In the offices of Hong Kong’s banks and fund managers, a transformation that will shape the world economy is in its early stages. This is the slow but steady process of turning the Chinese renminbi (RMB) from a heavily restricted currency to one that is open and internationally traded. The endgame, many believe, is an international reserve currency to rival the US dollar – and is perhaps not far away.

China today is at a halfway house between restriction and openness: a middle ground in which the current account is open and the capital account closed. It’s a situation that has created some quirks – one currency behaving in a wildly different way depending on whether it’s onshore or offshore – and a host of opportunities besides. The big topic of discussion in Hong Kong, and elsewhere in Asia, is where it goes from here.

To see this article as it ran, click here: Half open door

[Subhead] Slowly opening the door

For most of China’s modern history, the RMB has been a purely domestic currency, tightly controlled by the central bank, the People’s Bank of China (PBOC). When Chinese companies conducted business with foreigners, the trade would be denominated in US dollars and pass through the PBOC.

The first hint of a change of heart came in 2003, when personal banking services in RMB were permitted for Hong Kong residents – a largely symbolic gesture that went no further than deposit accounts and a handful of credit cards. The next came in 2007, when a handful of mainland Chinese financial institutions, starting with the China Development Bank, were allowed to issue RMB bonds in Hong Kong; the next year a handful of foreign banks incorporated in China, such as HSBC, were allowed to do the same. And in July 2009 China tried out a pilot trade settlement scheme, allowing five coastal cities to settle their trade with Hong Kong, Macau and southeast Asian countries in RMB.

But the big steps came in 2010. First, the Hong Kong Monetary Authority – Hong Kong’s central bank – said that any institution permitted to issue a bond in Hong Kong (that is, more or less anybody) would also be permitted to do so in RMB; shortly afterwards, limits on Hong Kong-based companies converting RMB, or launching investment products in the Chinese currency, were removed. At a stroke, this created a whole new capital market: the so-called dim sum bond market.  In the three years up to June 2010, when only policy institutions and the big banks could issue, a total of RMB34.3 billion in bonds were launched; 12 months later, gross issuance had quadrupled to RMB138 billion (outstandings were RMB175 billion as of early September). “Over the next three to five years, the total size of the market might reach RMB1 trillion, which would be close to 50% of the whole Hong Kong dollar debt market,” says Linan Liu, Greater China rates strategist at Deutsche Bank.

On the trade settlement side, the original five-city pilot scheme has been steadily extended – first to 20 cities, then wider again, and finally in August 2011 to the entire country. So any transaction between a Chinese and an international partner can now be settled, outside China, in RMB.

The latest round of liberalization came when China’s Vice Premier Li Keqiang came to Hong Kong on August 17 this year. It was a pivotal moment: what he said would give a clear indication about whether China was comfortable with or alarmed by the pace of internationalization of its currency, and where it would go next. The vote came down firmly in the positive. “Not only is Beijing still comfortable with the rapid pace of offshore RMB market development, but it is taking the process to the next stage,” says Donna Kwok, economist at HSBC. Among other things, he said that Hong Kong enterprises would be allowed to invest RMB back into China through foreign direct investment. This is crucial, because until now, while it has become increasingly straightforward for money to leave China, it’s been rather difficult for it to find any way to go back in again and serve any useful purpose.

So that’s where we stand today. But what don’t we have? The main thing that’s missing is convertibility in the capital account, which is one of the reasons that so far most of the flow across borders in RMB has been in one direction, outwards from China. And this arrangement is having some peculiar effects.

[Subhead: The strange case of the RMB]

Onshore and offshore RMB are referred to in a shorthand in the Asian financial industry: CNY for onshore, CNH for offshore. And ever since people started to distinguish between the two, they’ve been behaving in radically different ways. Offshore, interest rates on RMB-denominated assets are low, and have been falling, because there is far greater demand for ways to invest the currency than can currently be met. Onshore, interest rates have instead been rising. Traders have spotted an arbitrage, but it’s already making some bankers uneasy. “CNH doesn’t exist except in our heads,” says an Asia country head of a major western bank. “We are all for helping China in what I think it means to do, which is to make the RMB an international currency of trade and settlement. But the arbitrage… I’m saying to our wealth management people, be very careful, because if all this unwinds, you’ve got nowhere to turn.”

The sense of a strangely artificial environment also exists in foreign exchange. There are now three separate FX markets for exactly the same dollar-RMB trade: the onshore market; a non-deliverable forward market, which is how foreigners used to trade the currency before this process of liberalization; and now CNH, or offshore RMB. And there are pricing discrepancies between them, which again traders are seeking to exploit – probably not what China had initially intended.

But the biggest impact of this halfway open door has been an intense supply-demand imbalance which has had a major impact on the way the offshore RMB bond market has developed. At its heart is the pace with which RMB deposits have accrued in Hong Kong: from just RMB90 billion in June 2010, they had risen to RMB572.2 billion by July 2011, according to the HKMA. Before a recent slowing, they had been growing consistently at 10% per month.

These deposits need somewhere to go: they earn almost no interest sitting in the bank, so the holders of this cash are anxious to find a return. And this is the dynamic that underpinned the growth of the offshore RMB bond market: the dim sums.

[Subhead]The dim sum boom

In the early days after the July 2010 liberalization, the issuers were natural borrowers: Hopewell Highway Infrastructure, McDonald’s (which needs RMB for mainland expansion), China Resources Power. But as the sheer level of demand and pricing power became clear – the Ministry of Finance paid just 1% for a three-year bond in November 2010, in a deal that was still 10 times oversubscribed by institutions – more and more companies decided they should issue too. By the end of the year, issuers had included Galaxy Entertainment Group – an un-rated Macau casino developer – and the Russian bank VTB. While there’s nothing necessarily wrong with either of these names, they were able to raise money at dramatically lower yields then they would have had to pay in the dollar markets. At the same time, low-rated Chinese issuers (or generally their Hong Kong subsidiaries), particularly property developers, began to jump in. The market had gone from top-ranked government-backed banks to high yield issuers within a matter of months.

It didn’t take long for this to become alarming. Lawyers who have dealt with Chinese high yield issuers in the dollar markets are familiar with many dangers in buying their debt; in particular, investors often find they have absolutely no security over assets in China. “Exactly the same issues in relation to taking of security arise whether the bond is denominated in RMB or not,” says Joseph Tse, partner at Allen & Overy in Hong Kong. “But with RMB bond issuance there is an extra layer of regulatory issues separate from the security issues,” particularly around repatriation of proceeds. Yet investors, so keen to get a decent return on their money, didn’t seem to be seeking any covenants from issuers. “The market seems to have accepted that it can get comfortable with no security from these companies, particularly those which are listed,” Tse says. Another lawyer is more blunt: “Some of the deals coming out of China earlier this year were restructurings waiting to happen.”

Why the clamour? Investors aren’t just after the yield on the bond: they also believe strongly that the RMB is going to continue to appreciate against the dollar, and they factor that expectation – commonly 3-5% or so per year – into any decision about buying a bond. But the supply-demand imbalance is not really healthy for anyone. “Growth of 400% in the past 12 months [in offshore RMB deposits] is pretty spectacular, and that created the demand side of the supply-demand imbalance which is how the market developed,” says Eric Greenberg, managing director, financing group and head of leveraged finance in Asia ex-Japan at Goldman Sachs. “Out of the gate, because offshore RMB was receiving such low interest rates from the banks, it made RMB offshore bonds that much more attractive for investors. That meant an inefficient market, with longer tenor, loose covenants, and at rates below which one could borrow in onshore RMB.”

This is one reason that the August announcement around allowing RMB back into China as foreign direct investment is so important: by finding a way to recycle the Chinese currency back onto the mainland, it may relieve some of this supply-demand pressure. Already, bankers feel that some balance is returning to the market. “In the last few months the market inefficiencies have started to narrow as there has been some pushback from investors and the forward curve for RMB appreciation has come down,” says Greenberg. While retail and private banking clients have focused on enhancing their deposit yields, Greenberg notes a stronger price and covenant discipline among institutional buyers now. On top of that, one of Vice Premier Li’s other announcements in August was that all Chinese companies will now be able to launch offshore bonds, which should help to increase the available pool of issuers, creating more competition, higher yields, and a better deal for investors. “The demand and supply situation is beginning to correct itself,” says Rita Chan, an executive director at Goldman Sachs. “That is reflected in more scrutiny around whether the bonds are rated by international agencies, how liquid the bonds are, and whether the issuer is listed. We’re moving towards a true Regulation S standard rather than – as it was in the first half of this year – everything can sell.”

Another shift that might help to redress the balance is if investors’ views on the currency change. Expectation of a climb in the RMB is near universal, but as the world economy has deteriorated – hitting Chinese exports – expectations of the pace of that climb have become more conservative. “Earlier this year, people were expecting 2 to 3% appreciation per year for the next five years,” says Chan. “That was one reason they were so enthusiastic about investing. But over the past few months the forward curve has shifted around.” Greenberg adds: “Currency movements have helped to evaporate some of the market inefficiency.”

From an investor perspective, the allure of RMB assets remains very clear, and any change in supply-demand imbalances is in their interests. ““For investors in CNH, just like elsewhere, you need to form an opinion about the strength and quality of the investment,” says Li Cui, chief China economist at RBS. “In particular a lot of bondholders are attracted by the longer-term strength of the currency. What’s attractive about the RMB is China’s economic and trade size, the potential growth, much healthier balance sheet, and importantly macro stability, which bolsters confidence in the currency.”

And investment in these bonds is no longer just restricted to Hong Kong retail investors and institutions with a backlog of the currency to put to work. Across Asia, the private banking community is finding ways to get positioned.

“Given what is happening in Europe and the US, I think that is ultimately going to force the Chinese to speed up the internationalization of the RMB,” says Dr Lee Boon Keng, head of the investment solutions group in Singapore for Swiss private bank Julius Baer. He expects continuing RMB appreciation, more and more foreign institutions issuing offshore RMB debt, and a much faster liberalization of the capital account than many expect: “maybe a couple of years, instead of a couple of decades. It makes the Chinese growth story that much more compelling.” He considers the loosening of the Chinese currency “a megatrend.”

In positioning his clients for it, he has worked with Asian bank DBS to launch a fund that invests in offshore RMB bonds, and is also encouraging investors to look at the Chinese stock market. “I’m telling clients that the equity market is at valuations last seen in 2005. This is a great opportunity. Why are you waiting for that minus 10 or 15% potential drop before you dip yourself into the water? We may have bottomed out already.”Julius Baer has QFII quota from China – a system by which foreign institutions are permitted to invest a set amount in the mainland Chinese market – and is using it to launch a fund investing in both A-shares (Chinese domestic securities in RMB) and H-shares (Chinese companies listed in Hong Kong and traded in Hong Kong dollars).

Another opportunity that will evolve for investors is RMB-denominated IPOs in Hong Kong. There has only been one so far, a real estate investment trust (REIT) issue for Hui Xian REIT, a subsidiary of Hong Kong conglomerate Cheung Kong Holdings, in April; it didn’t go especially well. But in due course this will likely evolve into another major market. Elsewhere, mutual funds built around RMB assets are beginning to spring up, while in the other direction, Chinese clients will soon be allowed to invest in exchange-traded funds (ETFs) in Hong Kong.

[Subhead] The future

So where is this all heading? There are still some who don’t believe that China is looking for full convertibility. “Allowing Hong Kong to develop RMB offshore product doesn’t necessarily mean China wants to open the capital account,” says Christopher Wood, strategist at Hong Kong-based brokerage CLSA and author of the influential Greed & Fear Report. He describes the growth of the market as “more from the political desire to give Hong Kong a new toy.” He won’t be convinced full liberalization is coming until banks are able to lend RMB offshore, and in any case doubts that full openness would be in China’s interests anyway. “The PBOC will lose control of the whole system if they open the capital account.”

He is, though, in something of a minority. “I strongly believe full convertibility is the goal of internationalization,” says Liu at Deutsche. “Post financial crisis there is a growing recognition that growth should be less dependent on the US dollar in trade, the pricing of commodities and reserve management.” She thinks that there are “five to 10 years of structural reforms needed in the domestic market” before China will be ready for full openness, to address issues around the onshore banking sector, but that at the right time “I would definitely look to the RMB to become a global reserve currency. Not to challenge the dollar or euro, but to be one of four major currencies in the global FX system [the other being the yen], with the RMB hopefully one of the main currencies for emerging countries.”

Some feel that this ambition – a reserve currency, strongly reducing China’s exposure to a declining dollar in which it already holds more than $3 trillion in reserves – is why China is willing to tolerate the oddities and arbitrages that inevitably come with the process of gradual opening.

Others think that far-fetched. Cui at RBS says the RMB as a reserve currency is “still quite some time away,” and not really the point of liberalization. “In the near term, the main aim is to boost its role as a vehicle currency for trade and investment.”

She says a lot needs to be done in the domestic financial system before full convertibility will appear sensible to China, and others agree with her. “For the RMB to be fully convertible, we have to make sure China’s financial market is ready,” says John Sun, executive director, fixed income, at Citic Securities International. “All the banks must become fully market-driven businesses, as with convertibility the financial system will be opened to foreign markets directly. At this moment, the financial market in China is not robust enough to do that. It’s not going to happen in the next three or four years.

“And if the RMB cannot be fully convertible, then it cannot become a reserve currency for a relatively long period of time. I don’t see the possibility in five years or even longer.”

Still, the wild card in all of this is how the deterioration of the US economy and currency is seen in China, and whether it may force the country’s hand to move faster than it had at first intended. “I still have confidence in the US economy: it is still two and a half times larger than China’s,” says Sun. “Having said that, there is a global problem with US dollar depreciation, because of the trouble it causes in commodity prices and export inflation from the US to other countries. No currency, including the RMB, can replace the US dollar, but a lot of countries are going to try to find a better way to make their financial markets more stabilised.” And that could be a catalyst to faster change, and a new world currency.

ENDS

It is a queasy sort of a day when Asiamoney meets Zeti Akhtar Aziz, Governor of Bank Negara Malaysia, at Washington DC’s Four Seasons Hotel in September, and not just because of the jetlag and the changeable weather. We meet during a period of miserable uncertainty in world markets: the eurozone in crisis, the US staring at a double-dip recession, and markets looking hopefully to the IMF/World Bank annual meeting to provide some direction, which they utterly fail to do.

