For years Chinese property developers have had it easy. When China sought to spend its way through the financial crisis, developers benefited from the abundance of bank liquidity. More recently, they have benefited too from the vibrancy of the high yield bond markets and their thirst for China exposure. But are these markets drying up?

A host of Chinese developers have found success in the high yield bond markets this year. For example, in April 2010 two developers launched in considerable size in the same week: Yanlord Land, rated Ba2/BB, raised US$300 million in a deal through HSBC, RBS and Standard Chartered, and Agile Property, rated Ba3/BB, raised US$650 million through Stanchart, Bank of America Merrill Lynch, Deutsche and Morgan Stanley. Other PRC property developers to have raised funds have included Kaisa, Renhe Commercial Holdings and (on the equity side) Shimao Property.

Many considered these bond deals to be a sign of borrowers looking for alternative sources of funds following a tightening of bank liquidity in China, as the state has sought to rein in bank lending as part of broader austerity measures to curb potential overheating. In fact, that may not be the case.

“To be frank we haven’t seen much evidence that there’s a tightening of liquidity for developer companies,” says Jason Kern, managing director and head of real estate advisory for Asia Pacific at HSBC. “They still appear to have good access to relationship-type lending both from a domestic base and from international banks.

“I suppose the fear out there would be that at some point liquidity dries up, but we haven’t seen any sign of it thus far.”

HSBC is working on a number of high yield bond deals for Chinese developer clients, and an absence of bank liquidity is not being cited as a rationale by any of them. Instead, developers are using bond markets to diversify sources of funds and build new investor bases. “A lot of the issues we are working on are debut bond issues,” Kern says. “If you are a publicly traded PRC developer listed in Hong Kong, in the long term you want to make sure there is appetite for your bonds as well as access to banks in order to diversify your funding sources.”

There is, though, a sense that the easy money from the bond markets may be gone, for the moment at least. Surely before the Yanlord Land deal, Glorious Property postponed its own planned global bond. Issuance appears to have stopped post-Yandlord as the markets have become more volatile: a combination of the effect of the European sovereign debt problems, uncertainty about how China will handle austerity measures, and the amount of funds already taken from the market by the likes of Yanlord and Agile. Pricing on existing bonds has backed up, and bookrunners mandated to handle further high yield deals are simply preparing them to hit the market, not actively launching them, instead waiting for better conditions.

“You had a window of two weeks that saw US$2.4 billion coming out in one sector,” says William Pang, head of Credit Trading, Asia, at Deutsche Bank. “You have also had a very specific change in government policy that has negative implications on the business model of these real estate companies,” he adds, referring to measures such as limited access to second or third buyers of the same household, and potential city-wide limitations. “Together with that is the overhang of the European situation. All of this clearly has an impact and has created some headwinds.”

“But real money continues to have interest in this space, and given that this is a critical part of Asian high yield, I don’t see a dramatic adjustment to that medium term trend.”

Despite worries about overheating in Chinese property generally, investors do not appear especially worried about the credit quality of individual names. “For PRC developers as a whole, balance sheets are in fantastic shape,” says Kern. “There are probably only a couple of names where you could make an argument they have an overleveraged balance sheet. For the most part they have less than 100% net debt to equity, and many are self-financing with cashflow from actual projects.” They are, though, vulnerable to a drop off in sales volumes if they are protracted, though so far the yields on offer -  an 8.875% coupon on Agile, 9.5% on Yanlord, 11.5% on Renhe – have more than compensated investors for that risk.

In the loan markets, extremely large deals are being completed in the Hong Kong markets, including for developers with considerable China presence. Examples include Chengdu IFC Development, owned by Wharf Holdings (HK$8 billion five-year bullet); Sun Hung Kai (HK$10 billion, five-year); Sino Land (HK$8.8 billion); China Overseas Land and Investment (HK$5 billion); and Yanlord Land (US$400 million, three year).

However, while liquidity for big, listed names appears strong, it’s a different story for those Chinese developers who are pre-IPO. “Two years ago the trend was that everyone was looking for net asset value based on the land bank, so pre-IPO companies would borrow money to increase their land bank to get a better valuation in their IPO,” says Ruoyu Jiang, Managing Director, Credit Structuring at Deutsche Bank. “Now, although land bank is important, people are more focused on the ability of a company to generate cashflow and repay their funding. It’s fair to say the Chinese banks have basically closed. There still may be people looking at the property sector pre-IPO, but they are very selective.”

Finally, Shimao Property’s HK$1.96 billion follow-on offering in April – raised, through JP Morgan and Morgan Stanley, despite a profit warning – suggests a third option for developers: more equity.

 When an economy delivers first quarter year-on-year growth of 12%, it seems churlish to moan. Chinese exports grew 48.5% year on year in May; the trade surplus is widening; and the latest eye-popping figure for foreign reserves is $2.44 trillion. On the face of it, things could hardly be going better.

 But people are looking nervously at China, for a number of reasons. Most obviously, such a rate of growth is both unsustainable and undesirable; already there are fears of overheating across the economy, particularly in property. Reining in liquidity through new austerity measures is a balancing act between avoiding asset bubbles and maintaining growth. Banks will one day have to reckon with their vast extension of credit over the last year, some of which will inevitably sour. And, more than anything, the world relies on China to be its economic engine: its ability not only to navigate its own domestic challenges but ride out storms in the US and Europe is vital to global growth.

 One area of absolute consensus is that growth must slow; it’s a question of how, and how much. Frederic Neumann, co-head of Asian Economic Research at HSBC expects a drop to about 9% by the fourth quarter; Wang To, China analyst at UBS, expects it to slow to 8 or 8.5% in the fourth quarter, “assuming there is no double dip in the rest of the world” (UBS’s house view is that there will not be). “The long term future is pretty good for China,” she says. “A slowdown is inevitable because what happened last year was not meant to last and cannot last.”

 This is a common position. “I think growth this year will be perfectly decent,” says Eric Fishwick, chief economist at CLSA. “It will slow down – but it needs to slow down. The current pace of just shy of 12% is well above trend, and there is a correct recognition that such rapid rates of growth – in concert with institutional factors such as urbanization, the closed capital account and the way in which local government finances are organized – does mean the economy is prone to speculative excess. The authorities are to be applauded for recognizing those risks and stepping in early to deal with them.”

 China-watchers are, though, keeping a careful eye on Europe. China’s outstanding growth this year is partly a consequence of the export recovery, which in turn is mainly because of the bounce in demand from the key markets of the US, Europe and the rest of Asia. Exports to the US were up 44% year on year in May, and 50% to the EU, but the problem is this trade data does not yet demonstrate the impact of the European debt crisis or a weaker euro. That will take time to come through and will illustrate just how resilient exports are going to be this time around. “The exports recovery is so sharp partly because last year things really fell off a cliff,” says Wang. “It’s not related too much to China’s increased or decreased competitiveness, just that demand came back.” (That said, not everyone believes exports are quite that important. “The contribution of exports to the economy was fairly negligible,” Neumann says.)

 Even if exports do stay sturdy, there’s a general recognition that China’s recovery is, in some sense, not real: a bounty of stimulus, built on bank credit, that must inevitably be withdrawn. “You should anticipate growth will come down, but that’s absolutely desired by policy makers,” says Fishwick. And this is the hardest part: a pragmatic withdrawal of stimulus that does not stall growth.

 Still, one could argue that a recent, rather momentous decision reflected confidence at a state level in China’s economy. This was the announcement by the People’s Bank of China in June that it would resume its previous trading bands for the renminbi, removing the US dollar peg it had put in place during the global financial crisis. “It means they’ve gone back to their medium term agenda of appreciating the currency. All economists would applaud that, myself included,” says Fishwick. “The exact timing is driven by politics but it does recognize that growth is in good shape in China, and certainly that there is more risk from not pre-emptively tightening, be it macro measures like currency and exchange rates, or micro like property regulations.”

 Economists are pondering just what the measure means for policy. Jun Ma, chief economist for Greater China at Deutsche Bank, expects a flexible peg to a reference basket, leading to modest appreciation versus the dollar. “The reform will be part of the structural changes to reduce the reliance of economic growth on exports and facilitate the transition to a consumption-driven economy,” Jun Ma says, adding that the policy change will reduce the risk of an escalation in China-US trade tensions and will have a positive impact on a range of asset classes from H-share equities to commodities and commodity currencies. Certainly, he’s not alone in his feeling that appreciation will be modest; western economists have taken a far more tentative view on appreciation than mass media, which appears to be expecting a major revaluation with a considerable impact on, among other things, the US economy. “We’re a bit more cautious on that,” says Neumann. “A lot of people have hailed this as a move that [the PBOC is] about to aggressively revalue the currency. But we think it is more about volatility than an actual appreciation – there could even be a scenario by which China depreciates against the dollar as the euro continues to fall. Policy makers are still very risk averse in China: they don’t want to rock the boat by seeing the currency strengthen too rapidly.”

 Domestically, two areas of scrutiny are property and banking: one that is considered an issue today, and one that is likely to become one.

 When Asian economists are asked if asset bubbles are forming in Asia, the one area they tend to focus on is Chinese residential property. At a state policy level, China has spotted this early, implementing a range of measures to curb speculation, and recognizing that different cities represent different challenges and dynamics. “I don’t think a big bubble has accumulated nationwide,” says Wang. “Sure, there are pockets where prices go up 200% in a period of a few months and you have to think that’s not natural. But the government policy has aimed to stabilize prices and at the same time increase supply to prevent a bubble. You may see a downside in property construction and probably in prices, but not a crash in the sector or the broader economy.”

 Tightening measures are being closely watched. For example, China will extend the holding tax for commercial property to investment purpose-residential ones; media in China has suggested this could trigger a 40% crash in Chinese property prices. Analysts tend to be more sanguine. “We believe… the property tax may signal a bottoming for China property stock’s prices, and is unlikely to crash the physical property markets,” argues analyst Jinsong Du at Credit Suisse.

 Early signs are positive. May property data showed a slowdown in growth in Chinese property prices month-on-month; new housing construction is increasing; and sales have dropped. “This is exactly what the government wanted,” Wang says: “Prices to stabilize and construction activity to remain strong.” Neumann adds: “The more relevant question is whether the markets in Beijing and Shanghai have cooled, and there is considerable evidence that they have.”

