CFETS likely to include won and rand in RMB Index

The China Foreign Exchange Trade System (CFETS) has authorised direct trading between the renminbi and South African rand on the interbank foreign exchange market, and it will soon launch a similar initiative for the Korean won.

The move aims to lower currency conversion costs for economic entities, facilitate the use of the currencies in bilateral trade and investment, and promote financial co-operation between the countries involved.

The new measure, which involves spot, forwards and swap trading, was approved by the People's Bank of China on June 17 and went live on June 20 for the rand, while Korea's finance ministry said on June 21 that a total of 14 banks had been picked as market-makers for CNY/KRW direct trading, which is expected to begin on June 27.

The beginning of direct trading on the CFETS is likely to be a sign that the two currencies might soon be included in the CFETS RMB Index, which comprises a set of currencies linked to the renminbi.

"When the CFETS first launched the RMB Exchange Rate Index on December 11, 2015, one of the things that stood out was the exclusion of major trading partners like Korea... There was no explanation provided for how the currencies were chosen. Our conjecture at that time was that [currencies like the Korean won] were excluded because there was no direct onshore trading and therefore no daily central parity rates for both. Hence, only currencies that have direct trading on the interbank FX market were included in the RMB basket," says Khoon Goh, senior FX strategist at ANZ in Singapore.

We expect the CFETS RMB Index to eventually include the won and rand, which will increase the number of currencies in the basket to 15
Khoon Goh, ANZ

"Direct trading in CNY/ZAR was launched on June 20, and it has been reported that direct CNY/KRW trading will begin next week on June 27. As a result, we expect the CFETS RMB Index to eventually include the won and rand, which will increase the number of currencies in the basket to 15, from 13," he adds.

The weights assigned by the CFETS in its basket are based on international trade shares, adjusted for exports. Korea is a major trading partner with China, meaning the Korean won's inclusion will attract a higher weighting than the rand.

"Based on 2015 trade shares, we estimate the won will have a weighting of 12%, while the rand will have a 2% weight. [The] won's weight would be comparable to the Japanese yen's, putting it in the top four. We estimate what the RMB Index would be if both won and rand were included, based on 2015 trade shares. The expanded index would be around 1% higher than the current RMB Index, mainly due to the underperformance of the won," explains Goh.

Qi Gao, an FX strategist at Scotiabank, also expects the Korean won will soon be added to the CFETS RMB basket, with a weighting of about 10%.

Although a date for the inclusion of the two currencies in the basket has not been set, analysts agree the CFETS may want to wait to have a longer central parity rate history. When the index was first introduced at the end of last year, CHF/CNY direct trading had only been operating for a month, says Goh.

View to volatility

One implication of including the rand and the won in the basket is a greater expectation of volatility in the index, which could translate into greater volatility in the renminbi daily exchange rate fix.

The fix is set based on the previous day's 4.40pm onshore closing spot rate and the movements of a basket of currencies measured against the CFETS, the Bank for International Settlements and the Special Drawing Rights baskets – "hence, fluctuations in USD/KRW and USD/ZAR could result in larger swings in the fix", says Goh.

"Even amid more normal market conditions, the daily volatility in the yuan against the US dollar could pick up slightly. [The] inclusion [of the rand and the won] would dilute the weights of the greenback, the euro and yen, which are reserve currencies and safe havens," said a report published by HSBC.

"In our view, it is only a matter of time until more currencies trade on the CFETS platform – and thus be included in the yuan basket – as China gradually opens up its financial markets and establishes closer relationships with other central banks," the report continued.