For Zeti, the mood is not as bad as it is for some others: Malaysia is basically doing fine, and while it will clearly slow as a result of global problems, it would be a surprise if its growth rates dipped below 4% at any point in the next 12 months. But what’s striking about this meeting is that the normally reticent and softly-spoken Zeti has some unusually strong opinions about problems in the west – and how to fix them.

That’s because, having worked through the Asian financial crisis – she was rising through the Bank Negara ranks at the time and became governor in its aftermath, in May 2000 – she believes there are clear lessons about the process of recovery that the west has not yet shown much sign of taking on board.

“While we need to deal with the financial sector and bring about regulatory reform, it has to be accompanied by pro-growth policies,” Zeti says. “That is what we did in the Asian crisis. We had to do the financial and debt restructuring, but for a chance for those policies to be successful we needed to have growth.” She’s quite specific about what she means – which also stands out, in a week dominated by broad and grand statements and an absolute minimum of practical detail: she  highlights policies to support SMEs, households, access to finance, credit enhancements, infrastructure development and private sector incentives. “We had a V shaped recovery,” she says. “Many parts of the developed world, and the IMF, said we would have a lost decade. We didn’t.”

The west, she says, just hasn’t been doing what it needs to. “Only now are we seeing some of these measures being implemented in the US,” she says. “They needed to have been implemented three years ago.” She also calls for policy that is “more anticipatory rather than reactive. When we were managing the crisis in Asia we looked at what was the worst yet to come and what did we need to do to deal with it, rather than just implementing policies to prevent a collapse and thinking that was it.”

Malaysia is not a member of the innumerable groupings and federations in world finance – the G7, the G20, the G24 – instead making its presence felt more in Asean and in Islamic finance initiatives around the world. Lacking a voice on the world stage, it is perhaps not surprising that she is not a fan of the IMF, nor of representation of emerging economies within it. “The IMF has to become neutral,” she says. “This neutrality and credibility would be enhanced if there was greater representation of emerging markets in the role of the IMF and in its governance process. Crises don’t just happen in emerging markets; this is something the IMF didn’t highlight to the world until quite late.” She says while the IMF has sought to increase that representation, it has done so “in a very incremental manner.”

She goes further and doubts the leadership the IMF has shown; Asiamoney’s interview takes place directly before the formal start of the meetings, but it’s unlikely her opinion was changed by any of the statements of the following days. “The IMF doesn’t seem to have a significant role in this,” she says. “We have looked for the IMF to have a greater role in recognizing what the issues are in their surveillance, and we look for it to provide solutions to many of these problems. Their solutions have not been forthcoming.”

So how does all this affect Malaysia and Asean? “In emerging markets we are doing better [than in the west] but we are going to see moderation in our growth as well, because we are very much part of the global economy and most of us are highly open. But we are still going to see growth, and are still on a growth path.”

Across Asia, central bank governors are having to deal with shifting priorities. For much of the last year, most of them have had to fight off inflation, and have correspondingly been rising interest rates through the year. There are markets where inflation remains a challenge – Vietnam, India, China – but across most of Southeast Asia it’s all but stopped being an issue.

Take the Bank of Thailand, which has raised rates on seven separate occasions since December, reaching 3.5%. “I think we were on the right direction so far, but if you ask the question from now on, we do think the slowdown in the world economy will mollify somewhat the inflation pressure,” says Prasarn Traitvorakul, Governor. “The job is to take a proper balance, but the balance lately has tilted towards the risk of growth becoming more apparent than inflation pressure.” When the bank next meets to discuss rates, on October 19, it would now be a major surprise to see another hike.

In places like Thailand, where domestic consumption is strong and the outlook good, the global problems have arguably been helpful. “We hope that some slowdown in the world economy will lower the pressure from the supply side,” says Prasarn. (A wild card, though, is a new government policy offering to buy local rice at heavily subsidized rates; HSBC has warned that, with Thailand being the world’s biggest rice producer, this could put inflation back on the agenda in rice-importing countries.) Like many Asian nations, Thailand has sought to boost intra-regional trade’s proportion of the overall national trade balance sheet, reducing reliance on the west, and this should prove helpful. “The feeling is not too pessimistic or optimistic,” he says. “There are threats from what’s happening in the euro zone and the US, but there are also encouraging factors like regional integration in trade and financial flows.”

Zeti, in Malaysia, has been viewing the world with similar interest. From late 2010 Bank Negara raised rates four times in seven months, from 2% to 3%, and then stopped in July, “given the increased uncertainties and the significantly heightened risks to growth,” says Zeti. From her perspective, in a country with palm oil and rubber at the heart of the national economy, commodities were the most important thing to watch. “As commodity prices stabilized, which was a major factor from the supply side producing higher inflation, demand has slowed globally,” she says. “This will limit inflation, so most central banks have paused their increases in interest rates.” Official estimates of full-year growth in Malaysia are 5-6%, but it dropped to just 4% year on year in the second quarter of 2011.

Zeti says that for central bank governors in Asia, “the biggest challenge is to have price stability in an environment of sustainable growth. You have rising prices, and at the same time you also have risks to growth, and those risks have become higher because of what is happening around the world.”

One area Asia cannot escape is capital flows. In recent years foreign money has flooded into Asia, particularly Asian bonds, in search of yield backed by strong fiscal stories. But as always, when markets get really bad, capital instead is withdrawn from these supposedly riskier asset classes, despite the fact that the risks appear far bigger in the developed world. In some cases, this isn’t a judgment on risk at all, but a need to liquidate capital in order to pay down other exposures.

Indonesia is the market that has most to lose in this respect; by the end of August foreign ownership of rupiah-denominated government bonds stood at over 35%. That money has been chasing the Indonesia story: a transformed fiscal position over the course of the last decade, a growth model predicated on commodities and domestic consumption, and an apparently successful and stable democracy. But for some time, investors both local and foreign have worried: what if it all leaves again?

Rahmat Waluyanto, in the debt management office of the Ministry of Finance, says that a modest reversal has started to happen. In the space of a week in September, foreign ownership dropped from 35.4% to 33.6%. But he is at pains to point out that foreign ownership in the government bond market is still heavily net positive, at around US$5.5 billion year to date. The withdrawal, he says, “has nothing to do with domestic economic fundamentals but FX movements due to jitters caused by the worsening euro debt crisis.” Not all fixed income is fully hedged in terms of FX exposure, hence the withdrawal, he says, although in fact non-deliverable forwards on the rupiah have been moving up, not down. “There’s no reversal yet; the real money accounts still stay,” Waluyanto says. “Indonesia has the capacity to withstand,” he adds, citing relatively large foreign exchange reserves (which crossed US$100 billion for the first time earlier this year), a widening domestic investor base (including retail investors, pension funds and insurers), and a bond stabilization framework.

Indonesia has mentioned this framework before, but it’s not always been clear what’s involved. Waluyanto says there are four strategies to negate a negative impact of a sudden reversal: the debt management office will use funds from the annual budget to buy back government securities; state-owned companies will buy in; so will be Treasury Unit and Government Investment Unit of the finance ministry; and if necessary, parliament can approve the use of accumulated cash surpluses to buy government securities.

Zeti, too, notes a change in the threat of capital flows. “We are seeing very significant surges in capital outflows and reversals,” she says. “Previously it destabilized us quite significantly. But in the current environment we are seeing these flows are better intermediated by emerging economies.” In 2009, she says, Malaysia’s reserves declined by $25 to $30 billion, with a major depreciation in the currency. “But we could take it in our stride.” She says that, in contrast to the Asian financial crisis, Malaysia has more resilient financial institutions, more developed financial markets, higher reserve levels, a more flexible exchange rate, and more instruments to sterilize inflows than before. Today, around 20% of Malaysian government bonds are foreign-held.

Whatever else happens, southeast Asia is surely the only part of the world where you can still find people barracking for sovereign upgrades at a time when the rest of the world is falling apart. In the Philippines and Indonesia, expectations are high of improved ratings from international rating agencies. Both countries can provide long lists of improvements, from budget deficits to domestic market depth and government responsibility. With Turkey having been upgraded in early September, its Asean peers are not about to stop waving the flag now. Indonesia, Waluyanto points out, has credit default swaps trading considerably tighter than Turkey’s; proof, he says, that if the story is bright there, then it’s brighter still in Indonesia. “So Indonesia should now be in the investment grade category,” he says. It’s good that somewhere in an uncertain world, there are people looking up and not down.

One of the characteristics of this year’s market volatility has been a decline in the value of three of the four major world currencies – dollar, euros and sterling – and a precipitous rise in the fourth (the yen) and Asia’s local currencies. This creates challenges for Asia-based treasurers around hedging, risk management and even reporting.

Use of hedging has shifted since the financial crisis. “If you cast your mind back to 2007, clients were engaging in some hedging activity, but not on a systematic basis,” says Shankar Hari, regional head of FX, Asia ex-Japan, at JP Morgan. “That has changed completely. Hedging is now looked upon as a very important part of a client’s activity in terms of managing the volatility of their P&L and reporting their numbers.” Products have evolved too, from structured and complex to more vanilla and transparent forms. “But the most important thing is the way people hedge,” Shankar says. “With the enormous appreciation of Asian currencies, people have become more conscious of their exposure to an appreciating local currency versus the dollar or euro, and have taken conscious steps to hedge that.”

This is a widespread view. “Clients generally want to monitor their hedging positions and books, and we are now seeing a lot more interest in active management of their hedging,” says Mahesh Kini, regional head of cash management for corporates, Asia Pacific, at Deutsche Bank.

Methods and processes around currency management do vary from place to place, though. “Most treasurers at larger corporates will have a fairly well defined policy with regard to foreign exchange,” says Ray Zabarte, global head of payments at Standard Chartered. “For the most part, the guidelines will cover things like: what’s the base currency, and how much risk are they prepared to take outside of that base currency?” That makes today’s volatility challenging. “If their base currency is undergoing massive change, a corporate treasurer would need to think about how they reframe their policies or make recommendations to their management team about how they accommodate fluctuations. At one extreme they can convert everything back to their base currency as soon as they can, to avoid any currency risk.” That means analyzing their inflows, any natural hedges, and establishing processes for swift conversion. “Alternatively they may take a view on which currencies are moving which way, and whether that is favourable or not for their organization.”

That’s quite a big call: treasurers are, after all, in a position to benefit from Asian currency appreciation, but is it their job to do so? In one respect, companies need every free kick they can get at such a difficult time. “Corporate treasurers are clearly being squeezed for earnings like never before,” says Richard Brown, Asia Pacific regional head at BNY Mellon. “So bring able to conduct business efficiently across an ever-growing list of currencies is a priority.”

And particular for companies that borrow, there is no shortage of opportunity to take advantage of local currency strength over dollars. “We are seeing significant needs for dollar financing given the interest arbitrage many clients would have,” says Sridhar Kanthadai, managing director and Asia Pacific head of treasury and trade solutions at Citi. “They borrow in dollars because it’s cheaper and because if you have a view on a depreciating currency it is better to borrow in that, as you have a natural gain if you are covered in other currencies.” The combination of its dominance as a trade currency, cheapness, and likely further deterioration stacks up well for the Asian treasurer.

But as Kanthadai says: “Most prudent companies will hedge that, because their job is not to make money on the funds that are underlying the goods and services they provide.” A middle ground is to leave part of the exposure unhedged.

One added complexity arises when a company adds a new currency to the mix – not just the offshore RMB (see box) but newer market such as Vietnam. “If clients are doing hedging based on a fair estimate of their imports or exports in a particular currency it is not too much of a challenge,” says Hari. “But the problems start when they have a hedging policy with a mix of hedging and some open exposures, so they have some portion that is unhedged in various currencies. At that point, they have to start thinking about correlations.” (Introducing CNH – offshore RMB – is still more complex because it has no history of volatility to work with.) And in practice, this approach of partial hedging is by far the most common. “Hedging fully has never happened,” says Hari. “If you think of any Asian company with a good growth story, they always end up underhedging as their final revenue numbers exceed the estimates.”

More frontier currencies represent challenges to treasurers, and banks have been quick to try to fill the gap. “In these currencies that don’t see a lot of volume, we can offer fixed margin products despite the ebbs and flows of the currency, so we can provide them with certainty,” says Zabarte. “It provides transparency that has not been seen in this market before now, and gives the treasurer – and the market – confidence they can enforce their policy. In currencies outside the top 20, margins can be very wide: where the G3 currencies might be a few pips, further down the list you can see 20s, 30s, even 100s in the margin.”

The decline of the dollar has a particular impact for companies who do their reporting in that currency. The reversal in its fortunes has been so intense that it is causing some companies to think about changing their accounting currency, bankers say. “The majority of multinational clients will be reporting their financial results in dollars, euro or sterling,” says Zabarte. “They may well need to reconsider whether or not they should continue to be reporting in that currency. This period of turmoil and volatility could have a substantial impact on their financial performance as it is reported.”

But even if they do, while the dollar has been beaten down, it remains crucially important to world trade. “There is a continuing need and demand for the dollar,” says Kanthadai at Citi. “As a trading currency it has not been dethroned by any other currencies yet. A lot of the commerce is still dollar-based.”

That means that no matter how irksome the decline for companies, there’s not a great deal they can do about it. “For clients who predominantly trade in US dollars outside of the eurozone, it is more difficult to switch to another transaction currency as they have limited alternatives,” notes Shivkumar Seerapu at Deutsche Bank. “If they’re buying from or selling to Europe they can switch to euros, but for any other part of the world – Middle East, Africa, Latin America – the primary currency remains US dollars. Purely from a currency play point of view it might make sense for them to invoice in yen or Swiss francs, but it’s not so easy for them to do so in practice. There are implications for bank accounts, for example, and they also have to convince the overseas buyer or supplier to switch. What’s good for an exporter may not be good for an importer.”