 But Wang is cautious about reading too much into the May numbers. “Does this mean that the government’s precision property measures worked and will continue to work, and the concerns of a sharp slowdown in property-related activity is overblown?” she asked in a June report. “Well, not so fast. While we do not expect China’s property sector or economic growth to collapse, we do see a visible slowdown in housing starts and housing construction towards the end of this year.”

 After all, underpinning property is an intractable problem: it is almost custom-designed to invite speculation because of various structural elements distinct to China. “China has a savings surplus, contained within the country through capital controls, it has structural demand factors – it’s hardly surprising property prices are seen as almost a one way bet and people are jumping on the bandwagon,” says Fishwick. “The property market is prone to being used for investment purposes, and in those situations if you have a lot of domestic liquidity it is easy to see prices driven beyond where the supply-demand imbalance would suggest they should be. Clearly there are local bubbles in China’s property market and the authorities recognize that.”

 Another closely watched area is banking – not a problem today, but something that prompts the occasional nervous prediction. Bank liquidity was central to China’s performance through the financial crisis. But China’s banking sector has plenty of painful experience to draw from that can tell it just what happens when you lend too much without sufficient scrutiny of where it is going. An increase in non-performing loan ratios is almost inevitable; really it’s a question of when, and how big the impact is if that happens. “I’d be worried that in two, three, four years down the line there might be a deterioration of credit quality in the banking sector,” says Neumann. “For the time being there is no sign that’s a real issue.” He adds that most loans were to infrastructure projects which carried government guarantees, implicitly if not explicitly, which is seen as an insulation against risk. “The real test will come if the economy slows down. As long as growth can be maintained at 9%, there’s no real issue of credit quality; the risk comes if it falls to 6% or so.”

 Fishwick questions just how much of the surge in infrastructure and municipal building work that took place in the first half of 2009 will generate a monetary rate of return to cover its cost of funds. “That investment surge was disproportionately financed out of bank credit,” he says. “There are clearly potential problems on Chinese banks’ balance sheets.”

 But he adds: “China is a rapidly growing economy and can potentially grow its way out of a lot of capital wastage problems, which include NPLs. That process isn’t always market friendly. But the NPL overhang is not going to be too severe an economic problem.”

On August 16, the development of China’s futures exchanges took a significant step forward. That day, the first index futures contracts in the country began trading on the China Financial Futures Exchange in Shanghai. They became the first financial futures ever to trade in China, and mark the start of what is likely to be a major new market – one that, if China’s other futures markets are any guide, will become a world leader in volumes one day.

Commodity futures have been around in China for many years and are discussed in more detail in the next article. Although relatively young – the oldest established contracts date from 1993 and some are barely a year old – they have in many cases become world leaders. The Dalian Commodity Exchange is a world leader for a number of soybean and plastics contracts; the sugar contract on the Zhengzhou Commodity Exchange is the most widely traded agricultural future or option in the world; and the Shanghai Futures Exchange last year overtook the London Metals Exchange to become the world leader in copper trading volume, an extraordinary achievement for an entirely domestic exchange. What’s more, all are growing at a staggering rate, with a great many contracts on track to double their 2009 volumes in 2010.

But the significance of the new index futures is that they are financial products rather than commodities. “For the past 16 years there have only been commodity futures,” says Kathy Xu, who covers international business at Shenyin & Wanguo Securities in Shanghai. “Index futures will be a very important start for financial futures products in China.”

They matter because of the opportunity they give traders to take a view on the Chinese market. “In the securities market China does not have any short selling system,” she says. “Now we have index futures, that means investors can sell, so they have a shorting mechanism. In the past investors could only make money by buying stocks, and if the market fell, they lost money. Now it’s different, and that is very important for investors – retail and institutional.”

Janet Kong, Managing Director and Head of Commodities Research at CICC, agrees. “I used to work on the buy-side, and we used to talk about how the information ratio of an investment manager cannot be improved without relaxing the shorting constraints,” she recalls. “A manager needs to be able to buy a stock to express a positive view, but also to short a stock to express a negative view. These constraints eliminate half the universe for a manager to improve their information ratio.” Being able to do so now, she says, “helps them to add alpha for investors.”

The new index futures, based on the CSI 300 stock market index, follow four years of effort that demonstrate how China takes its time to ensure it gets things right. The CFFEX itself was formed in Pudong, Shanghai, in September 2006, as a joint venture between China’s three other futures exchanges – in Zhengzhou, Dalian and Shanghai – and the Shanghai and Shenzhen stock exchanges. Mock trading of CSI 300 index futures dates back to October of that year, but the State Council waited more than three years, to January 2010, before granting formal approval for the introduction of stock index futures in principle. In that time, a host of brokers were vetted and eventually approved to be clearing and trading members – today there are 128.

The State Council’s approval of index futures was part of a broader advancement of market tools. On the same day it approved index futures – January 8 – it also announced approval for a new margin trading pilot programme. “The margin trading and index futures programmes will open up the attractive hedging option for all kinds of investors in the market,” says Ivan Shi at Z-Ben Advisors, a leading Shanghai-based research group focusing on the Chinese asset management and financial markets industries. He counsels against reading too much into them: “The pilot stages are designed to contain potential risks and uncertainties to the minimum. For financial institutions, watching, trying and learning and the feasible choices at present.” But that is the local way, and still hints at a major new market. “It is paramount at this stage for CSRC to ensure a successful start for these tools,” he says. “Any experience and lessons learnt now will contribute to the perfection and further expansion of margin trading and index futures platforms in the future.”

Index futures have started strongly, with an average daily volume of 130,000 contracts in the first three weeks of trading, with a high of 190,000 and open interest of 13,000 contracts. “Since their 16 April inception, CSI 300 futures have become one of the most active contracts globally, with average daily turnover of RMB117 billion,” said Goldman Sachs analyst Jason Lui on April 26, scarcely more than a week in to the new contract. Lui says that figure is equivalent to 57% of the overall Chinese A-share daily turnover, and more than the total daily turnover of the CSI 300 constituent stocks themselves. It already ranks second in the region after the KOSPI200 contract in Korea (popular with Korean retail day-traders), and has outstripped the HSI contract in Hong Kong and FTSE 100 in London.

But that’s just the start. These volumes come purely from retail investors, as precise guidelines for institutional use are still under development. On April 23 the CSRC finalised trading regulations for domestic brokers and mutual funds, and once they are implemented and those institutions can trade, volumes will go up significantly, particularly since qualification standards appear to favour institutions over retail. Retail investors must have at least RMB500,000 in usable capital in margin accounts, and must show trading experience, either in mock trading of index futures, or for real in commodity futures markets. That’s reasonably restrictive. Institutions, on the other hand, have a minimum net asset requirement of RMB1 million – hardly a hurdle at all for an institution – alongside other practical stipulations such as a proven internal governance system. “It is apparent to notice, in this design, a bias towards institutional participation from the regulators,” Shih says.

The exchange itself confirms this. “We hope that China’s stock index futures market is dominated by institutional investors or sophisticated investors,” an exchange spokesperson says. “We adhere to the view that the main purpose of the product is to help them hedge market risk, this giving full play to its function of risk management.”

The exchange hopes that index futures will “enhance the mechanisms of the stock market, and improve the market’s operation.” It isn’t launching futures to help speculation: instead it has very specific hopes for what they will achieve.

Firstly, the exchange views index futures as an “internal stabilizer mechanism” for the stock market. By this, the exchange means that the presence of these futures should dampen volatility. It also hopes futures will help build price-forming mechanisms, and allow them to hedge risks, which has previously been exceptionally difficult in the stock market in China. Finally, the exchange hopes that the existence of index futures will help to build a mature group of institutional investors for the stock market – something which usually helps the market itself behave in a more steady, balanced and predictable fashion. “Giving institutional investors access to the futures market will help promote growth in the open interest and diversify the market away from retail day traders,” says Lui at Goldman Sachs.

Speculators, by contrast, are discouraged, as they have been in China’s commodity exchanges. “For speculative investors, there are strict limits on the number of positions they can hold,” Shi says. “The maximum number of a contract is 100 on a single direction, which is far lower than the market expectation of 600. Investors with hedging purposes, on the other hand, need to apply to the China Financial Futures Exchange for position quota, which is usually much larger than the position limits for speculative investors.”

While the guidelines that would allow mutual funds, securities firms and other institutions to invest are eagerly awaited, there is a still more significant set of guidelines to follow: those governing QFIIs, or qualified foreign financial institutions. QFIIs have been allocated quota to invest in China’s stock markets under certain conditions (such as not repatriating their capital outside of China), and by the end of 2009 US$17.07 billion of quota had been granted to these foreign institutions. But they have never been permitted to invest in futures.

There seems little doubt, though, that QFIIs will soon be permitted to trade index futures domestically; the regulator, the CSRC, is understood to have compiled draft measures already. “It is a very significant step for foreign investors to be able to participate in the futures market in China,” says Xu.

The CFFEX confirms this is underway. “Currently QFII can invest in the stock market of Mainland China,” the exchange says. “In the future, the regulators will formulate rules about how QFIIs can trade index futures, with the purpose of providing hedging instruments for them.”

When foreigners are allowed in, given the level of interest in Chinese securities from overseas, volumes on CFFEX are expected to show even more impressive growth, although opinions do vary on what the impact will be. “In Taiwan, for example, QFII investors are more active in terms of their participation in the futures market than domestic players,” says Dr Huang, Managing Director and Head of Sales and Trading at CICC. “I hope this is the case in mainland China: QFII investors will hopefully be very active investors in the market.” Institutions like CICC will certainly hope so – CICC has about a one third market share in serving the needs of QFII investors and stands to benefit from a lucrative new business line as they engage in index futures too. “We are talking with them, and like us, they are looking forward to participating in a new market,” Huang says of QFIIs already in China.

Janet Kong, though, argues that foreigners won’t necessarily bring bigger volumes with them. “If you look at cash equities, turnover is about half and half retail versus institutional, and of the half belonging to institutional trading, it’s dominated by domestic mutual fund managers, not QFII,” she says. “The QFII turnover rate is much less than at domestic managers. And if you’re just using index futures for risk hedging, then the pattern will probably be the same: the lower turnover will carry through to futures trading as well.”

