing higher yields through the world’s third largest bond market is compelling.

This article is intended for educational purposes only and should not be construed as investment advice. All opinions or views expressed in this article are current only as of the date of this article and are subject to change without notice.

1. A yield curve is a line that plots a set point in time of bonds having equal credit quality but differing maturity dates. For this example sovereign and treasury yield curves were chosen because they represent the highest credit quality yield curve for each respective nation.
2. Bloomberg as of 09/30/2017
3. Bloomberg News, “As China's Bond Market Opens, Global Funds See Watershed Moment”, 09/17/2017
4. Bloomberg as of 09/30/2017
5. IMF as of 09/30/2017
6. Bloomberg as of 9/30/2017
7. Bloomberg as of 9/30/2017
8. Bloomberg as of 9/30/2017
9. Julia Hollingsworth & Sarah Zheng, SCMP, “China’s renminbi joins the SDR – a basic guide”, 9/30/2016
10. MSCI, as of 9/30/2016
11. Bloomberg News. “As China's Bond Market Opens, Global Funds See Watershed Moment”, 09/17/2017
12. Bloomberg as of 09/30/2017
13. Bloomberg as of 09/30/2017
14. Bloomberg as of 09/30/2017
15. China Foreign Exchange Trade System as of 01/01/2017 retrieved 09/30/2017
16. Bloomberg as of 09/30/2017
17. Bloomberg as of 09/30/2017

The KraneShares ETFs are distributed by SEI Investments Distribution Company (SIDCO), 1 Freedom Valley Drive, Oaks, PA 19456, which is not affiliated with Krane Funds Advisors, LLC, the Investment Adviser for the Fund. Additional information about SIDCO is available on FINRA’s BrokerCheck.