While the movements in currencies do present some challenges, they’re only really part of the broader change in the way treasurers are having to be ever more vigilant around risk. “A lot of corporates over the last 12 to 36 months have been going through a transformation in how they approach risk and cash management,” says Mark Burrough, regional head of treasury services foreign exchange product management at JP Morgan. “While we have seen a shift in the way treasurers operate, we’re not seeing anything new or groundbreaking with the recent emergence of Asian currency strength. They still have the same challenges in incorporating any new currencies into existing operations: how to risk manage those currencies.”Risk, as ever, is key.

BOX: RMB

The Chinese currency is clearly the big story in Asian cash, trade and FX right now, particularly since August when the People’s Bank of China allowed all corporates in the country to conduct payment and receipt in RMB. Naturally, volumes are increasing, although a lot is still done in dollars. “There are two things happening in parallel,” says Burrough at JP Morgan. “A relaxation of rules around settlement, with more companies able to access RMB; and a customer preference moving towards RMB. There is definitely an increasing number of transactions.”

All the cash banks note increasing appetite for RMB services. “Transacting in offshore RMB is becoming increasingly popular for trade with counterparties in mainland China,” says Seerapu at Deutsche. “It is no longer something that will happen in the future; it’s happening as we speak and increasing by the day.” Client interest is focused in Hong Kong and Singapore, he says, with the beginnings of interest from Thailand and Korea. “We notice the bulk of demand is from foreign exporters selling into China wanting to invoice in RMB; we haven’t seen as much demand in the other direction, that is, Chinese exporters invoicing in RMB for overseas sales.”

There is some suspicion about what exactly has driven the growth; cash banks tend to be nervous of any activity that has grown out of trading bets rather than real underlying trade. “You’ve clearly seen a staggering growth in RMB trade between China and Hong Kong,” says Kanthadai at Citi, but he says it has been leveling off. “My understanding is that a lot of the underlying growth is commerce, but the reason it’s denominated in RMB is because of the arbitrage trade they can do around it. If you have a strong view on the RMB, you would probably love to take positions in it.” He says many companies are settling inter-company between their various entities in RMB, and then accessing dollar liquidity offshore using that RMB as collateral. “If you have a strong view the RMB is going to appreciate, it’s a good trade,” Kanthadai says. But because of that arbitrage approach, “I don’t think the staggering growth we have seen is really a pointer of what we should expect to happen in future.”

While arbitrage trades clearly have an impact, Zabarte at Standard Chartered says “we are definitely seeing underlying trade. The types of transactions that are taking place are quite obviously real trade, real business, real flows.”

The RMB involves several practical challenges, particularly since in its offshore form (CNH) it has no history. “There is the information management perspective, but also operational readiness,” says Burrough. “For example, CNH isn’t an official currency. It’s not recognized by SWIFT: you have to use CNY. So distinguishing flows between Hong Kong and China has become an operational issue for clients.”

There’s also nothing like the same potential for hedging offshore RMB as there is for most other big trading currencies. “Offshore RMB for trade settlement is clearly going to become more commonplace,” says Brown at BNY Mellon. “But there is still some way to go before we have the same hedging capabilities as the other major currencies, and that will continue to be a drag on adoption.”

Consequently the feeling at the cash management banks is still that greater use of RMB for clients is going to be a reasonably slow process. “Corporate relationships – buyer-seller, importer-exporter – will gradually be educated on the whys and wherefores of trading in RMB,” says Zabarte. “Clearly that trend is going to find an equilibrium but I don’t think we’re at that equilibrium today. Whether sales contracts are re-denominated in RMB this year or next or five years from now is going to be down to the party involved.”

India’s finance minister, Pranab Mukherjee, has warned there is a danger of currency wars as emerging market countries seek to avoid the pressures that come with their climbing currencies.

“If the crisis deepens further and there is greater volatility in financial flows, there is an increased risk of this happening,” he said.

“Our view is, if such tensions arise, they should be eased through dialogue, not through competitive devaluations.”

Mr Mukherjee argued that the rising level of emerging market currencies ought to be reflected in the mechanisms used to build special drawing rights, the international reserve assets created by the IMF.

“In the BRIC countries, as their contribution to world output and economy is increasing substantially, therefore the currencies used in these countries should have to be widely appreciated.” That, he said, “should have been taking into account while determining the ingredients of the SDRs.” He added, though, that India was not calling for that today because other factors, such as free convertibility of currencies, need to be taken into consideration. “But the importance of these currencies has increased.”

Reserve Bank of India governor Duvvuri Subbarao said that India was able to absorb the high levels of capital flows it has been receiving, and had no immediate intention of imposing controls upon them. “At the moment we have a current account deficit and are able to absorb the flows that are coming in,” he said. “We are quite unlike other emerging economies which are having a problem of excess capital lows.” He said the RBI would continue to use a range of “quantity and price instruments” to manage capital flows, “so that they bring foreign savings necessary for our development.” He said that using taxation to manage capital flows was “clearly not off the table,” but added: “the question of foreign controls is clearly outside any policy consideration at the moment.”

One of India’s most central challenges today is inflation, which logged a 9.8% (headline) and 7.6% (core) year-on-year increase in August, above consensus expectations. “The high inflationary environment is clearly not going away anytime soon, with underlying inflation pressures firmly in place,” said Leif Eskesen, chief economist for India at HSBC. “Moreover, there are further upside risks to the inflation outlook.”

The Reserve Bank of India has acted aggressively to combat inflation, raising interest rates 12 times and 500 basis points in (WILL CHECK), slowing growth as a consequence, without managing to bring about a decline in the headline inflation rate. But World Bank chief economist for South Asia, Kalpana Kocchar, said that momentum inflation is starting to come down. “The RBI has done a good job trying to put a lid on demand pressure,” she said. “A lot of these pressures are coming from a big increase in rural demand as a result of the push for inclusive growth,” such as a national rural guarantee scheme. “On one hand that’s a good story, putting more money in the hands of the poor, but it’s straining the resources of the economy and that’s causing inflation.”

She said India faces pressure as the only South Asian nation to be fully globally integrated, both on trade and finance, and noted that India’s main stock market index has fallen as much as or further than most developed countries, and more than emerging market composites. She noted “some home-grown problems with regulatory uncertainty and some policy paralysis in India,” and highlighted the need for investment.

Southeast Asian nations are braced for volatile capital flows caused by problems in developed world economies, but insist they are now strong enough to deal with them.

“We are seeing very significant surges in capital outflows and reversals,” said Dr Zeti Akhtar Aziz, Governor of Bank Negara Malaysia. “Previously it destabilized us quite significantly. But in the current environment we are seeing these flows are better intermediated by emerging economies.”

In Indonesia, Rahmat Waluyanto, in the debt management office of the Ministry of Finance, said foreign ownership of bonds had fallen from 35.4% to 33.6% in the space of the last week, but said net inflows into the government bond market stood at $5.5 billion year to date. “There is no reversal yet: the real money accounts still stay,” he said. “We have the capacity to withstand flows.”

In 2009, deleveraging by international investors led to the withdrawal of large sums from Asian markets, particularly Korea and Malaysia. “Our currency depreciated to levels we haven’t seen for a long time, and our reserves declined by 25 to 30 billion dollars,” Zeti said. “But we could take it in our stride.” Around 20% of Malaysian government bonds are foreign-held. Emerging markets generally have been heavy recipients of foreign capital since the 2008 global financial crisis, but Asian nations worry about the impact of sudden reversals during times of macroeconomic stress.

Both policymakers said their countries had specific reasons for being more resilient to capital flight. Zeti in Malaysia cited more resilient financial institutions, more developed financial markets, higher reserve levels and a more flexible exchange rate. “The central bank also has a wider number of instruments to absorb them and to sterilize some inflows so they don’t lead to the formation of asset bubbles,” she said.

Waluyanto said Indonesia was protected by its large foreign exchange reserves (which passed US$100 billion for the first time earlier this year), a widening domestic investor base, including retail investors and the growth of pension funds and insurance, and a measure called the bond stabilization framework. He said this involves strategies to anticipate negative impacts of sudden reversals, including buybacks of government securities by his office, the coordinated purchase of government securities by state-owned corporations, and using cash surpluses with the approval of parliament to buy into the market.

However Zeti said Malaysia is still not ready for full currency liberalization. Although foreign exchange in Malaysia is much liberalized since the Asian financial crisis, with no restrictions on inflows or outflows by residents and non-residents, the ringgit has not been internationalized in a way that would allow access to the currency in offshore markets. “At this stage, our assessment is that the internationalization of the ringgit should not be hastened,” she said. “The benefits must outweigh the costs. In an environment of highly volatile global financial markets, opening the ringgit offshore market could increase the risk of significant disruptions in our domestic financial markets.”

She set out the pre-conditions to internationalizing the currency: a stronger domestic foreign exchange market, with enough market players and products to promote two-way flows; capacity among domestic companies and investors to manage foreign exchange exposures; and better risk management and corporate governance practices.

Zeti said inflation had largely ceased to be a pressing issue for Asian central banks. “As commodity prices stabilized, which was a major factor from the supply side producing higher inflation, demand has slowed globally. This will limit inflation, so most central banks have paused their increases in interest rates.” Bank Negara hiked rates in four steps from 2% to 3% from late 2010, “to normalize interest rates and adjust the degree of monetary accommodation,” but ceased in July “given the increased uncertainties and the significantly heightened risks to growth.”

Zeti said she expected emerging markets to continue to grow, but at a slower rate due to the global economy. “In emerging markets we are doing better [than the west] but we are going to see moderation in our growth.” Malaysia’s economic growth was just 4% year on year in the second quarter of 2011, though Zeti has said she expects full year growth of at least 5%.

For central bank governors in Asia, “the biggest challenge is to have price stability in an environment of sustainable growth. You have rising prices, and at the same time you also have risks to growth, and those risks have become higher because of what is happening around the world.”

When the Swiss National Bank set a ceiling on the Swiss franc-euro exchange rate earlier this month, there were two key questions. One, does that mean the end of the Swiss franc as a safe haven currency? And two, if it does, then what takes its place?

On the first question, some big names are already calling a reversal in the Swiss franc’s fortunes beyond the 9% decline it experienced on the day of the SNB’s intervention; Goldman Sachs Asset Management chairman Jim O’Neill, for example, has said the Swiss franc may well fall back to parity with the US dollar before the end of the year, and drop well below its new cap against the euro.

But in Asia, it’s the second question is particularly interesting. Clearly the yen, somewhat bafflingly given Japan’s economic challenges, has already served something of that haven role, but Japan’s central bank has already taken efforts to alleviate the strength of its currency and is likely to do more. Instead, the currency that has received the most attention in this region is the Singapore dollar (one of O’Neill’s favourite alternative safe haven currencies). And this is of particular interest to the private banking community.

Lee Boon Keng is an example of a Singapore-based private banker who believes there are good times ahead for the Sing dollar. Look out for the private banking report in our October edition for more on his theme, but in summary he believes the Singapore dollar will become the new safe haven currency due to similarities in the two economies, and factors that give international investors comfort such as Singapore’s rule of law and its familiarity as a world financial centre, with good governance. He considers a strong Singapore dollar “one of the things that is least uncertain” in an otherwise endlessly uncertain world. Singapore is, after all, a AAA-rated economy, which can no longer be said of the USA.

Not everyone sees it that way. UBS’s chief investment strategist in the wealth management team in Singapore, Kelvin Tay, says the government bond market is too small and illiquid for Singapore to have meaningful safe haven status – plus, he thinks the inflows would be problematic for the Monetary Authority of Singapore, which manages monetary policy through the exchange rate, and could well be resisted. Even before the Swiss franc’s cap, there were murmurings of unrest at the MAS, which had already allowed the Sing dollar to rise 6.5% against the US dollar in the year up to August; it never comments on interventions but was believed to have stepped in to currency markets that month to prevent the US dollar falling below US$1.20 (it’s at US1.23 today).

Others say the correlation between the Singapore dollar and investor sentiment makes it riskier than safe haven investors would like – a claim that is also made about other safe haven candidates, the Norwegian krone and Swedish krona. But there’s little doubt that, whether investors call it a safe haven or a leveraged bet or a play on the relative strength of emerging markets, the Singapore dollar is going to receive more inflows; and even if the MAS intervenes to stop the currency soaring, it doesn’t look at all likely to deteriorate. In a difficult market environment, that’s enough for many investors. The next question: what to do with your Sing dollars once you have them. Don’t be surprised to see strong-yielding, stable REITs start to attract more interest.

Cesar Purisima is in full flow. The Philippines finance secretary is sitting in a cavernous Hanoi conference centre at the Asian Development Bank annual meeting and is talking up his country’s prospects in the light of a unified southeast Asia. “We are really bullish looking to the future of an integrated Asean,” he says, as images of idyllic Boracay beaches and the rolling chocolate hills of Bohol drift past on a TV monitor behind him, a pitch to attract more intra-Asian tourism to the Philippines. “Asean is an economy of 600 million people, a very favourable demographic, and the Philippines is very well positioned to actively participate in that.”

Purisima is doing something that more and more people in this region tend to do: speak of Asean as a single economic bloc. It’s a compelling case. A combined Asean economy would, UBS says, be the sixth largest economy in the world.

There’s just one problem with this unified vision: it hasn’t happened. It’s not even close to happening.

The Association of Southeast Asian Nations brings together 10 nation states embracing a greater variety of wealth, society and political process than could be found almost anywhere else in the world. Free-market, first-world Singapore has about as much in common with isolationist Myanmar (Burma) as the USA does with Bolivia. Oil-rich Muslim prefecture Brunei and impoverished, communist Laos might have some passing relationship in terms of geography and flora, but certainly not in economy, language, politics, religion or culture. Indonesia’s economy is 118 times bigger than that of Laos, and its population almost 600 times greater than Brunei’s. The 10 member states occupy a span of 141 rungs on the World Bank per capita GDP ranking, a greater range than the entire African continent.

“We are some distance away from Asean being an economic bloc,” says Taimur Baig, a chief economist at Deutsche Bank. “They are not homogenous economies, and not even comparable in many regards. Some are resource economies, like Malaysia and Indonesia; some are based more on electronics trade, like the Philippines or Thailand; even in terms of political systems, they are very different.”