(Whether foreigners will one day be permitted to invest in commodity futures is a different story, and divides opinion. In almost 17 years, they haven’t been permitted yet. “This time, with index futures, the regulators have decided to change the situation because QFIIs have cash market trading in the securities market, and need to be able to hedge their positions,” Xu says. “For QFIIs to be able to trade commodity futures, the regulators would need to modify the law – and I don’t think it will happen in the next few years.” See the next article for more on this.)

The development of index futures doesn’t necessarily create a new business stream for foreign banks though, and they have tended to be hesitant about commenting. “HSBC currently does not have the right to do China index futures – it would require a JV with a Chinese financial institution,” says a spokesperson there, adding that comments would therefore be hypothetical and inappropriate. It may, though, represent an opportunity for those foreigners who have managed to negotiate brokerage as part of their securities joint ventures in China: Goldman Sachs, UBS and CLSA.

Both UBS and CLSA declined comment, but Goldman is already putting out quite detailed research on the futures contract and making positive noises. “We would expect this to be not only a dominant index futures contract in China, but in time, it has the potential to become one of the region’s most liquid contracts,” said Christopher Eoyang, a Tokyo-based Goldman Sachs analyst, in a report timed for the first day of trading on April 15. “We are encouraged by the prospect of a well-designed equity derivatives contract in the Chinese domestic market. Although we anticipate the ramp-up period to be conservative and gradual, we expect the CSI 300 index futures contract to contribute to the deepening and maturity of the Chinese domestic equity markets, and look forward to the time when QFII investors are also permitted access to the contract.”

Foreign banks do, though, see a certain reflected opportunity. Deutsche Bank, for example, launched 11 UCTIS-compliant China A-share exchange-traded funds (ETFs) on March 25 in Hong Kong, all of them based around the CSI300 or its various sector indices. While index futures don’t technically impact these ETFs, their launch is still good news for Deutsche as it raises awareness of the indices themselves. “We are not directly impacted by the turnover in futures, because the Chinese market is not connected to the Hong Kong one, but the fact that we launched our ETF on March 25 and futures were launched on April 16 has of course helped us to market,” says Marco Montanari, Asia head of Deutsche’s ETF platform, db x-trackers. “The fact CSI 300 has been chosen for the first index futures in China is very important to us.”

He sees the launch of futures as momentous. “It’s a positive development for the market, and any instrument that can be used to hedge exposures for investors is a good thing,” he says. “If we are one day able to use it as a hedging instrument, it will help to offer even better market-making conditions to foreign investors.” For an ETF provider this would make quite a difference. “Instead of buying the standard stocks, you could just buy the future as a hedge. This would of course make our life easier and improve the conditions of final investors in our ETF.”

The CFFEX has started out with the CSI300 index, probably the most closely watched index in China, but there are several others that would lend themselves to index futures too. The CBN 600, for example, is the one quoted in the Wall Street Journal every day; others that are closely followed domestically are the Shanghai Composite Index and SSE50. “After the CSI 300 Index futures are launched, we will provide more financial futures or options products according to demand – and, of course, with the approval of the regulators,” the exchange says.

Kong at CICC, expects a steady evolution “when the regulators become more comfortable with the operations of index futures. The first step may be access to more institutional investors; the next step may be to offer futures or options on individual stocks, to give investors more flexibility to express their views.”

Kong’s colleague at CICC, Dr Huang, looks still further ahead. “I think there will be many more products to be developed, and another innovation would allow lending and borrowing in stock. Then I think China can develop its own hedge fund industry.” This would be a major step: while there are funds in China which express an absolute return philosophy, the inability to short means that hedge funds in any western sense – where the term is most commonly applied to long-short funds – do not really exist. “This is where I think index futures substantially change the landscape of the money management industry in China,” he says. “China is still a largely incomplete market, where many products are not fully developed. So this is a milestone for China’s capital markets development.”

BOX: How’s it doing so far?

The CSI 300 index has already shown some interesting characteristics. The exchange says that in its first three weeks average daily volume was 130,000 contracts, and open interest 13,000; brokers say that early average trading volumes in value terms were around RMB117 billion notional, which is one of the leading contracts worldwide and represents 57% of the average daily turnover of the overall A-share market.

After 10 days of trading, Goldman Sachs opted to look more deeply into trading patterns, and noted several traits:

• Index futures trading volume often reaches 50% of the cash market within the first six to 12 months of trading. The CSI 300 contract managed it within the first 10 days.
• More than 90% of CSI 300 futures trading so far has been in the front-month contract – that is, at launch, the May 10 contract. In the first 10 days of trading, 93% of volumes went into this contract, 5% into June 10, and 1% each into September 10 and December 10. This, says Goldman’s Jason Lui, is “similar to global patterns.”
• Open interest is dramatically lower the trading volume. When Goldman looked, in notional terms, open interest had reached only RMB7 billion, less than 5% of average daily volume. The exchange says that in the first three weeks of trading, open interest contracts were 13,000, just 10% of total daily volume by contract numbers. “Open interest is a useful measure for the growth of futures contracts because it reflects the level of long-term investor exposure in the market,” Lui says.
• Trading distribution shows volume picks up in the afternoon, which perhaps reflects the presence of retail investors. “We suspect this is partly caused by retail investors starting to close their intra-day positions,” Lui says.
• Goldman says all four CSI 300 futures contracts (May 10, June 10, September 10 and December 10) have been trading at premiums to fair value.
• CSI 300 futures have the largest mispricing of regional peers. Lui says this is “understandable due to its short trading history and the current conservative operational environment. Over time, the magnitude of CSI 300 futures mispricing should decrease as trading volume becomes more balanced (retail speculation versus institutional flow) and the operational environment becomes more flexible.”

It tells you a lot about China that many of its commodity futures contracts have become world leaders despite the fact that they are entirely domestic. No foreign money is allowed to participate in them; only locals can trade them. Yet in copper, plastics, rubber and a host of other areas, Chinese futures volumes are dominant.

China’s commodity futures market dates from a pilot trading program at the end of the 1980s. As with any new venture, it was not immediately successful: dozens of exchanges sprung up, many of them under local governments, and speculation and market abuse was widespread. China twice tried to grab the industry by the scruff of the neck, first in 1994, when the State Council took over 50 futures exchanges and turned them into 15, delisting a host of contracts. It began issuing formal licences for brokers, restricted trading on foreign futures exchanges, put the local exchanges under the control of regulators rather than local governments, and introduced new rules and regulations.

The 1994 changes helped, but didn’t fix the market, so the State Council had a second attempt in 1998, which created the landscape you still see today. Most of the 15 surviving exchanges were closed, restructured or merged, leaving the three that still control commodities trading today: the Shanghai Futures Exchange, which was formed from a merger of the Shanghai Metal Exchange, Shanghai Foodstuffs Commodity Exchange and Shanghai Commodity Exchange, beginning life in its new legal form in December 1999; the Dalian Commodity Exchange; and the Zhengzhou Commodity Exchange. Most contracts were axed – just 12 survived in 1993 – and the number of brokers fell from around one thousand in the early 1990s to 175.

From that foundation, the industry has thrived, and the Chinese state today tends to see that period as the real basis of the modern futures market. Yang Jiang, Assistant Chairman of the China Securities Regulatory Commission, explains elsewhere in this guide: “In the new century, the Chinese government put forward the strategic thinking of: ‘steadily develop the futures market’, which pointed out the direction for the development of China’s futures market.” See his interview for more detail on some of the key regulatory changes during that time, notably State Council opinions and regulations in 2004 and 2007.

With it, the whole appeal of China’s futures market as a credible method of risk management has grown. “Back in the 1990s, some incidents tarnished the name of commodity futures and people perceived the traders as being more speculative than having any real needs,” says Janet Kong, Managing Director and Head of Commodity Research at CICC. “But in recent years, from the regulators to the government to the exchanges themselves, there has been a lot of investor education around the country telling people that futures can be an important thing to manage risk. That awareness helps.”

Exchanges themselves are delighted with their new environment. “After decades of development, the futures market has entered a period of sustained and healthy development,” says Liu Xingqiang, president of the Dalian Commodity Exchange. “The futures regulatory environment has greatly improved.”

BUILDING THE INFRASTRUCTURE

Liu says this improvement is embodied in three ways: legal environment, regulatory environment and supervision by public opinion.

“China’s futures market has gradually improved and perfected its legal and regulatory system,” he says. This is underpinned by the Futures Trading Regulations, a foundation upon which other key rules such as the Futures Exchange Regulations and Futures Company Regulations have been developed. “These documents included the regulation and normalization of the relevant futures exchanges, futures companies and futures executives,” he says. “At the same time, it also established the futures margin deposit system, investor protection fund system and a series of other basic systems.”

On the regulatory side, Liu speaks of the building of a “five in one” regulatory model. In 2000, China established a self-regulating futures organization called the China Futures Association, to strengthen management and self-regulation of the growing futures industry. By 2006, the China Futures Margin Monitoring Centre was established to improve margin deposit management, and from this evolved the five-in-one model Liu refers to: the China Securities Regulatory Commission (CSRC), the CSRC Agency, the futures exchanges, the China Futures Association and the margin monitoring centre. “This model has helped to achieve control over the entire process of futures regulation.”

“Finally, in terms of supervision by public opinion, the media has begun to play a significant role in the regulatory system,” says Liu. “With the continuous development of the futures market and the growing awareness of finance in society, the reporting of futures-related content in both financial and comprehensive media outlets has increased and become more standardized.” The media, he says, has been responsible for delivering and disclosing futures market information, “and in this way it has directly supervised the market through public opinion.”

And while it can seem curious from a distance to have three different commodity exchanges in operation (in fact there are now four futures exchanges, with the launch of the China Financial Futures Exchange, which is part-owned by the three commodity exchanges), those who have followed the industry over the long term consider it a sharp rationalization. “I don’t think China will continue to reduce the number of commodity exchanges, because China is such a big market,” says Kathy Xu, who covers international business at Shenyin & Wanguo Securities in Shanghai. “And among the three commodity exchanges, they trade different products. We haven’t seen a single product listed at three exchanges.”

Indeed, a look at the three exchanges shows how they have all evolved with different characters and strengths. The Shanghai Futures Exchange, whose legacy institutions include the Shanghai Metals Exchange, is still best-known for its metals, plus rubber and fuel oil. Dalian Commodity Exchange is centred around agricultural products, particularly soybean and its derivatives; and has more recently built a highly successful specialism in plastics. And Zhengzhou Commodity Exchange is pure agriculture, with its greatest success in sugar, cotton and pure terephthalic acid (PTA).

