CNY and CNH: one currency, two markets

One currency, two markets

The Chinese yuan trades in two markets that are meant to be the same currency at the same price. Onshore, CNY trades inside mainland China under a managed float. The PBOC sets a daily reference rate (the fix) and keeps trading inside a band around it, a band it has widened over time, from ±0.3% before 2007 to ±2% in March 2014. Offshore, CNH trades freely in Hong Kong and other financial centres, with no PBOC intervention and no band, and it has done so ever since the market was created on 19 July 2010 by a PBOC-Hong Kong Monetary Authority (HKMA) currency clearing agreement.

Why the gap does not close itself

In a normal market, the same currency trading at two different prices in two places would invite arbitrage that closes the gap almost immediately: buy where it is cheap, sell where it is dear. That does not happen here, because China's capital controls restrict exactly the flow of money that arbitrage needs. Yuan cannot move freely between the mainland and Hong Kong in the size and speed an arbitrage trade requires. With that channel blocked, CNY and CNH can sit apart, sometimes for weeks, and the size of the gap becomes a live reading of how tight the controls are at that moment.

The 2015-16 stress episodes

The gap is usually small. It widens sharply whenever investors expect the yuan to weaken and capital tries to leave China faster than the controls allow. Two episodes define the pattern. In August 2015, the PBOC devalued its daily fix by about 1.9%, the largest one-day move since China unified its exchange rates in 1994, triggering a rush of capital outflows. In early January 2016, renewed depreciation pressure pushed CNH to a discount of roughly 2% against CNY. The PBOC's usual response is to intervene directly in Hong Kong, buying yuan offshore to drain CNH liquidity and make it expensive to bet against the currency there. That narrows the gap again, but it leaves the underlying interest-rate relation the two currencies are supposed to obey unchanged.

Covered interest parity, the relation built in lecture 5, says a currency's forward price is pinned down by the interest-rate gap between two countries. If a bank quoted any other forward rate, a trader could earn a riskless profit by holding one currency instead of the other and converting later. That argument carries a hidden assumption: it only works if money can move freely between the two legs of the trade. China's capital controls switch that movement off between the onshore and offshore yuan markets, so the arbitrage that would normally force CNY and CNH to the same price cannot run at full strength, and a persistent gap survives.

The mechanism is the same "one-sided arbitrage" form the course uses for the CSI 500 stock-index futures discount. Restrict one arm of a no-arbitrage trade, cross-border capital flow here, short-selling and hedging demand there, and a textbook relation leaves a measurable gap instead of being enforced away. That gap is not free money. Corporates and speculators disproportionately use the unrestricted CNH market to express views or hedge dollar exposure, which is exactly why CNH tends to move further and faster than CNY when sentiment turns.