Still, the fact that it’s not there yet doesn’t mean that progress cannot be made: as recently as 20 years ago, the idea that Portugal and Estonia might one day share the same currency would have been preposterous. “Asean is clearly not a single bloc now,” says Edward Teather, economist at UBS in Singapore. “There are barriers between countries in movement of capital, movement of labour, movement of ideas. But it’s precisely because you can move towards breaking those barriers down that opportunities are created.”

SUBHEAD: TRADE AND 2015

Asean came into being in 1967 in Bangkok, amid the Vietnam war, with a mandate to accelerate economic growth, social progress, cultural development and stability through the region with collaboration and mutual assistance. While it has expanded over time, its five original member states of Indonesia, Malaysia, the Philippines, Singapore and Thailand remain its core today. It has never really been a political or economic powerhouse, and didn’t even have legal form in its own right until 2008, but has nevertheless had a few milestones along the way, chiefly the signing of a free trade agreement in 1992, the Chiang Mai initiative of bilateral swap agreements in March 2000, and the formal introduction of broader FTAs (both intra-region and between Asean and China) from January 2010.

Asean’s biggest moment – and the closest thing to the unified Asean that some envisage – is due to happen in 2015, when the Asean Economic Community is created. This would involve free movement of goods, services, investment and skilled labour, and in theory a freer flow of capital – although this, discussed below, may be the trickiest part of all.

Economists quite like the idea: Teather at UBS argues that progress towards a single market should enhance growth prospects across the region, and will also spur infrastructure development and more cross-border M&A. It’s particularly appealing at a time when so much of the rest of the world is a mess (although Asean in aggregate would actually be very heavily exposed to the world economy, with one of the world’s highest export to GDP ratios). “What’s envisaged is a pretty big deal,” Teather says. “It would allow a spread of ideas across the region. That matters because there is such a divergence between Cambodia and Laos, for example, and Singapore: if you can bring capital skills ideas into those poorer countries, you could potentially make a huge difference to how those millions of people see their incomes grow in future.”

But right now, it’s interesting to note that, as Teather puts it, “Asean in aggregate has strong links with the rest of the world but less so with itself.” Only 25% of total Asean economy trade is with other Asean economies, he says, far lower than internal free trade within the European Union or NAFTA.

Anecdotally, people think this is changing – and in particular the need for trade to go in and out of Singapore, as it always used to, is declining. Purisima, for example, says the Philippine electronics industry has already been bolstered by integration. “Moving products from Manila to Penang to Singapore is like moving it from Chicago to the Silicon Valley,” he says. “It’s all efficient now. That’s going to be the strength of Asean integration.” Some analysts see improvements in regional activity too. “There is a lot of political chatter but the important point is businesses are moving together with to without agreements on free trade integration,” says Tai Hui at Standard Chartered.

But there’s clearly a long way to go. “There will be considerable transitional requirements” between now and 2015, says Baig. “It’s not just a question of unified visa-free travel or a removal of trade barriers. There will need to be far more advanced arrangements as far as customs, trade agreements and labour movement are concerned.”

There are also some questions about commitment. For example, the Asean Investment Fund is being established right now, probably with initial capital of US$500-800 million. Compare this with the US$80 billion the European Commission put to work to enhance growth and employment within the EU, or the US$596 billion the ADB has calculated is needed in capital for a better Asean transportation network between 2006 and 2015, according to UBS. Partly reflects the fact that the investment that brings Asean together, if it comes, will be from local money, not from some major supranational: Asean is only really there for coordination and doesn’t have a great deal of institutional heft (as anyone who has tried to get its Jakarta-based secretariat to respond to a phone call or email might attest).

The infrastructure side of it has a lot of foreigners interested. Various plans flourish and fade from time to time: a pan-Asean highway network; a Singapore-Vietnam-Kunming rail link, or another from Kunming to Laos and Bangkok; an Asean power grid, or a Trans-Asean gas pipeline. 2015 harmonisation might make it easier for projects like these to get underway, with all the knock-on effects that infrastructure development provides. This is a crucial point: progress in infrastructure development, and in particular private sector involvement, is seen as the weakest link in national circumstances from Indonesia to the Philippines and beyond.

SUBHEAD: THE CAPITAL QUESTION

The roadmap for 2015 includes a commitment to freer flow of capital: greater harmonization of financial security rules, mutual recognition of market professionals, a broader investor base with managed withholding tax issues, and market-driven efforts to establish exchange and debt market linkages.

And this flow of capital is perhaps the single most important point. Because if Asean doesn’t meaningfully exist as a trading bloc, it most certainly doesn’t exist as a single pool of liquidity. Southeast Asian nations have some of the highest savings rates anywhere in the world, but if those savings are ever invested cross-border, they don’t go into Asean neighbours; they fly into dollar assets. “There is a lot of work to do, especially at the regional level, to make sure the region’s savings are increasingly intermediated through the local markets, not the global markets,” says Sabyasachi Mitra, a senior economist with the Asian Development Bank’s Office of Regional Economic Integration.

It should be said first that since the Asian financial crisis – when Alan Greenspan said Asia didn’t have a spare tyre, in reference to the lack of local bonds – the region’s local currency debt markets have improved out of sight in terms of their scale, maturity and sophistication. Currency mismatches that blighted Asia in the late 1990s have been significantly alleviated by the availability of local funding in the same currency as an issuer’s liabilities; in the Philippines, for example, the state can raise funds at maturities out to 25 years (making infrastructure financing feasible in a way it never was before), while in the middle of the global financial crisis San Miguel Corporation was able to raise Ps38.3 billion (US$800 million) entirely from local markets at a time when G3 markets had shut down.

But the problem is not local market development, but an absolute lack of coordination among them so that they can attract funds from their neighbours. “Capital markets integration is much further away than on the trade front,” says Dato’ Lee Kok Kwan, Deputy CEO at CIMB, the Malaysian bank which is a rare example of an attempt to build a pan-Asean presence in local financial services. “Cross-border in Asean means US dollars. The excess savings in Asean are invested in the lowest yielding assets – US Treasuries – and then reinvested by western funds into high growth economies such as Asean+3. The question is, why can’t Asean + 3 invest in itself and instead require foreign fund managers to do it for us?”

Various initiatives have been started to try to improve things. The ADB has been behind many of them, notably the Asian Bond Market Initiative, launched in 2003 to help local bond markets to grow and develop integration between them. Among other things, this initiative tries to promote more local currency issuance, improves regulatory frameworks, tries to harmonize rules around the region, and looks for ways to boost liquidity. It also hosts the Asian Bond Market Forum, which is designed to bring the private sector into these initiatives, and publishes data sources such as AsianBondsOnline.

Another initiative is the Asean Capital Markets Forum, made up of Asean regulators and formed in 2004. In 2009 this group endorsed something called the Asean Plus Standards Scheme, which aims to set capital market disclosure standards for cross-border offerings of securities. The idea is that if an issuer makes a multi-jurisdiction offering in Asean, they can use common disclosure standards as well as whatever additional requirements each individual market requires (that’s the ‘plus’ bit). The ACMF is also in charge of a roadmap to implement the capital markets elements of Asean’s 2015 economic community blueprint.

Then there are the Asia Bond Funds, launched by the Executives’ Meeting of East Asia-Pacific Central Banks (EMEAP), made up of the central banks of 11 economies including most Asean states. Its first US$1 billion fund, launched in 2003, invested in dollar denominated bonds from Asian sovereigns and quasi-sovereigns; a second, with $2 billion in 2004, created a pan-Asian bond index fund and eight single market funds in Asian local currencies, to allow investors to get diversified exposure to Asian bond markets. There is much discussion in the region about what a third Asian Bond Fund would look like, with a growing belief that it should focus on investing cross-border in primary and secondary local currency bond markets. “ABF2 has done its job very well, but that job – buying local currency bonds – is done and dusted,” says Lee. “The market’s come a long way. The next big jump is into cross-border issuances and cross border investing. That should be its macro objective.”

On top of that, various bilateral deals have been struck; and there is the Chiang Mai initiative, which created a US$120 billion pool of foreign exchange reserves to preserve currency stability and liquidity in the region.

Market regulators in Asean sound keen. “We are very much at the forefront of the integration of Asean capital markets,” says Tan Sri Zarinah Anwar, Chairman of the Securities Commission of Malaysia. “But when we talk about integration, we’re not really talking about one single market, but more in terms of enabling access to each other’s market.” She is involved in harmonising debt rules around cross-border transactions, and is assisting the development of direct access between Singapore, Malaysia, Thailand and the Philippines’ stock markets, for example, “but without bypassing or marginalising domestic intermediaries:  a very important consideration that has to be taken into account when integration takes place.”

The qualifier Zarinah adds is interesting, because it suggests there’s a potential downside to integration: the potential erosion of domestic financial services. She’s not the only one who sees it. “Integration must be carefully designed,” says Nurhaida, chair of Bapepam, the Indonesian market regulator (like many Indonesians she goes by just one name). “The various initiatives being put forward at the Asean level try to improve on the current eco-system,” she says, but in some cases with side-effects: a proposal for a linkage among central depositaries, for example, would “kill domestic custodian institutions.”

SUBHEAD: BECOMING A SAFE HAVEN

Perhaps greater integration, or better credit ratings (see box), would help with a very annoying problem. From any rational perspective of sovereign debt and other fiscal indicators, Asian nations should be seen as safe assets. But whenever the world economy wobbles, capital tends to flee Asia, and go back to the US and Europe – precisely the places that have generally caused those wobbles in the first place.

When does Asia become the safe haven? “To some extent, it has already happened,” says Neeraj Seth, managing director and head of Asian credit at BlackRock. “You see it more in fixed income than equities, which have been more volatile; in bonds the capital flow in Asia has been consistent and positive, and I do believe over the long term it will continue. The only risk is in the short to medium term there could be small patches of reversal.”

But these short term reversals remain considerable, and this is something that keeps finance ministry and central bank officials awake at night in Jakarta, knowing that 35% of rupiah government bonds are now held by foreigners who could in theory disappear at any time. In equities, it’s worse still.

Fund managers think the long term answer to this is the development of significant institutional investors. “I would expect the Asian stock markets to continue to be higher volatility, because they are still the marginal stock markets in global equity portfolios,” says Kerry Series, founder of 8 Investment Partners, an Asia-focused fund manager in Sydney and a great believer in the long-term outperformance of Asian equities. “Asia Pac is only 6% of the MSCI developed world index. When investors change their attitude to risk, it’s going to be marginal stock markets that perform better or worse. And Asia is only now developing the institutional investment structures that underpin long-term investment in markets.”

And perhaps this is the most crucial point of all: when Asian pension funds, insurers and other institutional investors reach meaningful size, as they inevitably one day will, this could potentially be the tipping point that has been missing from Asean. It will lead to stability of markets and capital flows, and to the establishment of sensible long-term investors with the ability to look closer than the dollar markets and instead see opportunity in their near neighbours. “The creation of local pension funds is just at its beginning in some countries, especially in Indonesia and the Philippines,” says Sitohang. “But as they become more established and institutionalized, that counterbalance of local money filling the gap left by foreign capital flight is going to get more and more powerful.”

There are those who feel that for 20 years Southeast Asia has promised a lot and failed to deliver. But the truth is it, and Indonesia in particular, is the world’s bright spot today: low debt, high growth, demographically well placed. “Southeast Asia has already been through the issues plaguing the rest of the world now,” says Teather. Maybe this time, at least, it can steal a march on the rest of the world.

BOX: THE CURRENCY IDEA

If a single currency in Asean looked far-fetched before, it looks positively absurd in light of the stresses afflicting the euro zone today. “I think Asean leaders are watching what’s happening in Europe extremely carefully now,” says Helman Sitohang at Creit Suisse. “It may provide some good lessons about how far you should push cooperation and integration.”

A single currency is not on the agenda. You won’t find it in the long-term visions of Asean mission statements or ADB ambitions. But actually, is it so strange an idea?

Edward Teather at UBS points out that if you were to look at the ratio of the Thai baht to the Malaysian ringgit prior to the Asian financial crisis, and again today, it would be pretty much the same: around 10 times. “There is a linkage there, though it is not explicit in any way,” he says. “Southeast Asian central banks and countries like to make sure their currencies don’t appreciate suddenly and in a fashion that renders their exports uncompetitive.”

Not all cross-rates follow this rule, but they’re generally pretty close. Asean currencies have, pretty much en masse, appreciated against the euro and dollar; they have also behaved in concert against resource currencies like the Australian dollar and the Swiss franc.

“From a de facto exchange rate regime, how big a step is that?” asks Teather. “It’s not such a pie in the sky idea as you might think.”

BOX: RATING AGENCIES

Asean is one of the few regions of the world where the talk is not of downgrades, but of upgrades. Mostly, this is about Indonesia, where all three international rating agencies have Indonesia just one notch below investment grade, with a positive outlook; most analysts expect Indonesia to be upgraded by at least one of them by the end of the year (the smart money’s on Fitch), and probably all three within 12 months or so. The Philippines, too, is on the right track, with Finance Secretary Cesar Purisima on a personal crusade to get a ratings upgrade (the country is BB+ at Fitch, one notch lower elsewhere) in recognition of the undeniably impressive reductions being made to the budget deficit. “As our debt to GDP goes down, it creates more fiscal space for additional investment,” says Purisima. “When you do that, you get into a more virtuous circle. Our hope is that will be rewarded with an upgrade to investment grade: the market is already rewarding us by allowing us to borrow at close to investment grade prices. Our CDS prices are tighter in some cases than our friends in Indonesia.”

But there is another question about sovereign ratings in Asia: have they been getting a raw deal?

One person who is certain they have is Dato’ Lee Kok Kwan, Deputy CEO of CIMB. “There are real problems with international rating agencies,” he says. “They do not reflect credit risk in this region. Leverage is low; savings rates are high; governments are in strong fiscal positions; and you can see both cash spread prices and CDS prices for credits in this part of the world that trade way better than their international ratings.”