EXTRAORDINARY GROWTH

All three have enjoyed tremendous recent growth across the board, and what’s really noticeable is the pace at which that success seems to be increasing.

Take Zhengzhou. Its sugar contract was, according to the Futures Industry Association, the top agricultural future or option anywhere in the world in 2008, and by 2009 logged 292.13 million contracts worth RMB12.82 trillion in the course of the year. But look at 2010: in the first four months alone it had already shattered the 2009 full-year value, with RMB13.78 trillion – which, if continued through the year, would equate to 281% growth. 259.6 million contracts changed hands during that time; at this rate it won’t be long before China sees a billion contracts change hands in a single commodity futures contract in the space of a calendar year.

Zhengzhou is enjoying similar growth in its other key commodities. Turnover in cotton was up 82.7% in 2009 over 2008, at RMB1.29 trillion, with contract volume up 58% to more than 17 million; yet in the first four months of 2010 both the volume and contract figures for 2009 had already been comfortably eclipsed. Similarly in PTA futures, the first four months, in which RMB1.33 trillion of trades were made, represented 91.98% year on year growth.

Similarly on the Dalian Commodity Exchange – now the second largest agricultural futures market in the world by volume – volumes on its soybean meal contract (1.55 billion metric tons of turnover in 2009) and soybean oil (948.37 million tons) were in both cases well ahead of their equivalents in Chicago, traditionally considered the global leader for agricultural futures, although its contracts in soybean itself still lag Chicago. The soybean meal turnover gives an illustration of just how dramatically Chinese contracts can grow: its 310.8 million contracts in 2009 were double the figure for 2008 and 35 times the total in the contract’s first year of trading.

Another aspect of the Dalian Commodity Exchange is even more revealing. The exchange launched its first ever plastics future – for LLDPE, or linear low-density polyethylene – in 2007, following it up with a PVC contract in 2009. Yet in that exceptionally brief period of time, Dalian has become the world’s leading plastic futures market, with 126 million contracts worth RMB5.74 trillion traded in 2009. “Although China’s plastics futures market is still relatively young, the scale of its market has far exceeded that of other international exchanges,” Liu says.

In Shanghai, it’s the copper contract that has been grabbing global attention, because it has taken on one of the true heavyweights of the world’s futures markets. The London Metals Exchange is traditionally seen as the world focus for copper: clients from all over the world use that exchange either to hedge their exposures or to speculate, and have been doing so for more than 130 years. Yet in 2009, the world’s largest trading volume was not in London, or New York, but in Shanghai: 81.22 million lots. It is clearly one of the major price determination markets in the world, but extraordinarily has become so based entirely on domestic trading.

Shanghai is also the world leader for natural rubber futures, and its fuel oil contract is the next largest energy future or option in the world after the NYMEX West Texas Intermediate and Brent crude contracts. Its steel rebar and wire rod contracts are world leaders too – even though both were launched in only March 2009.

THE ECONOMIC DRIVER

It becomes easier to understand why such huge contracts volumes have been achieved in a domestic market when one considers just how active China is in the underlying commodities, both as a producer and a consumer. “China is a leading global commodity production and consumption nation,” says President Liu at the DCE. He cites World Bank statistics showing that among 16 selected bulk commodities, China is in the top three worldwide for production and consumption in 12 of them. “At the same time, China’s economy continues to develop at a rapid pace, and it has already become the world’s third largest economy.”

Some examples: China produces 15 million tons of soybeans each year – but consumes 50 million. The difference has to be imported. Another: Macquarie Bank analyst Bonnie Liu forecasts 6.6 million tons of real copper consumption took place in 2009, and expects net imports of 2.5 to 2.6 million tons of refined copper in 2010.  She also says China became a net importer of aluminium in 2009, that iron ore imports will hit 650 million tons in 2010, and adds: “Chinese zinc demand has been growing strongly since mid-2009, especially from the construction, appliance, machinery and automotive industries.”

In all industries where there is an interplay between domestic production and imports, there is a need to hedge against price movements, and this more than anything is what has driven the extraordinary growth in futures volumes. It is, in some sense, a play on the Chinese economy itself: as the economic engine grows and grows, the volumes of raw materials in play grows too, and with it a need to hedge. “The increase in volume we have seen in the commodity markets in recent years I think is due to the increasing importance of the Chinese market, especially the increasing demand for commodity products,” says Xu.

Janet Kwong at CICC adds: “It’s not until the last five years that strong economic growth has propelled China into being a global economic powerhouse. That has made China very important in commodities in particular: it consumes almost 40% of world copper and 35% of aluminum. That’s reflected in the futures commodities markets becoming more important.”

In many cases, volatility in commodity markets has been extreme in recent years, underlining the need for hedging: in 2008, for example, cotton futures prices on the Zhengzhou exchange hit both a record high and a record low in the course of the same year. In others, volatility is combined with increasing interaction between local and international markets. Soybeans are an example. “Due to the severe volatility in the agricultural products market, the growing linkage between the domestic and international soybean markets, exchange rates, shipping fees and other volatility risks have created a strong demand for hedging in the soybean crushing industry,” says Liu at the DCE. He says China’s dependence on the international economy has now passed 60%, which also feeds a need for hedging.

CHINA’S CHANGING AGRICULTURE

A close look at how agriculture has developed in China is useful in order to understand why hedging is growing and will continue to do so. “In recent years, the extent of marketization in China’s agriculture has steadily increased,” says Liu in Dalian. “This has not only created demand for specialization in production and operations of agriculture, but also created demand for farmers to obtain a sense of certainty in cultivation and sales,” he says. Agricultural futures help to create that sense of certainty for farmers, “a sense of market security,” as he puts it. For its part, the Dalian exchange launched the Village and Household Market Service Project in 2005 to provide free training to northeast Chinese grain farmers and rural civil servants; in more developed areas, it ran trials on futures styles that would fit farmers. “The purpose of these programs is to help the parties better understand the futures market, and to use the relevant prices and information from the futures market to better serve the cultivation and sale of agricultural products.”

As China’s agricultural market develops and becomes more industrialized, these themes will continue. “Rural and farmer cooperative organizations have developed together, and these organizations will help to bring together and unite the operations of many scattered farming households,” Liu says. “This there is an urgent demand for greater market information and for futures hedging.” Rural co-op leaders are now being trained on futures markets.

Unlike Chicago or London, where much trading simply follows a pattern of where traders believe they can make money, the futures available in China so far are vital to the stability of the industries around those commodities. “Our listed commodities [wheat, cotton, white sugar, PTA, rapeseed oil and early rice] are widely recognized for their functions and roles in industrial economy development,” says xxx at Zhengzhou Commodity Exchange. “ZCE cotton futures play a significant role in guiding production, consumption, and providing a reference for domestic macroeconomic policy.” Similarly, xxx at Shanghai Futures Contracts says: “All our contracts are responding to the call of China’s economic development and the needs of risk management at corresponding industries and enterprises. They have all been well tested by the market and have shown stability, functionality and received sound feedback from the real economy.”

 LOCATION LOCATION LOCATION

All three exchanges believe they are in a favoured location for further growth. Zhengzhou, for example, makes much of its central location: the crossroads between north and south, east and west, on the Beijing-Guangzhou and Longhai railways, the Beijing-Zhuhai and Lian Huo expressway, and two national highways. “In China’s economic development pattern, Zhengzhou is in a central strategic position whether it flows from east to west or north to south,” says xxx. It has China’s largest railway marshalling yard and a container transfer station supporting the shipping routes from Shanghai, Kowloon, Lianyungang, Tianjin and Qingdao. It’s also in Henan Province, whose wheat planting area and output ranks first in China; it’s a main producer for soybean, corn and cotton besides.

Dalian benefits from the Northeast Asia Revitalization plan and other state-driven programmes to revamp its surrounding region. “According to the national government’s plan, Dalian is to be positioned as a regional financial centre and as Northeast Asia’s international shipping centre,” Liu at DCE says. “These two centres will promote each other’s development.” On both counts, it should help the DCE achieve its mandate from the state, to develop “into Asia’s leading futures trading centre” and “to promote the Northeast Area’s inherent advantages and match them up with the DCE’s futures products.” Liu says that, with this backing, “our goal is by 2020 to be Asia’s largest fully-functional derivatives exchange with standardized operations, a rich product offering, advanced technology and significant influence in the global marketplace.”

As for Shanghai, the advantages of that city are clear – the key financial and markets centre of the world’s most exciting and vibrant nation.

What’s next? “Now that commodity futures have been operating in a relatively smooth mode for 10 years, a lot of consumers and producers are expressing a desire to have more futures contracts specific to their needs,” says Janet Kong at CICC. “So far you can only trade three metals: copper, aluminium and zinc. That leaves out lead and nickel, which are important to operations. If you look at their price volatility, they are no less than the other three: there is a growing industry need for more contracts to be introduced for commodity futures.”

There’s also oil. A fuel oil futures contract trades on the Shanghai exchange, but there’s no crude oil. “That potentially may be another area the exchange looks into. If you look at Chinese production, they have become an increasing importer of crude, and a major producer of refined products.” If the inputs are imported from the overseas markets, then those with approval to do so can hedge the risk in overseas markets too. But as futures contracts have developed locally, “there should be a way to hedge risk on a totality basis,” says Kong. “Over time, there should be more leeway, to hedge risk both overseas and in the domestic market.”

For their parts, the exchanges are certainly keen to do more. Liu says Dalian will continue to develop agricultural futures, and expand in plastics, and into energy futures. “Research has already been underway on coke futures,” he says. Shanghai Futures Exchange has a five-year strategic plan for 2008 to 2012 which talks about developing contracts in sequence from base metals t precious metals, energy products and chemicals. Xxx names steel, lead, silver, oil, petroleum, diesel, liquid gas, electricity, asphalt, glycol and methanol as possible underlyings, as well as “actively developing other derivatives such as options, index futures and emission rights.” In 2010, he says Shanghai will “push forward the launch of lead or silver futures, intensively focus on research and efforts to launch oil futures and options, and deepen R&D on metal index and carbon emission rights.”

Whatever contracts they decide to launch, expect them to be challenging for world-leading volumes within a year.

