Yesterday's comments by HKEx's CEO indicate a fundamental misconception driving its obsessive attempts to price its products in a currency which is not freely convertible.

HKEx's yuan-denominated gaffes
20 January 2012

In the SCMP page B1 today, Charles Li Xiaojia, CEO of Hong Kong Exchanges and Clearing Ltd (HKEx,0388) speaking at a media lunch, says:

"HKEx is in a unique position to introduce yuan-denominated commodities products which allow investors to trade and hedge their risks in both yuan and commodities".

Assuming that quote is accurate, this is a fundamental misconception. Regardless of the currency in which a commodity is denominated, the risk is in the value of the commodity, not the currency you paid for it. You could just as easily price the product in HKD or USD and get the same investment return as if the product was denominated in Yuan, because any difference in price movements of the commodity in one currency versus the price of the same commodity in another currency is exactly negated by the change in exchange rates between the two currencies.

If that sounds too complex, then consider this - you can buy shares in HSBC priced in HKD in HK, GBP in London, or USD in New York. Do the shares in London represent a bet on sterling and do the the shares in New York represent a bet on US dollars? Of course not. The shares represent a play on the value of HSBC, and arbitrage will ensure that any change in the price of one divided by the price of another will be reversed by the movement in the currency pair.

For sure, movements in currencies and commodities can be correlated, particularly where the country which issues that currency has a large commodity component in its trade, as Australia does, but that has nothing to do with the denomination of transactions in that commodity.

This is also fundamentally why investors see no point in convoluted methods to trade shares in CNH (offshore yuan) denominations when they can trade the same shares in a freely convertible currency such as the Hong Kong Dollar, and why HKEx's efforts to persuade companies to issues shares for CNH (or possibly both CNH and HKD in a "dual tranche" model) have been met with a collective shrug (one REIT doesn't make it right). This won't change unless and until the Yuan becomes a freely-convertible currency and stays that way for some time to establish credibility as a medium of exchange.

So any efforts by HKEx to broaden its offerings in commodities contracts should focus on HKD-denominated or USD-denominated contracts, not CNH. Separately, they should press ahead with proposals for currency contracts, particularly on the HKD/CNY and USD/CNY pairs. These would be "non-deliverable" - the bet would be settled in the international currency. HKEx wanted to pursue those contracts back in 2007 (p15) but was deterred by mainland authorities even as other markets overseas traded the same contracts.

As if that comment wasn't enough, Mr Li added:

"China is the biggest spender on many commodities but has no say in determining the prices."

Of course it does. If China didn't buy so much of commodities, prices would be lower. Supply and demand determine prices, and exchanges just "discover" those prices. Establishing more commodities exchanges in HK wouldn't be a bad thing, but it would not make any difference to China's influence on prices. Perhaps the best quote from yesterday's media briefing was contained in the WSJ this morning:

"[HKEx] will also aggressively hire experts to bolster its limited knowledge in the complicated asset class, he said. "Even I as a CEO don't understand it," Li said."

Full points for honesty.

©, 2012

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