His particular complaint is with the sovereign rating system, which then affects the entire Asian corporate world because of the sovereign ceiling. Ratings agencies tend to include measurements such as media freedom, or right to free assembly, within their assessments. “What’s that got to do with the probability of default?” Lee says. “Thailand has $700 million of total foreign currency debt, supported by $160 billion of reserves. Its debt is almost zero and its local currency bonds are so popular it can’t issue enough to satisfy domestic demand. Its savings rates are about 30%.” Yet Thailand, at BBB+ from Standard & Poor’s, Baa1 at Moody’s and BBB at Fitch, is rated considerably below troubled European sovereigns Italy (A+, Aa2, AA-), Spain (AA, Aa2, AA+), and on a par with Ireland (BBB+, Ba1, BBB+).

Some internationals think he may be on to something. “Standard & Poor’s sent their report to the US treasury before it was published?” says Kelvin Tay, strategist at UBS. “In this part of the world there is no pressure on that front: Asian governments have no leverage over ratings agencies. But the flipside is, the transparency on getting numbers, hard data, is a lot more difficult here.”

It will be interesting to watch the development of Dagong, the Beijing-based international credit rating agency; already some Asian states appear to think it a more tuned-in, relatable voice in Asia. In truth the ratings aren’t actually that different:  Dagong has Malaysia at A+, Thailand at BB, the Philippines at B+ and Indonesia at BBB-, in line with international standards (and in the Philippines case, worse). But it is harder on Spain, for example, which it rates A.

One subject that often comes up allows for a greater role for local, home-grown ratings agencies, such as TRIS Rating in Thailand, Rating Agency Malaysia (RAM) and Malaysian Rating Corporation (MARC) in Malaysia, Pefindo in Indonesia and MARC in Malaysia. Generally, there is no mutual recognition of one another’s ratings cross border, which is one of the many impediments to integration of bond markets, whether from an issuer or an investor perspective. “If you are going to expand the market in the region then there’s got to be guidance for investors to look at in terms of the credit standing of different issuers in the region,” says Amando Tetangco, Governor of Bangko Sentral ng Pilipinas, the Philippines central bank.

From time to time people suggest a single credit rating for Asia, but the idea does not seem to have caught on, and in some quarters triggers outright indifference. Nurhaida, the chair of Indonesian capital markets regulator Bapepam, was asked about the regional agency idea by Euromoney in April. It is, she said, “something which I find amusing.”

BOX: Governance: has anything changed?

In July, a Boeing 737 belonging to Thailand’s crown prince touched down at Munich airport. It was to stay there considerably longer than planned. German authorities, upon realising who owned the plane, seized it in connection with a long-standing payment dispute between a failed German construction group, Walter Bau, and the Thai state, which insolvency administrators claim owe it more than Eu30 million – the reason the company went under in 2005.

The dispute dated back 20 years, to the construction of a road between Bangkok and its airport. Thailand never paid and the Thais have long since refused to respond to claims for the money.

The plane has since been released – so somebody’s presumably paid surety – but the incident recalled a pre-Asian crisis, fast-and-loose era of bad governance and questionable creditworthiness, long gone. Or is it? How much has Asian governance really changed?

The accepted barometer of corporate governance standards is the Asian Corporate Governance Association and its CG Watch publication, produced in conjunction with CLSA. “Corporate governance standards have improved over the past decade, but even the best Asian markets remain far from international best practice,” began its 2010 report, bemoaning that regulators make it too easy for companies to get away with box-ticking, markets lack effective rules on governance, and institutional investors generally don’t do enough to push for reform. “Rather than use the global financial crisis as a platform to push reform forward, governments have taken a complacent view, happy that the crisis this time did not start in Asia.”

Jamie Allen, ACGA’s Secretary General and the driver of the report, sees a mixed bag around the region. Singapore, he notes, has moved ahead on a number of issues, including company law amendments, voting methods in shareholder meetings, and appointments of proxies. Thailand has improved from a regulatory perspective, but the change of government – led by the sister of the deposed and convicted Thaksin Shinawatra – raises questions. Malaysia has just unveiled a wide-ranging new corporate governance code, which is clearly positive, and there is progress in Indonesia. “There are lots of difficulties there and I don’t want to overstate the case for Indonesia,” Allen says. “But we did feel that in terms of what companies, the government, Bapepam are doing, their efforts were more thought out and better organised than the Philippines.”

The Philippines dropped to last in the 2010 ranking, which didn’t go down particularly well – chiefly, it is understood, because they couldn’t believe they were worse than Indonesia. “The Philippine government doesn’t support the securities commission; there are real governance issues on the stock exchange, where brokers still dominate the board; we found cases where major companies were breaking listing rules and there didn’t seem to be any enforcement. There’s just the whole level of corruption in the Philippines: it’s bad in Indonesia, but at least they’re trying to do something about it there.” ACGA’s latest report chiefly reflected practice under the previous administration; it remains to be seen if the Aquino government, which built a large chunk of its entire electoral platform on ending corruption, can make a difference.

Note: this was a sponsored report and not editorially independent, but is included here as a resource

SECTION 1 – interview with Alisher Ali, Chairman, Eurasia Capital

EM: Set the scene: what is the opportunity in Mongolia today?

AA: Mongolia has so many things going for it. It is physically located next to China, which has become the de facto engine of growth in the global economy. It has been blessed with natural resources. And you have the government and political system: the country is a true democracy, so as a result there is a good chance of the country being able to manage effectively not only its mineral wealth but the economic growth that will come with the development of those mineral resources.

So we have been early believers in Mongolia. We opened our office in 2008 in the same week as the Lehman disaster, and even though the timing may not have been perfect, we are still proud of the fact that we saw the opportunity for Mongolia’s growth potential and investment opportunities much earlier than many others. We built the infrastructure, we focused on building relationships with government entities, and with the corporate sector and international investors. Now we have the largest investment bank in the country, well positioned to capitalize on opportunities. The mission for Eurasia Capital is to provide a bridge between Mongolia and the international markets: to give international investors access to Mongolia growth, and to facilitate the entrance of Mongolian companies and banks to raise capital internationally.

EM: What shifts have you seen in the business climate since 2008?

I’ve appeared at least 20 times in studios for interviews with Bloomberg, CNBC, Al Jazeera and others to talk about Mongolia. And I always get the question: why haven’t we heard about Mongolia before, with its massive resources? The reason was that for years, the Mongolian government, parliament and public in general have had intense debates about how to develop those resources. It took a long time and was frustrating for foreign investors trying to bring big mining projects into production. The big example was Ivanhoe Mines, which discovered the Oyu Tolgoi deposit a decade ago yet only signed the landmark agreement allowing it to develop it in October 2009. But when we set up here there was no doubt in our mind that the government would decide to develop its strategic projects and large mines. The question was when.

The 2008 crisis hit Mongolia very hard: by the first quarter of 2009 the government was running out of money, foreign exchange reserves were depleted and investors were fleeing. It led to a bailout with support from the IMF and a number of bilateral agreements. But that crisis, in my view, had a silver lining, because it helped the government and public to focus on the key need to develop mineral resources. It became clear they had no luxury to wait and debate further. So we were all relieved when, on October 6 2009, they finally came to agreement with Ivanhoe and Rio Tinto. That was a turning point. It was a big sign: this country is ready for business. It was a crucial milestone and the catalyst for a change in investment sentiment towards Mongolia. The country has never looked back since then.

EM: Where are the opportunities in investment? Everyone knows about the mining, but how about the knock-on effects in the economy?

One of the main reasons for us spotting the opportunity in Mongolia early on was our early experience in Central Asia, especially Kazakhstan. Our time in frontier markets and Eurasian countries allowed me to see the parallels: that once you have momentum, and the development of world class resources, you are going to see knock-on effects. Yes, mining is going to be the largest and most important sector for Mongolia, but there will be other sectors and the opportunity is not going to be confined only to mining.

In January 2010 we produced a report called Mongolia Outlook 2010 – a historical document in the development of our firm. It was positive and optimistic about Mongolia at a time when the turnaround wasn’t obvious, but we said that Mongolia was going to go through a multi-year bull market: that there would be growth in GDP and in FDI. Beyond that macro vision, we made two important calls which were – this is important – executable investment recommendations for international investors. The first was that the Mongolian tugrik was going to appreciate and influence FDI. There is no derivative or spot market, so investors had to initiate bank deposits with Mongolian banks, which at that time were offering 16% in tugrik local currency deposits. Those investors who followed our advice made over 25% return after subtracting all costs, a combination of high deposit rates and the appreciation of the currency.

The second important call was that we recommended investors start investing in local equities. In January 2010, this was considered an optimistic call: the local market collapsed in 2008 and was also negative in 2009 in dollar terms. But we were confident the worst was behind us and estimated the market would gain 70% that year. In fact, it went up almost double that amount. In 2010 the tugrik was the second best performing currency globally, and the stock market was the best in the world.

From the beginning I have trained our research team to think in a way so as to come up with actionable recommendations. We look at opportunities in the currency markets, in fixed income, in public equities – domestic and international – in private equity, infrastructure and property, then tailor recommendations around them. We have built indices allowing investors to track performance of Mongolia-related companies listed in countries around the world.

EM: What funds and businesses have you built to do this?

Eurasia Capital Management is a Central Asian investment and fund management business. Silk Road Management, which started in 2008 as a wealth management advisory firm, is now being transformed into a Mongolia-focused investment management firm. We aim to build the largest such institution in the country. Our first product was the first ever venture capital and private equity fund focused on Mongolia, the Mongolia Human Capital Fund, which raised US$30 million from investors. The idea of this fund is to focus on non-resource sectors where human capital is going to be crucial in the success of the business: areas such as media, healthcare, education, professional services industries and information technology. These are industries in their infancy stage that are going to benefit from strong economic growth.

We have plans to launch funds across different asset classes. We intend to launch a publicly-listed Mongolia-dedicated fund. And we have teamed up with a Korean group, Goran Capital Partners, to launch a Mongolia-Korea resources fund and to tap the interest of Korean institutional investors looking for investments in Mongolia. We tailor investment products around the interests of investors.

Eurasia Capital itself has been recognized by several international publications; this year it was named the best investment bank in Mongolia by Euromoney magazine.

SECTION 2 – interview with Ganhuyang Chuluun Hutagt, Vice Minister of Finance, Mongolia

Euromoney: At a time when the rest of the world is struggling, economic projections for Mongolia are extremely positive. Is the outlook realistic?

Minister: The outlook will be as good as the demand for what we are producing. In recent years what we possess in terms of minerals has attracted a lot of investor interest, based on global demand for these commodities: copper, uranium, gold, coal, iron. There will be demand for our products despite what happens with Chinese inflation, the American budget and debt ceiling, and European defaults.

EM: What is a realistic expectation for GDP growth?

Minister: It will depend on what’s going to happen in the US and how it will affect production in China, and what appetite China will have for Mongolian commodities. I don’t think the Mongolian government can become too arrogant: I advocate we watch out for negative trends, and manage risks. Consecutive crises have shown that they do have an impact on the Mongolian economy.

Despite that, the outlook that is being projected by the international community, our development partners and ourselves is pretty positive. We will have tremendous growth in our economy based on mining and the building of physical infrastructure to make our products more available to international markets: border ports, railways, roads, airports. We are going to need to build new cities in the new mining areas, currently mostly in the Gobi. Most of the business will happen around the mines and in the value chain. We need new power plants, new houses, and even here [Ulaanbaatar] with growing incomes we have a minimum of 200,000 people who will need houses and apartments. You don’t need too much imagination to think of the investments behind these numbers in terms of water, sewage, energy, roads, schools and hospitals. It entails huge business opportunities, but mining can support it only through steady and growing cashflows.

What will be the role of the state in all this investment?

The role of the state is going to not diminish in the near future. At this stage of development the government needs to take a leading role, creating not only the environment and good opportunities for foreign investors, but also intervening in managing the economy, supporting our traditional industries such as agriculture, as we did today [in an issue of bonds to support agricultural producers and SMEs]. We need to help our industries in this tough environment with foreign competitors coming in and cheap imports, aggravated by the impact of the strong tugrik. We will need to continue direct involvement such as the development bank, to build public services. This year we budgeted MNT627 billion for capital investments, and the number will go above 1 trillion this year. Altogether in the past 20 years put together, the capital expenditures were only MNT1.6 trillion; in two years we are doing what was done in 20.

What will be the role of the private sector in this?

The private sector has plenty on its plate already. Almost all of the banking sector is in private hands: out of 70,000 registered companies, only 100 are state-owned, although they include the champions.

How do you rate ease of doing business in Mongolia?

We have fared pretty well. Mongolia is one of the friendlier environments in which to do business. Because we are latecomers we can implement some systems immediately: for example we rank one of the top countries in terms of extractive industries transparency. If you compare us with some Eastern European countries, we are pretty similar; if you compare us to former Soviet Republics, we are way better.

And what still needs to be done?

Last year the government announced the year of Business Environmental Enabling Reform, or BEER. The results of it are yet to be fully reflected, but the government made an important decision to continue with reform here in 2011.

Can you explain the mandate of the new Development Bank? For example will it fund small business as well as long-term infrastructure?

It’s not for small business, it is to support large national projects and to help the government invest in energy, infrastructure and to help us utilize our mines more efficiently. It is specifically stated in the law what sort of projects will be funded, and they will include housing. The bank is operational – it has not yet funded projects, but we have given them the guarantee to issue MNT800 billion of bonds. They are working hard to issue those bonds, get the funding and start financing projects.

Are you considering a sovereign wealth fund?

We have set up a stabilization fund, which by the end of the year will have MNT180 billion. When it hits 5% of GDP we will start investing it actively; in the meantime it’s in cash. I will do my utmost to make sure the government makes the right decisions and does not have incentives to spend it all right now. It is a big responsibility for our future.

What are its sources of funding?

Any income that is in excess of certain fixed prices for coal and copper. We also have the Human Development Fund; we put revenues from the mines in that fund and will start investing this money outside of the country to protect our economy and insulate it from foreign currencies, as well as preserving wealth to share with future generations.

You said Mongolia is dependent on demand for commodities. What is being done to diversify the economy away from such reliance on mining?

Traditionally Mongolia has been an agrarian economy: livestock and anything related to it like meat, pelt, felt, wool and cashmere. They are all industries of high potential. Food security is a big concern for us; Mongolia has become self-sufficient in terms of wheat, which is a success. We could focus on and develop other industries: our increasingly educated workforce will be able to drive industries such as tourism and financial services to become major contributors to the economy.