The year is 2030 and the renminbi is one of the world’s major reserve currencies. Since becoming fully convertible it has been embraced by central banks the world over and is now on track to rival the dollar as the reserve of choice, reflecting the fact that China’s economy is now approaching the size of the USA’s.

It seems a very distant prospect given that the renminbi is not even convertible today. But as the currency does become more international – and every trend of the last five years suggests it will continue to do so – it is almost inevitable that its use by world investors, institutions and central banks will increase dramatically once they have the chance.

“If you talk about the very long term, most people see an international currency as a natural outcome for China,” says Wensheng Peng, head of China research at Barclays Capital and a former China specialist at the Hong Kong Monetary Authority. “A small economy, no matter how hard you try or what policy support you give, will never have an international currency. But if you are one of the largest economies in the world – and this year China is likely to become the second largest – it is natural that your currency will become international. It’s a fundamental driving force and although you can restrict it for some time with policy I don’t think you can prevent it forever.” China already has a relatively open stance on trade, and its currency controls seem increasingly odd in that context. “That disparity will face increasing international pressure as China’s economy grows.”

Others agree. “The goal is definitely a convertible currency,” says Callum Henderson, head of global FX research at Standard Chartered. “It’s part and parcel of the liberalization of the economy. When we get it is a tougher call.” He says most reasonable estimates put it at 10 to 15 years away. “Certainly not immediately, but it’s undoubtedly the goal. Eventually it will be a reserve asset for banks around the world.”

That’s the long-term picture. But getting there is going to take time – few see full convertibility in anything less than a decade – and in the meantime, the debate is preoccupied with the currency’s value and the degree to which China should allow it to shift. Over the years (see box) the currency has drifted through various pegs and managed exchange mechanisms, but since mid-2008 has effectively been pegged to the US dollar with limited scope for gradual variation. Since the dollar itself has gone through dramatic periods of strength and decline in that period, the effect has been that the RMB has moved quite dramatically back and forth against European and Asian currencies through the financial crisis. The question most people have is when the latest dollar peg will be abandoned, and what the path to appreciation will be.

China-watchers got particularly excited about the People’s Bank of China’s third quarter monetary policy statement in November, which in its section on the RMB exchange rate included the words: “With reference to international capital flows and trends in major currencies.” Just as important was what it didn’t say: the usual sentence, about “maintaining the broad stability of the RMB exchange rate at a reasonable equilibrium level,” was gone.

Many took this as an indication that a new exchange framework, and a period of appreciation, were on their way. “We think the central bank did make it clear – as clear as a central bank can be – that in light of the weakening US dollar and increased capital inflows, the RMB is facing increasing appreciation pressure and may need to break the de facto US dollar peg and be more flexible,” says Tao Wang, economist at UBS. He doesn’t expect a change until there’s evidence of exports recovering, but nevertheless he expects the RMB to appreciate to 6.4 or 6.5 against the dollar by the end of 2010, compared to 6.83 at the time of writing. (Tao notes, though, that what really matters is not so much the dollar rate – which has appreciated over 20% in the last few years – but the effective exchange rate against a trade weighted basket of currencies.)

Most other economists and strategists broadly agree, with the only major differences being the degree of change. Peng at Barclays expects a break away from the tight range against the dollar and appreciation against it of “up to 5%” over 2010. Shen Minggao, economist for China at Citigroup Global Markets, is predicting a 3% appreciation in 2010. Henderson is calling a modest decline to 6.7 in 2010 (a 2% appreciation from today’s rates), with a shift away from the de facto peg in the second and third quarter. “Our view is that China continues to approach economic reform in a gradual and very focused way,” he says. “We see the next move as being an expansion of flexibility.”

In any event, while international pressure is clearly there, nobody is really expecting China to do anything other than on its own terms. “China is still showing all the signs of conducting FX policy on the basis of its domestic needs, rather than necessarily what other countries might view as more desirable for them,” says Richard Yetsenga, managing director, Asian FX strategy at HSBC. “That is likely to mean a gradual pace of reform to China’s capital control regime and its openness to global capital. It’s also likely to mean that China moves the RMB in a way which is consistent with its domestic policy settings rather than some global objectives.”

“A stronger RMB is likely to be desirable whether the dollar is weakening particularly sharply at that time or not,” he adds.

But why is that? We all know why the rest of the world wants a stronger yuan – for trade and export reasons, particularly when unemployment is high in developed countries – but why is it China’s interests? One key reason is inflation, which is back on an upward track. “Renminbi appreciation will likely create more winners than losers over time,” Shen says. Larger firms can shift the burden of a stronger yuan to their customers, he says; importing firms get cheaper imported goods and expanded domestic markets; H share companies become relatively more profitable in dollar terms; and capital inflows support property prices. “However, as a stronger yuan will boost imports, overcapacity problems could worsen in sectors that don’t have comparative cost advantages,” he says.

There’s also the issues of China’s vast reserves to consider. Opinion varies on what the effect of the falling value of China’s dollar-denominated holdings – whether cash or treasury reserves or physical assets held through the China Investment Corporation sovereign fund – will have on policy. “The dollar has a major impact,” says Henderson. “If you have roughly $2 trillion of FX reserves and the majority is in dollars there is obviously a valuation effect on your reserves, which theoretically has a P&L impact. It doesn’t in reality until you realise it, but it definitely has resulted in an increased focus on diversification.”

Peng sees it differently. “If you are a government or a central bank, you manage your wealth not for the next three to five years but for the next generation, so you need to take a very long term investment horizon,” he says. “In that investment horizon it is difficult to forecast exchange rates. So diversification is not about the currency, per se; it’s more about the assets. As a side effect that may give rise to a reduction in the share of US dollar denominated assets, but it’s not one of the motivations.”

If appreciation is eventually to lead to full convertibility and a totally open exchange rate, a number of structural changes need to take place, and some are expected in the near future. Ditching the peg for a wider trading band and a link to a basket of currencies would be a start. Others would like to see the development of better yuan asset markets.

 “A lot of the basic infrastructure is already in place,” says Yetsenga. “There is already a mature spot market and something of a forward market, some cogniscence about currency volatility and how to manage it. But many of the systems and institutions which surround those issues have not been exposed to significant currency volatility, and third markets don’t necessarily support some of the derivative markets which in other developed economies appear necessary for hedging forex risk.”

Another element to China’s forex debate is the liberalization of its capital account. FDI is clearly still strong and brings money in to China, but a trend of recent years has been for China to acquire more resources and companies overseas. As Chinese companies (and the State) become more comfortable about investing abroad – as its resource companies and the CIC demonstrate – then those outflows should help to offset the FDI inflows. China’s recent approvals for QDII (qualified domestic institutional investor) licences and mandates also creates a source of outflows, while the QFII program (qualified foreign institutional investors), under quota, allows foreign money to participate in Chinese domestic securities.

“Significant process has been made in the last decade,” says Peng. “Basically all the direct investment, inward and outward, has been liberalized. China attracts a lot of FDI, and in recent years we have seen significant Chinese investment abroad: Chinese companies investing in Australia, Africa, Latin America, Russia, as well as domestic markets.”

Peng envisages that these ventures may also become testing grounds for a greater use of renminbi outside China, because at the moment, restrictions on the currency are a natural barrier to practical trade settlement. “If a Chinese exporter pays RMB to its exporters, those exporters have no place to invest their assets. And if a Chinese exporter says it wants to receive RMB from foreign importers, where will that foreign importer get the RMB from? The only source is from China.” So, for that to start to happen, he predicts some ad hoc arrangements could be made for, say, an oil company to pay in RMB to offshore exporters, and allow that exporter to invest in RMB assets. Going further, he believes foreign central banks would like to set up QFII-style arrangements with the PBOC in order to buy RMB bonds in China as part of their reserves.

So, if China were to become a reserve currency, how powerful would it be? The Hong Kong Institute for Monetary Research put out a detailed study in May – jointly authored by Peng in his HKMA days – about just what the renminbi’s potential as a reserve currency could be. Using different models they came up with figures of 10% and 3%, but that’s based on the size of China’s economy today rather than at the point when convertibility is possible, by which time it will presumably be much larger. “These results suggest that at present the renminbi’s potential as a reserve currency would be comparable to that of the Japanese yen and British pound,” the report says.

The report makes another telling conclusion too: “Whether the renminbi realises its potential as an international currency that is line with the size of the Chinese economy will be a market choice.” And it will, more than anything, be China’s choice, done at China’s pace. “Deng Xiaoping said so many years ago that he was crossing the river while feeling the stones with his feet,” says Henderson. “It’s a very well-worn cliché but it’s very appropriate in terms of what’s happening in monetary reform.”

BOX: The RMB bond market in Hong Kong

Over the years China has undertaken a few experiments involving the use of the currency outside its borders. These have included increased use of the yuan in Hong Kong and Macau, bilateral agreements with countries including Brazil and Malaysia.

The Hong Kong RMB bond market is, in many people’s eyes, the most significant of those experiments. At RMB38 billion outstanding it’s not a huge market – the RMB6 billion sale of government bonds to Hong Kong retail investors in September was the largest ever deal in this market, and only the 13^th in total since the China Development Bank kicked off the market in July 2007 – but it’s really not about the size.

“I think it’s very significant,” says Simon Jin, head of fixed income for China at UBS in Beijing. “If you look at the trends and discussions that are going on around the internationalization of the RMB, it’s clearly an interesting strategy to develop an RMB market that’s not just functional in the domestic market but potentially other markets.”

The market works because retail investors and local merchants have been accumulating RMB deposits and need to be able to do something with them other than putting them in hopelessly low-yielding deposit accounts. Today, potential investors are strictly limited, but if other buyers were allowed in the appetite would likely be insatiable, and this may well be the long term plan. “Hong Kong is the perfect candidate,” Jin adds. “It’s so interlinked with mainland China, people understand China well and are very bullish on the economy, and there is a need for the currency.”

The experience helps China to get to grips with RMB outside the mainland.  “It seems China’s intention, at least partly, is to build up a pool of RMB offshore that can be gradually used to settle outside the country,” says Yetsenga. “The perception seems to be this will take some pressure off China’s balance of payments.”

It’s also seen as a significant step towards convertibility. Says Jin: “If you look at the big picture in terms of RMB internationalization, this is an integral part of that process.”