The financial services industry had a rough time in 2009. How is its health today?

Over 95% of the financial industry is commercial banks. The system is doing well: it is growing, NPLs are decreasing on the back of the economic boom, and the stock market has consistently outperformed most others. But we start from a low base and there is a need for reforms. We need to approve the draft law on securities – hopefully this year – and reform in the pensions system will need to happen. We need to overhaul our insurance sector. And with this we will create local institutional investors who will help us create robust, dynamically growing local stock markets.

The world is watching the forthcoming Erdenes Tavan Tolgoi IPO. How transformative will it be for Mongolian markets?

The current capitalization of the local stock exchange is $2 billion; we are talking about $10 billion in an IPO of one company. That’s the magnitude, and if we decide to float some percentage locally it will have a huge impact. Right now 10% is owned by the Mongolian people and another 10% will be sold to Mongolia-based companies. This will provide a strong incentive for international investors to come in early and take part in the trading of those securities.

What is the idea behind giving shares in it to every Mongolian citizen?

It gives people a feeling that they are benefiting from the big national treasure directly. It’s a good lesson to all Mongolian citizens in terms of managing capital, really understanding what a stock market is and how it works, and what being a shareholder entails. It brings accountability to the person, whereas if the state was to manage the wealth for our own citizens, it is more indirect. Tavan Tolgoi will be a better governed organization because it is owned by individuals, not just the faceless state.

With the US and Europe in turmoil, what is your resilience to external shocks?

I don’t think we have been particularly resilient at any time in history. We depend on our buyers; we have one rail line. Economically we are dependent on two neighbours: we import all of our gas from Russia, we export most of our coal to China.

What message do you want to give to foreign investors about Mongolia?

It makes sense to get exposed to Mongolia. It is the top opportunity globally in terms of our mineral resources. We possess almost all the elements in the periodic table. We are tripling coal exports this year. The ambition with our partnership with the London Stock Exchange is that one day Asian investors can trade on the Mongolian exchange with their stocks listed in London, on the same platform, the same systems.

Cashflows are exploding, the budget is in surplus and we have record high cash levels in our treasury. We will one day make a decision on sovereign bonds: we are issuing local currency and giving a very good return to our investors. Debt to GDP is just 17%, so we can borrow, and I think we want to borrow to make investments and increase the capacity of the economy.

SECTION 3: ECONOMY

Economy

Mongolia has experienced rapid economic growth since the global financial crisis. Eurasia Capital, an Ulaanbaatar-headquartered investment bank, estimates that Mongolia became the world’s second fastest growing economy in 2010 in terms of US$ GDP growth rate at current prices, with a 44% year-on-year increase, driven by the 12.9% appreciation of the Mongolian tugrik (MNT), the national currency, against the dollar over that period. This means that Mongolia outperformed the BRIC emerging economies as well as all other leading frontier and high-growth economies globally. Fueled by investment in the mining sector and a significant increase in exports, real GDP growth reached 6.1% last year, according to official data, versus 2.7% in developed and 7.1% in emerging and developing economies. And it is getting better still: in the first half 2011 it was up 14.3%, or in nominal terms 29.1%. The second quarter, with 17.3% year on year growth, was the fastest expansion since 2005.

Significant investments and demand from China, the major market for Mongolian products, have allowed Mongolia to double coal output to more than 25Mt in 2010, up from 13Mt a year earlier. Coal exports increased 2.9 times in 2010, overtaking copper for the first time, and in 1H2011 Mongolia overtook flood-hit Australia as the largest coal exporter to China. Crude oil production rose 17% to 2.2MMbbl, and iron ore output more than doubled to over 3.2Mt. Major manufacturing industries, such as food and beverages, grew 24% in 2010.

Mongolian foreign trade surpassed its historical high in 2010. Trade turnover surged 53.5% year-on-year to US$6.2bn. 2010 was a record year for exports, reaching US$2.9 billion, with a 53.8% annual expansion driven primarily by Chinese demand (it bought 85% of Mongolia’s exports), commodity price increases and volume expansion. Record level exports have been the primary driver of Mongolia’s impressive economic growth. And they are getting better still: Mineral exports jumped 72% year-on-year in the first half of 2011, with coal up 135% and iron ore exports 122%.

Increases in international prices for Mongolia’s major export commodities boosted already substantial export earnings. The price of coal, the largest 2010 export earner for Mongolia, rose more than 14% over 2010, with copper, gold, iron ore and crude oil gaining 28%, 26%, 52% and 8%, respectively.

Eurasia Capital expects Mongolian foreign trade to grow at an even faster rate in 2011. A positive outlook on commodity prices, increased output from existing operations, the launching of new mines, and strong growth prospects in major trading partner markets – particularly resource-hungry China – should fuel increased exports from Mongolia. Eurasia now believes that Mongolian economic growth should beat its original projection of 10% GDP growth for 2011.

Foreign direct investment (FDI), which was considered frozen until as recently as 2008, hit a record high of US$1.6bn in 2010, according to official data, further underpinning the economy. The mining sector was the major destination for FDI.

China was for many years the only major FDI player into Mongolia, accounting for US$2.5 billion between 1990 and 2010. That is changing. Canadian FDI, the second biggest in Mongolia, increased more than 140 times in 2010 to US$147.8 million. Investment from Hong Kong is also climbing.

By sector, geology and mining have attracted US$3.15bn in FDI – 65.3% of the total – since 1990. The majority of this investment has come since 2008, when the mining industry began to entice resources giants around the world. Hong Kong and Canada’s FDI focus is mainly on mining and related activities, while South Korean and Japanese investments have targeted trade and service, engineering construction, and financial sectors. The biggest investor, China, has followed varied targets covering almost every sector. Infrastructure is likely to attract more FDI in coming years, with 1100km of Mongolian railways planned, for example.

Remarkably, Mongolia is thriving with limited inflation. Prices rose around 13% last year, and there were concerns from the World Bank that an expenditure plan – including major increases in salaries – could push inflation over the 25% mark. Yet according to N Zoljargal, deputy governor of Bank of Mongolia, the central bank, inflation has instead declined to around 6.5% year on year in June. In any case, he says, Mongolia is an exceptional case when it comes to considering inflation. “Mongolia has for so long been under-invested,” he says. “So when you see a flow of new cash wealth, how much of it do you sterilize and how much do you let trickle into the economy? That is the challenge we faced in 2010, we are facing it now and we will probably live like this for the next few decades.” Last year the bank sterilized around 30% of net inflows in foreign exchange, feeling that it was short-term and speculative; this year, it has sterilized far less.  “Yes inflation is a worry, with banks over-extending credit in the good days; people argue the economy is getting too hot,” he says. “I say we are nowhere near to that: we are just warming up. Everybody has their own temperature.”

Indeed, some argue inflation should actually be higher, and monetary policy looser. “Economists say that if there is inflation, just take out money from the economy,” says Sambuu Demberel, Chairman and CEO of the Mongolian National Chamber of Commerce & Industry, and a key economic advisor to Mongolia’s president and prime minister. “It’s nonsense. We need money in circulation: the more money the better. People in real sectors want money to create business and profit, but the majority of SMEs don’t have access to lending. We need decisive action to change our monetary environment to drive the economy.”

Rich mineral resources

Mongolia hosts world-class mining deposits, including estimated coal resources of over 160Bt, ranking fourth in the world after the USA, Russia and China. Erdenes Tavan Tolgoi, one of the world’s largest untapped coking coal mines, is a vivid example of a world class resource: it is estimated to contain 6.4Bt of thermal and coking coal worth approximately US$390bn. The Government of Mongolia is in the process of finalizing the deal with international bidders.

Another world class mine is Oyu Tolgoi, which is one of the world’s largest undeveloped copper-gold deposits, rivaling Escondida and Grasberg. Oyu Tolgoi contains approximately 37Mt of copper and 1,300 tonnes of gold, with a project cost of US$5.9bn. Based on conservative calculations, the monetary value of the Oyu Tolgoi project is approximately US$252bn. It may become as much as US$424bn if measured, indicated and inferred resources are taken into account.

Balanced Political Environment

Mongolia is to hold parliamentary elections in the summer of 2012. The newly elected parliament will oversee the implementation of major mining, infrastructure and industrialization projects, which will define Mongolian politics, economy and society for years to come.

The parliamentary election in 2008 saw a brief period of turmoil, but the formation of a coalition government between the two main political parties, the Mongolia People’s Party (MPP) and the Democratic Party (DP), has resulted in a stable functioning government. Domestically, the coalition government has focused on expanding investments in Mongolia’s vast natural resource wealth, diversifying the economy, job creation and improving living standards. Internationally, the government has maintained good relations with Mongolia’s traditional partners, Russia and China, as well as expanding relations with countries beyond its traditional partners.

In June 2011, Mongolia and China agreed to upgrade bilateral ties to a strategic partnership level and to bolster economic ties. The agreement is expected to bring more Chinese investments and financial support into resource and non-resource sectors and infrastructure development. Mongolia also enjoys strategic partnership status with Russia. In terms of “third neighbor” relations, Mongolia has held high-level meetings with Japan, the USA, Korea and India, among others: it expects to sign an Economic Partnership Agreement, roughly equal to a free trade agreement, with Japan in 2012. During the visit of Mongolian President Tsakhia Elbegdorj to the USA in June 2011, the Obama Administration stated that it was committed to developing a broader, deeper and more strategic relationship with Mongolia, including expanded commercial, political and cultural ties. India is actively pursuing cooperation with Mongolia in nuclear energy and mining.

With upcoming elections, the coalition government is eager to start the Tavan Tolgoi coking coal project in partnership with major international mining players. Large mining deals, infrastructure development and poverty reduction will remain recurring themes of parliamentary elections in 2012. There is a wide political consensus among major political parties about the development needs of Mongolia. Therefore, regardless of the election results, the country should be expected to stay on its current course of resource-driven growth.

SECTION 4: CAPITAL MARKETS

Public equities: Best Performing Market Globally

Despite its relative tiny size in global market terms, the Mongolian Stock Exchange (MSE) is increasingly gaining importance for local and international investors intending to gain exposure to the Mongolian market. Naturally, most of the market is resource-related.

Mongolia has so far this year maintained its title as the world’s best performing equity market. Having gained 138.4% (173.7% in US$ terms) last year, the MSE Top-20 Index has continued its global outperformance in 2011 at +43.8% at the time of writing. By comparison, the MSCI Frontier index gained 16.6% in 2010 and is down 11.6% so far in 2011; the MSCI EM Asia index gained 12.9% in 2010 and is down 0.7% year to date; and the Shanghai Composite Index fell 14.3% and 5% respectively.

After the Mongolian Stock Exchange benchmark surged 123.3% within the first two months of the year, hitting 32,954.97 on February 25, it went through a significant correction, losing 43.8% by the end of May. This volatility is a function of speculation, low liquidity, a small free float in listed companies, and unrealistic and uninformed investor expectations. Improved investor sentiment driven by the expected launch of Tavan Tolgoi coal mining operations and proposed IPO, the strategic partnership agreement between the MSE and the London Stock Exchange (see box), and a strong outlook for commodities, contributed to the surge and underpin further growth.

The MSE market capitalization grew 2.5 times in 2010, passing the landmark US$1bn in November 2010  and reaching US$1.7 billion by July 2011. The top five stocks (Coal groups Baganuur, Tavan Tolgoi, Shivee Ovoo and Sharyn Gol, and beverage group APU) contributed 82.1% of this growth. The combination of expected double-digit economic growth, and the experience of other commodity-linked emerging markets, suggests that the momentum has just begun: Kazakhstan Stock Exchange’s market capitalization grew 100-fold to US$100 billion between 2000 and 2008, while the Qatar Stock Exchange grew 31 times from 1997 to 2007 to US$95 billion. Stock market penetration – total market cap representing just 20% of GDP – is relatively low compared to other emerging and even frontier markets, underlining the growth potential.

The MSE, with its huge gains, is still challenged by companies with small free floats and low trading volume. Average daily trading volumes were US$234,000 from January to February 25, and US$33,000 from then to May 30. It is likely that the lack of liquidity will remain a concern in the short term.

The Mongolian government has approved a list of state-owned enterprises that are slated for privatization starting from 2011. These SOEs are in mining, mineral processing, construction materials, power distribution and generation, telecommunications and airline industries. Many will pursue a listing locally on the MSE to serve as a vehicle for privatization and then seek additional listings in regional or international markets to raise capital for expansion and modernization.

The leader among these expected privatizations is the highly anticipated IPO of Erdenes Tavan Tolgoi, expected early next year, and potentially worth over US$10 billion. This government-owned company holds the licence for Tavan Tolgoi, the world’s largest undeveloped coking coal mine. The government has distributed 10% of the company’s shares to Mongolian citizens, with a lock-up period that has not yet been decided, and plans to sell another 10% to Mongolian companies and offer 30% on a combination of domestic and international markets. It should substantially boost MSE market capitalization and liquidity while also enfranchising citizens in the capital markets. “The entire population of Mongolia will become shareholders,” says Munkhtushig Dul, Deputy Director and head of finance and logistics at the MSE. “When that happens, new brokerages will have to develop, as will the capital markets themselves.”

“There are several separate pipelines of new listings,” he adds. “First there are the big strategic mineral deposits, which by law should have no less than 10% listed on the MSE. Then there are many companies with huge assets in Mongolia who are not listed here: we are hoping to repatriate them to create more involvement in the Mongolian markets. And then there are local privately held companies: cell phone companies, food companies, very strong businesses that will need more money.”

There have been no new IPOs on the MSE in the last two years, but it is expected this will change dramatically in the coming years as a number of leading domestic private companies are expected to launch IPOs first internationally and later on MSE. Mongolian private business groups that are expected to launch IPOs at a group or subsidiary level include MCS Holding, Petrovis Corp, Bodi Group, Newcom Group and Monnis Group. New IPOs, whether from state or private sources, should ease liquidity concerns and therefore volatility.

Many Mongolian companies – now over 20 – have listed overseas, often instead of domestically, in locations including Toronto, London, Hong Kong and Australia. But Mongolian authorities do not see this as capital fleeing the country. “I don’t see it as a bad sign,” says Bayarsaikhan D, chairman of the Financial Regulatory Commission of Mongolia. “Companies are using the opportunity to raise funding in large amounts.” The hope is that companies that have listed overseas will come to list more of their stock domestically as the Mongolian market gains in scale and sophistication.

Eurasia Capital believes the outlook for Mongolian equities in the short to long term is very positive. This year, it expects the MSE to retain its title among the top three equity markets, if not the best.

BOX: The LSE partnership

Mongolia took a historically important step to develop its capital markets when MSE and London Stock Exchange (LSE) signed the landmark Master Service Agreement to manage the MSE on April 7 2011.

Through this agreement the MSE will be modernized with the LSE’s support over the next three years. LSE will introduce an integrated securities trading system, create an effective legal and regulatory environment, and will bring infrastructure, technology and human resources capability in line with international standards. LSE has appointed a management team at the MSE to oversee its development and privatization, and has brought in Millennium IT, the leading global exchange technology provider, to assist with trading, surveillance and post-trading infrastructure.

The partnership should bring modern market rules, procedures and operations, as well as broadening tradable asset classes to derivatives and ETFs. The ultimate aim is for MSE to become a regional resources hub for international investors. In future it may even attract resources listings from neighbouring countries.

“The main purpose of the agreement is to bring the stock exchange to international standards,” says Bayarsaikhan. “A lot of work has been done so far on the legal framework, on IT, and in corporate governance and transparency. The future is bright and all the professional players in the market are working hard.”

In Eurasia Capital’s view, this partnership should accelerate the process of MSE becoming a viable source of capital for Mongolian companies and an efficient channel for wealth distribution from mineral resources among the Mongolian population.

Private equity

Flurry of M&A Activity

In recent years Mongolia has seen a flurry of M&A activity, particularly in the resources sector. M&A volumes doubled from 2009 to 2010 to a record level of over US$1bn, most of it in mining, and chiefly coal; international interest has grown dramatically since the investment agreement on the Oyu Tolgoi (OT) mine was signed in late 2009. The origins of acquiring companies were diverse but Hong Kong and Australia led the charge: Hong Kong was involved in US$473mn worth of M&A deals through injections of resource assets into existing publicly listed companies.  Australian companies have not only bought assets but held IPOs.

This year M&A activity is more vibrant still. Total deal value for the first half of 2011 increased 45% year on year to US$636mn, and had reached US$690mn by July 27; Eurasia Capital expects another record year. Close to 50% of the announced deals were reached in participation with Australian companies, suggesting Mongolia will continue to be on the radar of cash-rich mining companies that have strengthened their cash positions through improved operational efficiencies and high commodity prices. The Erdenes Tavan Tolgoi deal will impact this year’s numbers: some bankers estimate the overall worth of the asset at US$15-20bn.

Fixed income: Bond Market Kicking off

Until very recently, not many people knew of the existence of the bond market in Mongolia. But it is becoming more active. The market has been waiting for the right time and conditions while building knowledge, experience, and infrastructure. News about bond issues is not on-and-off anymore; the market is underway.

The Mongolian Government is being cautious in approving new issues, knowing the damage any default would cause to the reputation and credit rating of the market. Government issues have focused on national benefit: for example, in September 2010 it issued a MNT60bn bond, half of which was offered to the public, to fund the “4000 Apartments for Public Servants” project. So far, offers worth MNT69.6bn out of a planned MNT72bn have been launched for project funding.

Backed by confidence in Mongolia’s expected growth, the government is planning another offering to support the cashmere and wool sectors, and small-to-medium enterprises.

Through the Development Bank, established in 2010, big industrial, infrastructure and mining projects will be funded and the government will issue MNT800bn bonds for necessary funding as new projects come up. The Bank also supports those projects by providing guarantees to the loans. Both domestic and international investors can participate.

Corporate bonds will become an interesting area for investors. For most of the companies who intend to tap the debt markets, it is a testing period: they need models to follow, but there have been only 12 issues since 2001. But by waiting, they risk losing out to competitors. Just Agro has made the first move this year to attract bond investors with a MNT30bn bond offering. If successful, other companies may follow.

Trade and Development Bank (TDB) is the only bank in Mongolia to tap the international bond markets so far, with a US$75mn deal in 2009 (successfully repaid), and two new bonds in 2010. Other banks, Khan Bank and XacBank, have followed suit and announced smaller debt issues. But bank deposits, offering more than 11% returns in MNT, remain favoured by many local investors.

BOX: Currency

After an impressive 12.9% appreciation in 2010, the Mongolia tugrik (MNT) has been relatively volatile this year, appreciating 1.6% year to date by August 4. Eurasia Capital believes it will remain a strong currency to hold. This confidence comes from expected capital flows to the large projects in the mining industry and infrastructure: FDI was US$1.5bn in 2010. The revenues from the two mega-projects of Tavan Tolgoi (coal) and Oyu Tolgoi (copper and gold), both under development, will consolidate the MNT for many years to come. Mongolia’s exports of mineral resources will dramatically increase when the necessary infrastructure, including the rail lines, become ready.

The currency is comparable to other resource driven currencies, such as the Australian dollar or Brazilian Real, which have experienced large appreciation. The MNT has emerged as a new resource currency and is increasingly correlated to the export commodities. It represents an excellent carry trade opportunity.

SECTION 5: PROPERTY, INFRASTRUCTURE AND FINANCIAL SERVICES

Property

As mining has brought wealth to Mongolia, the property market has experienced speculation and rapid expansion. After the highest ever price for a luxury residential apartment was registered at US$8000/sqm in the new Blue Sky Tower, an April Fool’s joke by a local broker about Donald Trump’s plans to build 120-storey “Trump Tower” for US$1bn in the center of Ulaanbaatar was picked up and distributed by some respected online sources.

Although Mr. Trump is not planning to build a tower in the capital city of Mongolia, the property market is poised to benefit from the country’s mining-led economic growth. Already, the residential, office, retail and hospitality property segments have consistently grown over the last few years, with supply struggling to meet demand. The market in Ulaanbaatar stabilized in 2010 following the turmoil of 2008-2009, and has benefited from increased inflows of foreign capital. Industry experts expect a period of accelerated growth.

Residential property prices in Ulaanbaatar have nearly quadrupled since 2002, although the global financial crisis corrected the steep market growth up to 3Q2008. The past year’s strong economic growth, national currency appreciation and speculative inflows of foreign capital for Mongolia have driven residential property prices up nearly 20% in the capital; the average residential property prices in 2010 was around US$900 per square meter, although much of that can be attributed to the 12.9% MNT appreciation.

Although foreign investors have an impact, the growing number of wealthy Mongolians is also significant, boosted by successful capital raising by mining companies. Fundamental demand for housing in Ulaanbaatar and nationwide will be a key driver of near-term growth. Since 2005, the population of Ulaanbaatar has increased 22% to 1.16 million, which represents over 40% of the total Mongolian population. More than half of Ulaanbaatar’s inhabitants live in traditional “ger” settlements, whilst the others live in old buildings that are deteriorating fast. Facing the need to accommodate its population, the Mongolian Government has initiated several measures that stipulate construction of mid-budget accommodation through government support. These initiatives include programmes such as the “100,000 Apartments Project” which aims to alleviate the strains on infrastructure services, social services and pollution.

Despite the newfound wealth, more than one third of the Mongolian population lives below the poverty line. Increasing prices might deter low income earners from buying property. However, 2010 was marked by a revival in the mortgage market as major Mongolian banks have started providing loans to the population, albeit at high rates – currently from 11% to 28.8%, with required downpayments as high as 50% (but more commonly 30% and sometimes 10% if the construction company takes on some of the risk).

Ulaanbaatar is again crowded with construction cranes, just as before the 2008 crisis. Maybe Mr Trump will really build a Trump Tower in Ulaanbaatar during the next few years.

Infrastructure

Mongolia’s mining boom may stutter if the country cannot solve its infrastructure problems. Infrastructure is regularly listed among the major inhibitors of Mongolian growth, and vast investment is needed, probably in excess of the current GDP of the country.

The Concession Law, adopted in 2010, sets the legal framework for private sector participation in the development of infrastructure projects. The Mongolian government has approved a list of 121 projects in road and railroad construction, power generation and transmission, industrial development, urban development, telecommunications, education and healthcare, inviting private sector investments. Both foreign and domestic companies can participate in the projects individually or jointly. Concessions can be gained via open tender, competitive bidding or direct contract.

The development and expansion of railroad infrastructure is one of the most pressing issues in the Mongolian economy. To support its mining sector, Mongolia is currently focusing on extending its railroads to major mining areas within the country, as well as on opening trade corridors and export routes to neighbouring countries. In the next five to ten years, the country is planning to build about 5,700km of new railroads, providing easier access to Mongolian minerals and exports to neighbouring and international markets. The railroads will be constructed in three stages. The first stage, which has already started, envisages construction of a new 1,100km main rail line from the Tavan Tolgoi coal deposit to Choibalsan, the town connected to Russia by the existing railroad. The new main line will intersect the existing Trans-Mongolian Railway in Sainshand station in Gobi region. Mongolian Railways was selected to implement the project. The project is in feasibility study stage. It is expected to be completed in the next 4-5 years.

In the near future, major infrastructure projects in Mongolia may offer numerous investment opportunities. Construction of new railroads would create opportunities for investors, construction and operating companies. A new US$10 billion development, the Sainshand Industrial Complex near the Chinese border, will be a hub to process Mongolian raw materials for export, and should spur investor interest. A number of other government-priority projects will be open for private bidding in the coming year.

Financial services

Mongolia’s banking industry endured a difficult financial crisis in which two banks failed. But there is a sense that it has returned to health on the back of the growing economy. N Zoljargal, Deputy Governor of The Bank of Mongolia, the central bank, says the banking system has “never been better than it is today. It is very healthy.” Those banks that survived the crisis are now strong. “During the crisis our banks were well managed, beefed up their liquidity, and since then have seen high growth in assets.” Non-performing loans, which at one stage topped 20%, are now around the 6% mark, he says, and “coming down dramatically” as previously troubled businesses in construction and other areas pay back their loans. As Zoljargal says: “It the economy is growing 10%, it’s hard to produce NPLs. You have to be doing something very wrong.”

Some local banks with distinct strategies look healthier still. Xac Bank’s NPLs peaked around 7% and today stand at 1.7%, according to CEO Bat-Ochir Dugersuren, because its portfolios are well diversified. Xac Bank is an interesting study: founded in 1998 under a UNDP program, it is fundamentally a microfinance institution, with a governance and shareholder structure unique in Mongolia (EBRD and IFC are stakeholders, and the board is independent). Today, SMEs are very much a focus for expansion. “We have big corporates in this country but I don’t believe they are going to expand and carry the country’s growth forward,” says Bat-Ochir. “We need a broad base of promising SMEs to allow double-digit growth to take place in our economy.” Xac Bank, like most, gets around 90% of its income from interest, and accepts that growth in other business lines will have to take place to diversify earnings.

Another example of an unusual strategy is Chinggis Khaan Bank. Chairman Sergey Gromov – a pioneer investor in Mongolia whose holdings also including the leading brewery APU and the insurer Mongol Daatgal, discussed below – says the bank focuses on areas like agriculture and building materials, but not mining. “Agriculture has huge potential,” he says, pointing to the sheer scale of land and the as yet limited use of fertilizer or other techniques.

International players such as ING and Standard Chartered have started to appear in Mongolia, though chiefly with representative offices rather than significant on-the-ground commitment so far. PricewaterhouseCoopers, KPMG and Ernst & Young are also represented.

Eurasia Capital is the nation’s leading investment bank today, and it is likely that this will be a growing part of the market in future. “There will be more of a focus on long term investment funds and institutional investors in future,” says Bayarsaikhan D, Chairman of the Financial Regulatory Commission of Mongolia. As the finance ministry interview explains, two quasi-sovereign wealth funds – the Stabilization Fund and Human Development Fund – are being developed, while a development bank focused on long-term infrastructure has been formed and will soon start lending. The development of new investment, capital markets and securities laws, in varying states of readiness, will help growth.

Another area ready for dramatic growth is the insurance industry. Mongol Daatgal, the country’s first insurer, dates from 1924, but the industry is still in its infancy; only one company provides life insurance, while a handful of others provide property and commercial cover. “It is a very virgin market,” says Batzul Tumur-Ochir, Mongol Daatgal’s CEO. “It only holds 7.4% of GDP, and total premium income in 2010 was just US$30 million for the whole industry. People have not understood insurance, or have seen it as a cost in the past; but now the economy is growing because of the mining industry, people have more money from wages and may spend some on insurance.”

On top of general economic growth, legislation will drive the industry too. Mongolia today does not have mandatory insurance for drivers, but this year a new law is likely to change that. “That will automatically give a 30 or 40% increase to the market,” Batzul says. Professional liability insurance will also become mandatory in the near future, while the growth of the mortgage market is also going to feed through to insurance – through corporates and banks, and through individuals. Batzul plans to enter life insurance too within three years, as he also sees momentum for growth there.

Even by the exuberant standards of the offshore RMB debt markets, synthetic RMB – a market within a market – has had an extraordinary life. Invented only in December, it has thrived, broken records, and then apparently faltered again, all within six months.

It all began with a remarkably successful deal in December for Hong Kong-listed Shui On Land: the first straight bond to be launched in RMB, but settled in dollars.

Shui On Land is a solid name, but the scale of demand it attracted – an RMB32 billion (US$4.81 billion) book for a deal that had been marketed at RMB1.5-2 billion – surprised everyone. Shui on and its bookrunners, Deutsche Bank, Standard Chartered and UBS, increased the three-year deal to RMB3 billion and still had to scale orders back tenfold. Shui On, it is worth remembering, doesn’t have a credit rating.

The appeal of the synthetic format to investors was very clear. It allowed them to gain exposure to movements in the RMB, which are universally expected to be upward; and it did so without the investor having to navigate the swap markets should they hope to turn the investment into their home currency. The lack of depth in the swap markets had already, by December, become a clear potential bottleneck for RMB issuance. Dollar settlement also got around some restrictions global investors might face.