BOX: Yuan reform

Back in the 1950s and 60s, China frequently changed its foreign exchange rates in order to encourage exports and restrict imports, first pegging to the dollar, then to the pound. After the Bretton Woods system – the post-war monetary agreement signed by the world’s industrial states in 1944  – broke down in 1971, China moved instead to a broad basket.

Next came a multiple FX rate structure with a controlled float in the 1980s, followed by a more market-determined FX rate in the 90s as China sought admission to the General Agreement on Tariffs and Trade (GATT). By 1994 the official rate had become the prevailing swap rate, where the yuan’s external value would be managed against an undisclosed basket of currencies. This lasted just 16 months: after a period of volatility in global currency markets in April and May of 1995, China moved back to a straight peg, at RMB8.28 to the dollar. Current account convertibility came in 1996; capital account liberalisation was interrupted by the Asian financial crisis, although China was applauded at the time for shoring up the peg and avoiding further regional devaluations.

In July 2005, the peg was abandoned for a managed float against a reference basket, which was calculated using elements including the composition of China’s trade, inward direct investment and foreign debt. Since then spot dollar/yuan cross rates have been cautiously adjusted as economic conditions change. In 2005 the daily fluctuation range was set at plus or minus 0.3%, and was widened to 0.5% in May 2007. The ranges have been much wider for non-dollar currencies: originally plus or minus 1.5%, but since 2005, 3%. As the global financial crisis kicked in in September 2008, China informally moved back to a peg to the dollar, and now the debate is when it will relinquish it.

Part of this material is abridged from Deutsche Bank research

In September Hong Kong’s renminbi bond market took a major step forward. To that point, it had been a fascinating but fairly insubstantial new venture, attracting some interesting credits but lacking the scale or liquidity to have broader impact. But then China’s Ministry of Finance launched a RMB6 billion sale of government bonds to retail investors in Hong Kong – and by the time the offer closed on October 20 had attracted bids for three times that much.

The deal was significant on a number of grounds. The 13^th RMB bond issue in Hong Kong, it was the biggest, the first by a sovereign, the first to come in multiple maturities, and it increased the market’s curve from three to five years. Not only did it provide a government pricing benchmark to this new market, it also represented the first time the Chinese sovereign had issued an RMB bond anywhere outside the Chinese mainland. And, in so doing, it heightened the sense that what’s happening with this market in Hong Kong is a tentative but vital step towards convertibility of the Chinese currency.

“China obviously doesn’t need the money for fiscal purposes, so you have to ask why they are issuing,” says Tim Condon, chief economist for Asia at ING Financial Markets. “The answer is to prepare to give the renminbi a wider circulation outside of China – and so a small step towards internationalizing the renminbi. I see these small steps as being towards the end of full convertibility.”

Hong Kong’s RMB bond market started out with a RMB5 billion issue – still the second biggest to date – from China Development Bank in July 2007, and was followed by other Chinese state-linked agencies (Export-Import Bank of China in August that year) and major mainland banks (Bank of China in September 2007 and again a year later, and Bank of Communications and China Construction Bank in July and August 2008). The next milestone was allowing foreign banks with incorporation on the mainland to issue too through their Chinese subsidiaries: HSBC (China) was first, with a RMB1 billion institutional bond, the market’s first floating rate issue, in June 2009, followed by Bank of East Asia (China) with a RMB4 billion raising the following month. HSBC was back again in August with a RMB2 billion deal, this time chiefly for retail buyers.

With the Ministry of Finance deal, the total raised now stands at RMB38 billion from eight issuers, with tenors from two to five years and coupons between 2.45 and 3.4%.

Whatever China’s broader ambitions for the currency, the Hong Kong RMB bond market is underpinned by a pragmatic rationale: the steady accumulation of the Chinese currency outside of China. “Although as a percentage it’s small, it’s something that China has allowed and wanted to see,” says Anita Fung, treasurer and head of global markets for Asia Pacific at HSBC. “It started with the growth of renminbi deposits, and the RMB bond market in Hong Kong reflects the fact that it’s important to give investors a wider choice of investments than just those deposits.” Hong Kong resident retail investors can accumulate RMB20,000 a day, and by September 2009 RMB deposits in the city’s banks stood at RMB58.2 billion.

Aside from retail, selected specialist merchants can open RMB accounts with banks – those groups who naturally accumulate Chinese currency in the course of their business, such as international trading companies that accept RMB from their Chinese mainland counterparties. It’s a limited field: even these businesses must get approval from the Hong Kong Monetary Authority before being allowed to open an RMB deposit account with a Hong Kong commercial bank.

Between them, these two groups have created a modest institutional market too, made up of the banks in Hong Kong who offer the accounts that service those retail and merchant clients. “The RMB bond market in Hong Kong provides a means for the banks in Hong Kong to diversify their RMB assets from just placing them with the clearing bank,” says Fung. There is only one clearing bank licensed to handle RMB today – Bank of China (Hong Kong) – and it pays just under 1% interest, hopelessly unattractive for an institution. “If you have RMB deposits, you can invest them in RMB bonds at a more attractive yield without compromising the risk, if it’s a quality issuer.”

Consequently there is healthy appetite for any new issue. “Renmimbi retail deposits in Hong Kong receive a very low deposit rate, below 1%,” says John Sun, executive director of fixed income at Citic Securities International. “Anyone who has an RMB bank account in Hong Kong is going to receive that interest rate; compare that against 2.7% [the rate on the three-year tranche] for a bond from the Chinese government. That’s why the response is so good from retail.”

Between retail and the modest permitted institutional market described above, there’s already more demand than supply has yet been able to cater for. But if the net was broadened to a greater range of buyers, that demand would become truly insatiable. “When the MOF issued this bond I got a lot of calls to see if they could buy this bond – from Taiwan, the Middle East, Europe,” says Sun. “A three year bond offering 2.75% yield, and the potential appreciation of the renminibi – which on a two year trade is probably roughly 5% – means in US$ terms this bond offers more than 5% yield. It’s very attractive when US treasuries and yen offer so little. But unfortunately none of them can be involved in the deal.”

One consequence of this is a market that lacks liquidity. Deals fly out the door, but don’t then tend to trade. “Because of a lack of participants, the secondary market is not active,” says Sun. “Retail use these bonds as a replacement for their deposits, and so hold them. And commercial banks do the same thing – there’s no other way for them to invest their renminbi.”

More broadly, the market helps develop expertise, opportunity and familiarity. “By having an RMB bond market in Hong Kong it expands the range of RMB products and services outside China,” Fung says. “It’s part of integrating into international trade and financial markets, and it complements QFII, QDII and other initiatives to open up the financial sector.” QFII refers to qualified foreign institutional investors, a system whereby selected foreigners are permitted to invest in domestically-listed securities in China; QDII, or qualified domestic institutional investors, is the reverse process, where mainland asset managers can invest outside of China and launch mutual funds giving domestic investors exposure to world markets. Both have long been seen as early experiments in opening up China’s financial markets while improving the expertise of domestic participants.

In this context the Ministry of Finance bond was particularly important, since quite apart from soaking up available deposits in Hong Kong, it demonstrated the conviction in government towards this process of gradual openness. “It’s very significant,” says Fung. “It provides a sovereign bond curve, provides a wider range of investment tenors, and provides a pricing reference for future issuance. It also arguably provides a foundation for building an offshore interest rate swap market, or even a cross-currency swap market, as and when regulations permit.”

But she cautions against going too far. “People tend to mix up this market with the liberalization of the currency, saying it’s going to appreciate faster or means we have a faster timetable for capital account convertibility. I don’t think that’s the right way to look at it. It’s more a continuing process of gradual opening up of the financial market, becoming more internationalised, more market driven.”

From an issuer’s perspective, for the foreigners, RMB bonds in Hong Kong are not really about the money. “In terms of our funding needs we are well funded in RMB in China,” says Fung. “When we issued RMB in Hong Kong, it was not because we don’t have the RMB deposits to fulfil our local ratio of assets and liabilities. We issue because we think it very important to broaden the investor base and the types of investment products available in Hong Kong. We want to be the front runner in terms of the development of the RMB market for onshore and offshore.”

There are really only three major RMB deposit banks in Hong Kong: Bank of China (Hong Kong), HSBC and Standard Chartered. Bank of China (at the parent level) and HSBC have both tapped the market already, so all eyes are on Standard Chartered, which instead has more frequently been linked in the trade press with RMB issuance in China itself. Asked about Standard Chartered’s intentions, Sundeep Bandari, regional head of global markets, says: “As an active capital markets participant in Hong Kong, Standard Chartered is very keen to be involved in the development of the market.”

Whatever Stanchart decides, or is permitted to do, the trend appears to be towards a greater range of issuers. “We have seen good progress over the last two years,” says Bandari. “Initially only a few select Chinese banks were allowed to tap the market. Since this year, it has broadened to include the China subsidiaries of Hong Kong-based banks as well as the sovereign.” Bandari notes the China subsidiaries of Hong Kong’s banks, rather than the banks themselves, were permitted to launch RMB bonds in Hong Kong. “This is significant as it signals the Chinese regulators may be willing to consider non-Chinese issuers to tap the RMB market in Hong Kong, and may pave the way for possible future consideration of other foreign issuers.”

Fung’s perspective is also useful as an arranger, since HSBC has held a lead arranger role on nine of the 13 issues to date. “Issuing an RMB bond in many ways is no different to issuing a bond in other emerging currencies, but there’s a lot of work and coordination required in bringing these to market as it’s about transcending between the Hong Kong and mainland Chinese markets,” she says. “Coordination and setting the price discovery processes is critical to ensure it’s not a one off transaction, but benefits investors as well as setting a good benchmark for issuers, and this requires a lot of cross-border work, including with the regulators on both sides.” HSBC wasn’t a lead on the MOF deal, which instead was handled by Bank of China (Hong Kong) and Bank of Communications as bookrunners.

So what next? In launching the Ministry of Finance bond, vice finance minister Li Yong said that investor response to the issue would determine whether the Chinese sovereign issues more RMB sovereign debt in Hong Kong. Judging by the reception, they’ll be back.

Attention at the Copenhagen summit on climate change this month [DECEMBER] will mostly be focused on the US. But in terms of emissions trading the most influential place, and the one most likely to be affected by any change in a global framework for climate change, is Asia, and especially China.

The most important vehicle in carbon trading is the clean development mechanism, or CDM. This is the deal struck under the Kyoto protocol which allows industrialized countries, with commitments to reduce their greenhouse gas emissions, to invest in projects that reduce emissions in the developing world. This is the foundation of carbon trading: approved CDM projects generate credits, which can then be traded. The whole arrangement is overseen by a branch of the United Nations Framework Convention on Climate Change (UNFCCC), and according to that group’s data, the vast majority of eligible projects so far have come from Asia: 1398 out of 1890 registered projects, the bulk of them in China.

It’s been clear from the outset that this has been an imperfect process that needs streamlining, as Lex de Jonge, chair of the CDM Executive Board at the UNFCCC, readily admits to Euromoney: “The entire CDM development has been a massive learning-by-doing process, to be frank about it, and we are still not there yet.” So any changes that come out of Copenhagen will be closely watched in markets like China and India that have to date been the greatest beneficiaries of westerners hoping to offset their own pollution.

For de Jonge, the biggest challenge he faces is capacity. Already the UNFCCC doesn’t have as many staff as it needs: they are frequently poached by the private sector once trained. Getting a project from the drawing board to approval is a laborious process, and indeed has to be, in order to preserve the environmental sanctity of the whole market. He is confident with his agency handling 500 projects a year. But if a new climate deal in Copenhagen commits to bigger emission reductions and so creates a much greater demand for carbon credits and the requirement moves to 2,000 projects a year or so, “it’s too much.” Expecting this, there are moves towards shifting CDM approvals to a sectoral approach in certain countries big enough to organise themselves: power sector projects in China and India, for example. If those projects could then be evaluated in bulk, the UNFCCC is free to devote more time and attention to one-off projects in smaller states. This is something else that could get started in Copenhagen, and again it has a big impact in Asia: a sectoral approach ought, logically, to increase still further the dominance of China in particular as a source of tradable carbon credits, as it will be able to get still more projects through the approval process.

Another group watching closely is the Asian Development Bank, which to date is one of only a handful of institutions to have launched carbon trading funds that deal in credits post-2012, which is the date upon which the Kyoto protocol expires. The ADB, which already launched a more mainstream US$150 million carbon credit fund in 2007, noticed that uncertainty about the future of carbon credits was stopping development, so launched the new fund with a flexible clause allowing it to take into account future changes in the CDM, “as a price signal,” says Toru Kobu, senior clean energy and climate change specialist at the Asian Development Bank. “It’s basically an assumption by the investors, as well as ADB as a trustee, that the parties negotiating would not change any rules to have a retroactive effect,” he says. After Copenhagen, we may find out if they were right.

Alongside this, emissions trading exchanges are approaching readiness in Asia, from Singapore and Australia to two separate Chinese ventures, in Beijing in Tianjin. “It’s only natural,” says Harry Derwent, president of the International Emissions Trading Association in Geneva, “that when you have a major production line you start seeing points where people can buy or sell closer to the point of origin.”

Derwent is unapologetic about his industrial language: “This is essentially a production process, I don’t think anybody should be frightened of that perspective.” And his line of thinking is bound to strike a pragmatic chord in China, which having long enjoyed the benefit of foreigners paying to build up its renewable energy resources may yet go a step further and corner the consequent trading revenues too.

Spectator Business, December 2009

Andrew Ross Sorkin’s Too Big To Fail, the behind-the-scenes account of Wall Street’s brush with oblivion, contains an interesting detail that tells us a lot about the power of Chinese money. In that lurching week in September 2008 after Lehman collapsed, Morgan Stanley – by now looking perilously close to the edge – invited Gao Xiqing, the president of the China Investment Corporation sovereign wealth fund, to New York to talk about increasing the 9.9% stake it already held in the American bank to as much as 49%. In those uncertain days, it looked like a deal that could save the whole bank.

Gao, lying flat on his back on a couch in a Morgan Stanley conference room to ease his bad back, offered the ultimate lowball offer for the increased stake: up to $5 billion and a credit line. Even in those dark days the American firm was considered to be worth $40 billion, and it was a sufficiently hardcore negotiating stance to shock even the archetypal Wall Street ballbuster, Morgan Stanley chief John Mack. Sorkin says Mack was “stunned”, and anyone who’s ever met the man knows that takes some doing.

It didn’t come to that in the end – the Japanese came to Morgan Stanley’s rescue instead and Gao took CIC’s money home again. But the incident speaks volumes about how China’s newly minted sovereign fund, established only in September 2007, has grown up and, after initial mistakes, is nobody’s fool now.

The subtext to that stand-off with Mack is one of CIC’s first ever investments: a $5.6 billion stake in Morgan Stanley on December 19 2007 which, by the time of that apocalyptic week nine months later, had halved in value. CIC had been similarly bruised by another investment, a $3 billion stake in private equity group Blackstone. CIC was far from being the only sovereign wealth fund to be battered by taking stakes in western banks – others included Singapore’s Temasek and GIC, and funds in Kuwait, Qatar and Korea – but many of those had wisely insisted on provisions that enabled them to reset their purchase prices if the firm subsequently raised equity at a lower level. CIC, new to these investments at the time, had not done so with Morgan Stanley; Gao’s tough offer to Mack was an attempt to implement such a reset after the fact.

Consequently, one banker who deals closely with CIC says that today, if he comes to them with a deal, “The very first question I get asked is ‘will it have downside protection?’”

“With Blackstone and Morgan Stanley they didn’t, but they now consider a comfortable level of protection to be a key component of any new deal,” says the banker. “They didn’t have the sophistication back then and got taken for a ride. That’s never going to happen again.”

CIC was not irredeemably put off American banks – indeed, in June this year it bought another $1.1 billion of Morgan Stanley stock, and after the rally of the last six months, is in the money on its investments in the US bank. But there’s no question CIC has changed its stance since, in terms of the type of assets it buys, the locations in which it buys them and the approach it takes to buying them.

Almost every recent deal CIC has taken on has been in the energy and resources area, and the bulk of them have come in frontier markets. An example came in October when CIC bought $500 million of convertible debentures from South Gobi Energy Resources, a Mongolian coal mining and exploration company listed on Toronto’s TSX Venture Exchange. The debentures can convert into SouthGobi common stock if the company goes ahead with an expected Hong Kong listing.

The same week came a potential $700 million investment in another Mongolian mining group, Iron Mining International, this time through a convertible loan. Then there’s the $300 million, 45% stake in Nobel Oil Group in Russia. Or the 11% of Kazakh energy company JSC KazMunai Gas Exploration Production’s global depositary receipts, bought for $939 million in June. CIC has put $1.9 billion into the Indonesian mining group PT Bumi Resources, and $858 million into the Singapore-listed agriculture and energy supply chain leader Noble. In the developed world, CIC paid $1.512 billion for a stake in Canada’s Teck Resources, and most recently paid $1.58 billion for 15% of Virginia-based power company AES, plus $571 million for a 35% stake in AES’s wind development business.

Somewhat surprisingly, CIC publishes an annual report – its first one ever came out in August – and from this, we know that by global standards it has done pretty well so far. In 2008 it made a 2.1% loss in its global portfolio (relatively speaking, a standout among sovereign funds) and if we include CIC’s Central Huijin subsidiary, which invests in domestic banks on behalf of the state to improve governance, the overall group generated a return on registered capital of 6.8%. But in truth CIC hasn’t really demonstrated investment nouse yet: it put only $4.8 billion into overseas assets in 2008 and by far the biggest driver of returns was that by the end of the year 87.4% of the global portfolio was in cash.

CIC declined to answer Business Spectator’s detailed written questions, but its chairman, Lou Jiwei, occasionally speaks out at conferences to give the world a sense of where the fund might go next. In October, for example, he told a Beijing audience that CIC had invested about half its $110 billion in available funds for offshore investment, mainly in publicly traded assets. He went on to call returns “not bad” and warned of a bubble in global asset prices, saying that the fund’s focus on investments in commodities and real estate – it is a major investor in the UK’s Songbird Estates, for example – is partly as a hedge against inflation and currency depreciation.

The point about the currency is key. CIC’s existence stems from a sense that China’s vast foreign exchange reserves ­– $2.273 billion as of September, according to China’s State Administration of Foreign Exchange – could be earning better returns, and it was given a $200 billion chunk to form the foundation of its registered capital at launch in 2007. China’s state agencies, CIC among them, are concerned about falls in the value of the US dollar, with a knock-on effect on the real value of China’s reserves and the exchange rate.

But investing in energy is not just about currency hedging. Various arms of the Chinese state, from its behemoth listed oil groups (Petrochina, Sinopec and CNOOC), to unlisted state entities (such as Petrochina’s parent, China National Petroleum Corporation) have been buying up companies and oil fields from Sudan to Kurdistan Iraq in a bid to improve China’s energy security. Expect to see CIC buy into African energy assets before long.

This brings up a favourite subject among CIC-watchers: the degree to which it represents the state in its investment decisions. Lou knows it: he said in October, “the outside world is very suspicious of us, saying we have a national agenda. But our strategy is just one of long-term risk-adjusted returns. It is to make money.” Others say that, of all sovereign funds, CIC fits most closely with broader national objectives in reflecting the interests of the sovereign. “It’s a part of the jigsaw,” says a senior banker who deals closely with them.

While this is hardly surprising, and entirely within China’s rights, it does create a political sensitivity when CIC invests. It’s a big issue, for example, for a Chinese state agency to go into Mongolia, where local people are adamant that they won’t see their natural resources swallowed up by Chinese or Russian interests. It’s perhaps because of this sensitivity that CIC had to get its South Gobi exposure by buying into a business listed in Toronto, and even then with a business structure that gives it a maximum 22% stake if the company went ahead with a Hong Kong listing.

Nevertheless, emerging markets represent fewer complications for a state Chinese entity to buy into than developed nations, where attitudes towards CNOOC’s tilt at Unocal and Chinalco’s at Rio Tinto demonstrate clearly the unease western politicians feel at Chinese ownership of their mines and oil rigs. With no need to explain the rationale of their decisions (or their ethics) to a democratic public, CIC’s future investments will take it to some unloved parts of the world – and a long way from Wall Street.

To see the article in its printed form, click here: http://www.chriswrightmedia.com/spectator-dec09the-spectator-cic-changes-tack/cic-spectator-pdf/

One of the quirks of the Chinese banking industry is that, while the biggest banks in the world are now Chinese, they have achieved this apparent world dominance without really leaving home. The world’s three largest banks by market capitalisation are Industrial & Commercial Bank of China (ICBC), China Construction Bank and Bank of China – all of which are chiefly domestic enterprises. Even ICBC, among the most internationally intrepid of Chinese banks, generated less than 2% of operating income from outside China in its most recent full financial year.

But, with cash behind them, Chinese banks have the opportunity to expand and become more global players if they want to. And, in a limited sense, there are signs of international expansion.

ICBC is the bank that has made the most eye-catching acquisitions. In September it bought a 19.62% stake in ACL Bank, a Thai institution, from Bangkok Bank, and will make a tender offer for the remaining shares. This follows the 2008 purchase of 20% of the shares in Standard Bank of South Africa, making it the largest single shareholder.

These transactions tell us a lot about the way further acquisitions are likely to take place. Most obviously, they both involve institutions in emerging markets rather than the developed world. It makes a lot of sense for a bank like ICBC to seek a foothold in Africa, because many of China’s bigger companies – and in particular its energy giants Petrochina (and its unlisted parent CNPC), Sinopec and CNOOC – are expanding rapidly in the continent a bid to secure energy reserves. By the end of March 2009, the two banks had carried out 65 collaborative programs and completed nine, among them a co-lead financing for China Oilfield Services to purchase Awilco. Another example: the two banks were appointed by the government of Botswana to arrange a syndicated loan and take charge of export buyers’ credit for a coal power plant in which China Electrical Equipment Corporation is the general contractor for the power generation segment.

A deal like this makes a lot of sense to analysts. “It has multiple purposes,” says Victor Wang, an analyst at UBS. “One, it is in line with large banks’ intentions to gain expertise in more business areas. China will open up more and will need more sophisticated financial products to support economic growth. It makes sense for them to learn through an acquired organization. Secondly, it is virtually impossible for them to outgrow their peers in the domestic market, so they can leverage their healthy balance sheet and expand selectively overseas.”

The appeal of Thailand is less obvious, but reflects a likely strategy to engage in Asian markets rather than the west. “ICBC has always attached great importance to the Thai market,” said Dr Jiang Jiangqing, ICBC chairman, in a statement announcing the purchase on September 29. “This transaction will be of great significance to ICBC in the expansion of its business and network in the Mekong River region and also the South East Asia region. ICBC will endeavour to contribute to the development of the Thailand economy and bilateral trade between China and Thailand.”

Hong Kong is also a natural draw, although strictly speaking it is now a special administrative region of China rather than a separate state. In June 2008 China Merchants Bank bought a 53.12% stake in Hong Kong’s Wing Lung Bank for HK$19.3 billon, as part of what CMB chairman Xiao Qin described as “our international expansion strategy”, which “allows CMB to enter a strategically critical and highly sophisticated market”. CMB was founded in Shenzhen, the city on Hong Kong’s border.

Contrast this with the experience of Chinese financial services groups trying to buy assets in the west. In October 2007 Citic Securities announced it would acquire 9.9% of Bear Stearns under a joint venture, the first time any Chinese-controlled entity would take a major stake in a Wall Street investment bank. The deal eventually fell apart in 2008, and it’s just as well: Bear Stearns collapsed later that year. Ping An, the insurance group that hopes to become a major playing in banking and asset management as well, was less lucky, proceeding with a landmark purchase of a stake in the Belgian banking and insurance group Fortis; the write-downs on that purchase almost wiped out a year’s profit.

Consequently it’s easy to see why China prefers the allure of emerging markets: better potential returns, greater familiarity, and apparently less chance of the entire institution being brought down by risky behaviour. “With hindsight, not getting into Bear Stearns was a good thing,” says Nick Lord, analyst at Macquarie Research. “What that tells you, and what Chinese banks learned from that, is that you don’t necessarily buy things because they are cheap, you buy things because there is a strategic reason to buy them. There will be much more of a degree of caution: I don’t know that any Chinese banks have appetite for a big deal at the moment.”

There may, though, be an exception: as this article was being written it was widely believed that China Minsheng Bank, the country’s first privately owned bank, was seeking to raise its stake in UCBH Holdings, a San Francisco bank, from 9.6% to 50% or more and was approaching the regulators for approval. UCBH, while not exactly a distressed asset, needs to bolster its capital base and has already been a recipient of $298 million of Troubled Asset Relief Program (TARP) funding. Minsheng, considered something of a visionary first mover in Chinese banking, is already UCBH’s biggest shareholder and has approval to increase its stake to 20% already. Wan Qingyuan is Minsheng’s appointee on the UCBH board.

Alongside these occasional acquisitions have come some organic growth into other markets. Big Chinese banks typically have offices all over the world: for example, China Construction Bank opened a subsidiary bank in London and a branch in New York in June, bringing its total worldwide to seven branches, two subsidiary banks and one investment bank.

If Hong Kong is considered an overseas market, then the clearest example of organic expansion is Bank of China, which broke off its Hong Kong branch into a separate entity, Bank of China Hong Kong, in 1998; this vehicle is listed in Hong Kong quite separately from the Bank of China parent. A full service commercial bank, it offers retail and corporate services, notably deposits, personal loans, wealth management and mortgage lending; it has over 200 branches in Hong Kong, over 450 ATMs, and is a designated clearing bank for personal transactions in renminbi. It also has a Hong Kong subsidiary, Nanyang Commercial Bank.

Outside of Hong Kong, though, opening a few branches doesn’t make a Chinese bank a full service player. “If you look at the very tight regulatory environment in China, banks have a lot of limitations in terms of the products they can offer their clients,” says Wang. “If you look at international banks most of them are one stop shops providing commercial banking, retail and wholesale services, products like derivatives and rates, brokerage, and asset management. In China the preliminary business is still lending. They are trying to do some wealth management, but they don’t get the full licence to provide insurance or brokerage. As a result, their expertise in operating in very sophisticated financial markets is still very limited.”

Consequently, branches in New York or London are chiefly for corporate wholesale business. Many Chinese companies are Fortune 500-ranked these days, and Chinese banks can help them with their overseas operations. None of the Chinese banks yet have a sufficient network overseas to attract personal banking services in those markets, for example.

Lord at Macquarie says that “syndicated lending is the obvious thing you’ll see them do” as they expand overseas. This is already clear in Hong Kong where Chinese banks participate aggressively. “You’ll also see them build up trade finance capabilities, really focusing on Chinese firms’ outward and inward investment, and over time you’ll see them develop forex capabilities” although in the short term this is obviously impeded by the fact that the RMB is not fully convertible. In time, they may develop derivative structures for clients, and eventually will become more active in advisory, although the focus will be very much on things like Hong Kong listings of Chinese companies. “It’s going to be a long time before you see Chinese banks advising on non-Chinese related deals.”

The Guangdong property developer Country Garden has a long track record of bold issuance. Its April 2007 IPO raised US$1.9 billion, the defining transaction of a clutch of lucrative Hong Kong listings of mainland developers at that time; it went up 35% on the first day of trading and reportedly turned five founding shareholders into billionaires. Strategic shareholders at the IPO included Temasek, Malaysia’s Robert Kuok, Citic Pacific, New World Development chairman Cheng Yu Tung and Henderson Land Development chairman Lee Shau Kee.

Then there was a similarly ambitious, but wholly less successful, attempt to launch a US$1 billion bond in October 2007, a deal whose failure also caused the axing of three other dollar bonds due to price that week.

And this year it was back again, with a US$300 million 144A/Regulation S five-year bond – subsequently increased to US$375 million – that can stake a strong claim to represent the reopening of Asia’s high yield bond markets.

The latest deal priced on September 2 with JP Morgan as sole lead. Paying a mighty 11.75% coupon, it drew considerable attention and received a book of $800 million of orders, on the back of nothing more than a two-day non-deal roadshow in Hong Kong and Singapore earlier in the year.

While Country Garden drew some criticism for the pulling of its 2007 bond, head of investor relations Johnson Murr argues that the familiarity of the credit from that time helped it this time around. “Because we had planned to issue a high yield bond back in October 2007, the fixed investors had seen us before, and we had been keeping them up to date,” he says; a convertible bond from February 2008 also increased familiarity with the credit. “We’re not strangers to them and they’re not strangers to us.” On top of that, property markets in China have entered a period of a very positive outlook, with pre-sales climbing rapidly. Country Garden is, Murr says, the second highest-rated Chinese developer listed in Hong Kong after China Overseas Land and could boast a strong capital position, including a net debt ratio of only 35%, which he says helped with the deal’s reception.

That low debt level, and the fact that the group had a cash position of RMB9.43 billion (albeit RMB4.58 billion of it carried as restricted in the accounts) as of June 30, begs the question: why borrow at all? The reason has to do with the rules about use of funds for Chinese developers. Onshore money in China can only be used for building projects, not purchasing land. To buy land, you have to use internal recognised profits or offshore funding. That’s what the raising was for. Again, the need was not immediately clear since Country Garden had 43 million gross floor area square metres of land bank at the time of the deal, but the company decided it was a good time and environment to replenish.

Just two days after pricing, Standard & Poor’s downgraded the company from BB+ to BB, based on the additional debt load and weakened financial performance over the last year. And the 11.75% cost obviously raised some eyebrows, but Murr seeks to put it in context. “Some investors think it is on the high side, but we look at it this way. Before the issuing of the straight bond, most of the money was onshore except the CB at an overall 9% interest rate. So the weighted average cost of funding before issuing the bond was about 6.3%. After issuing the bond it was up to 7.4, 7.5%. So in terms of the funding cost for the group, it’s only about 1 percentage digit up.” On top of that, he says the average cost of land at the moment is RMB317 per square metre, so adding the 11.75% debt cost on top of that would add about a further RMB40 per square metre. Historically, net profit per square metre has been at least RMB600 per square metre. “So the cost in terms of using debt to buy land is relatively low compared to the value it will bring.”

Did Country Garden reopen Asia’s high yield markets? One can make a case for Matahari Finance and PLN, both launched in August, although PLN is sovereign-backed and the Matahari deal was partly an exchange facility of an existing bond. In any event, the Country Garden issue, with its oversubscription, provided indisputable evidence that the markets are open again for the right credit.