From the issuer perspective, it gave them an alternative method of reaching funds; at that time property companies had been struggling to access the dollar high yield markets (though they would regain momentum early in 2011). It avoided creating RMB proceeds in Hong Kong that may be troublesome to remit to the mainland. And the yield, while higher than on pure RMB dim sum bonds, was generally more attractive from an issuer point of view than a dollar bond would be. Shui On paid a yield of 6.875% (having tightened from guidance of 7-7.125%), which is higher than typical dim sum yields (unrated Macau casino operator Galaxy Entertainment had borrowed at 4.625% earlier in the month) but lower than the likely 8.5% or more it would have paid in the dollar markets. In deciding whether to buy, investors are clearly factoring in the likely increase in the value of the RMB itself as part of the equation.

While several issuers had previously conducted RMB-denominated, dollar settled convertible bonds – including Country Garden and Shui On Land itself – the new synthetic bond was seen as a momentous development for the market.

After Shui On, the floodgates opened. On January 7, China SCE Property raised RMB2 billion in a five-year dollar-settled bond through HSBC and Deutsche, paying 10.5%. Like Shui On, the deal was upsized and tightened along the way. China SCE is rated B1/B+, and its bonds B2/B; analysts said at the time that it would have paid around 13% for the same deal in dollars.

The following week came the biggest deal yet: Evergrande Real Estate Group, another Chinese developer, raised RMB9.25 billion (US$1.4 billion) in a synthetic dual-tranche deal. Just weeks after this part of the market had been launched, Evergrande had launched the biggest ever high yield bond in any currency from a Chinese property company. “The size that Evergrande have achieved in synthetic RMB is phenomenal: US$1.4 billion equivalent, which is by far the largest Regulation S deal ever seen for a high yield credit,” says Terence Chia, in debt syndicate at Citi, one of four lead managers on the deal alongside Bank of America Merrill Lynch, BOC International and Deutsche Bank.

Everything about this deal was dazzling. Its order book came in at RMB33.1 billion; 136 orders came in for the RMB5.55 billion three-year tranche, and 108 for the RMB3.7 billion five-year; and at 7.5% for the three year and 9.25% for the five year, in line with guidance, it was strikingly cheaper funding than the 13% Evergrande had paid for a $750 million five-year global one year earlier.

For Parry Tse, Evergrande’s CFO, the contrast between the two bonds was very welcome – and not just because of price. “In terms of procedure, they were very different,” he says. The Rule 144a bond in January 2010 required “three or four weeks” of preparation to meet the various regulatory requirements, he says. “When we issued a synthetic RMB bond, the majority of investors were located in Hong Kong and Singapore. Investors in this region have a better expectation of the appreciation of the RMB, so were very interested to purchase RMB bonds. Because we did not need to go to the US for marketing, it only took two weeks of preparation work. It saves a lot of time.”

And so other issuers began queuing up. Later in January Shui On Land came back again, just five weeks after inaugurating the market, raising RMB3.5 billion of four-year paper at 7.625%, through Deutsche Bank, Standard Chartered, UBS, Barclays Capital and BNP Paribas. It attracted RMB17 billion of demand from more than 150 accounts. And Kaisa Group raised RMB2 billion in the first private placement of synthetic RMB bonds.

But after Evergrande, whose immediate secondary market performance was poor, sentiment in the market had started to change.

In February, the Chinese solar wafer maker LDK Solar raised RMB1.2 billion in three-year bonds settled in dollars, with a yield of 10%. Those numbers look solid enough, but the atmosphere around the deal was very different to those that had preceded it: it was downsized from RMB1.5 billion, and the yield had to be raised from a planned 8-9%. Even at those levels it was barely oversubscribed, and then dropped in the secondary market.

The deal, lead managed by Citi and Morgan Stanley, ran up against several headwinds: a tightening of reserve requirements shortly after the deal began trading, which was part of the reason for the drop in the secondary market, for example. And an unrated issuer in a new technology area was difficult to sell at the yields the borrower appeared to want.

Also, the deal did subsequently bounce back somewhat in the secondary market. But it was the first black mark against the synthetic RMB market, which really hasn’t recovered since. Around this time Country Garden successfully raised $900 million in a seven-year non-call four dollar bond, which then traded up, reminding people of the merits of longer-established vanilla markets. Names that had been expected to launch in synthetic RMB started to delay or cancel their trades; first Zhong An Real Estate, which had planned a Regulation S-only three-year bond in February, and then another for Global Dairy Holdings planned for April.

In fact, only one more synthetic issue has followed to date: from Powerlong Real Estate, which raised RMB750 million in three-year dollar-settled bonds in March through HSBC, Macquarie Capital and RBS. The coupon was 11.5%, priced at 99.383 to yield 11.75%. While this deal went well enough, it was notable that the pricing was just 200 basis points less than a dollar bond of the same tenor it sold in 2010, suggesting that the really big savings over dollar funding have already passed by.

Meanwhile mainstream dim sum bonds continue to thrive. By the time Guangzhou R&F successfully launched the first dual-tranche dollar and offshore RMB bond in April, it was clear that these markets were back in favour. Notably, by then, most synthetic bonds were trading below par, and most dim sum bonds, above. And so the market, worth about $3 billion in aggregate, is somewhat becalmed.

It’s interesting to look at who has bought synthetic deals. The Powerlong deal went 55% to private banks, for example; in Shui On and Evergrande, too, they topped 50% of allocation. When Powerlong had issued in dollars, private banks were 40% of the allocations, less than funds with 49%. These bonds clearly have a different, non-institutional target market to sell to.

It may be that the synthetic market dies away as some of the inefficiencies in the dim sum market that it seeks to remedy are resolved by the maturing of that market. For example, when longer tenor is available in dim sum bonds, when the swap market is more mature and repatriation of capital is easier, there will be less of a need for issuers or investors to consider the synthetic route.

Even issuers accept that the time in the sun may be fleeting, and that all RMB offshore bonds are benefiting from a currency play that may be temporary. “It may be a temporary situation,” says Tse at Evergrande. “You would expect the appreciation of the RMB to be vigorous in the next couple of years, but it will just be a transitional period. When the expectation of RMB appreciation is no longer so high, investors may not have the same interest in RMB bonds. The traditional US dollar bond market is still very important and will continue to be the main source of financing in future.”

The rise and subsidence of the synthetic market will eventually be seen as part of the broader market’s rapid evolution. “The China market was going down a two-pronged road,” says Henrik Raber, global head of debt capital markets at Standard Chartered. “Firstly the dim sum bonds, which started off as all local currencies do, being more oriented to high grade issuers, and as a mechanism to soak up some of the deposits building up in Hong Kong. Then, as the market started to develop, some of the dynamics around the market started to change: the US dollar market for Chinese high yield issuers started to get a bit weaker, and we started to see those issuers in the synthetic format.” Now, the dynamics are shifting again.

A debt market that has trebled in size in a year. An evolution in issuers from top-rated policy banks to high yield names, both Chinese and international, in the space of a few months. A trade settlement program that has gone from five coastal cities to more than 67,000 firms in two years. The formation of a new forex market and the launchpad for a new field of investment products. It’s not a bad start.

But what’s next for the offshore RMB?

The most obvious next step is more of what we’ve seen already. By May 20 this year, the total outstanding offshore RMB issues came to RMB103 billion, up from RMB34.3 billion just before the transformative new measures from the Hong Kong Monetary Authority came into effect and widened the range of potential issuers in July 2010. There’s nothing in the near term to stop that rate of growth. RBS predicts a total of RMB180 billion outstanding by the end of 2011, and if anything, that’s the conservative end: Vishal Goenka at Deutsche Bank expects RMB200 billion, across a range of issuer types.

It’s a safe prediction to expect further growth on this scale, because the body of capital that has created this new market – RMB deposits in Hong Kong – is growing just as fast. In June 2010, RMB deposits in Hong Kong amounted to RMB 90 billion; by the end of the year the figure was RMB315 billion and at the end of March, the most recently reported figure, it was RMB451.4 billion. At the moment, deposits are growing at 10% a month; RBS is calling RMB700-800 billion by the end of 2011, and HSBC RMB800 billion  to RMB1.2 trillion.  “Even if new issuance of CNH bonds in 2011 triples from the 2010 level, it will reach only 24% of the CNY deposit base,” says Woon Khien Chia, managing director and head of local markets strategy for emerging Asia at RBS.

With volume, it’s reasonable to expect a further evolution of the market. It’s already open to fairly low-rated credits, even unrated ones, but so far tenor is limited. It would be natural to expect that tenor to increase over time.

It’s also likely that some of the inhibitors of market development will be addressed over time. One of the most obvious of these is the process of remitting funds back to the mainland, a process that so far is slow, exacting and somewhat opaque. The State Administration of Foreign Exchange is likely to add more clarity and efficiency to the process if it appears, as it does, that the market is being damaged by the situation. Similarly, the swap market – an expensive and inefficient barrier to growth – should be expected to mature over time, and to become cheaper than the 250-300 basis points it typically costs today.

When those things happen, one knock-on effect may be the demise of the synthetic RMB market, which exists partly because of the problems of tenor, repatriation and swap in the dim sum market. The chapter on synthetics talks in more detail about how and why this might happen.

Another inevitable area of growth is in investment products for RMB outside China. Clearly, it’s already happening, but there is plenty of room for further development: not just RMB bonds but RMB life insurance products, derivatives, mutual funds and so on. Some feel that this might put pressure on the high yield issuers who are today making such remarkable headway with their issues: HSBC expects high grade issuers to be robust and underpinned by technical analysis, while high yield comes under pressure as alternative investment products become available.

On trade settlement, the pace of liberalisation has been particularly swift. It was only in June 2010 that an initial pilot scheme was expanded to 20 Chinese cities and to all foreign trade partners; then in December, the number of eligible Chinese participating firms was lifted from 365 to 67,359. But that’s still not everyone: the next step will be a further broadening of permission to cover all potential firms in China.

Whether that happens swiftly or not, we should expect a considerable increase in mainland Chinese businesses trading in RMB. RMB trade settlement took a while to get moving after liberalisation began, before real momentum became evident at the end of 2010, by which time the total RMB trade settlement value had hit about RMB486 billion. But this is just the start: HSBC has said it expects trade settlement volume to average at least US$2 trillion per year by the time RMB trade settlement hits critical mass.

HSBC Bank (China) announced the results of a survey in May which found that eight in 10 businesses in mainland China which do not currently use RMB to settle cross-border trade are planning to use RMB, or adopt it conditionally in future transactions. The survey covered 1,300 commercial banking customers across 18 mainland cities, a representative sample; 45% of them who did not have any experience in RMB trade settlement said they had plans to adopt it for future cross-border trade, and a further 33% will consider it depending on pricing and services offered by banks. In Shanghai, Beijing, Guangzhou and Shenzhen, 29% of respondents expect to adopt the RMB for trade settlement in the next 12 months.

The survey also found that 37% of mainland traders considered one major obstacle to be the acceptability of RMB among counterparties outside the mainland, and this is clearly another area for gradual evolution in future. It will require greater development of channels to use RMB they receive as payment, more support from banks, and greater education generally on RMB trade settlement. “These issues and challenges are inevitable as the RMB goes global,” Montgomery Ho, head of commercial banking at HSBC, says. “We believe that with the continued extension of the use and investment channels for offshore RMB, overseas markets will see a steady and continued rise in RMB holdings and strengthened local support for RMB settlement over time.” HSBC estimates that about US$2 trillion – more than half of China’s total trade – will be settled in RMB by 2015.

As an aside, one other interesting finding of the HSBC survey was that 49% of respondents that are already using RMB in cross-border trade said their main motivation was to hedge foreign exchange fluctuation risk, and another 44% said they hold RMB in view of its long-term appreciation.

Additionally, since August 2010, several foreign banks have been permitted to invest their RMB holdings into the China interbank bond market, with Standard Chartered, HSBC and Bank of China International in the first wave; another logical next step is further expansion of that permission to other banks.

In the longer term, another next step will be the resolution of anomalies that have developed from the way the market has been opened. Liberalisation has come at a time when the currency itself is still restricted on the capital account. That has led to imbalances in supply and demand, which in turn means that the same currency is behaving in two completely different ways according to whether it is onshore or offshore. Offshore, interest rates are low and falling because of demand. Onshore, they’re higher, and rising.

For the moment, this has clearly led to arbitrage possibilities. Strategists like RBS’s Chia believe that, while China doesn’t necessarily welcome the arbitrage that arises for issuers and traders, it accepts it as a necessary evil and part of the process of becoming a truly international currency – one that will, eventually, become an international reserve currency. “They know there will be some sacrifices along the way,” she says. Arbitrage possibilities will remain for at least a few more years, while money is tending to move outwards more than it is moving inwards, but eventually when two-way flows are more prevalent – and, ultimately, the capital account is liberalised – they will start to fade.

Related to this, it can’t always be the case that there are three separate foreign exchange markets for exactly the same cross-trade (RMB to US dollars), all behaving differently. There is, today, an onshore deliverable forward curve, a non-deliverable forward market, and now an offshore deliverable market for dollar/RMB spots and forwards. HSBC’s Donna Chan argues that for foreign corporates with both offshore and onshore entities engaged in trade settlement, there are options to hedge RMB and US$ flows in no less than five different RMB curves. Again, greater openness in the currency itself will eventually harmonise these markets, at least to a degree.

Another clear next step is the long-awaited mini-QFII scheme, which will allow Chinese securities and fund management companies to raise funds in Hong Kong and then invest them into China’s asset markets. Guidelines on this market have been expected for some time, and keenly so, as the method used for the scheme will have a major knock-on effect for asset management firms.

The backdrop to mini-QFII is that there is far more capital wanting to get in to China than is permitted to today through the existing QFII program, which is one reason H-shares have tended to be so expensive in Hong Kong. “There is a clear reason why Hong Kong assets are such a common substitute for the real thing: at US$20 billion, the mainland QFII program comes nowhere near meeting current foreign demand,” notes Z-Ben, a research consultancy on the asset management industry headquartered in Shanghai. “If supply and demand were balanced, there wouldn’t be 100+ foreign firms waiting patiently for their QFII application to be approved, nor a similarly long list of firms with applications outstanding for an increase in quota.”

Z-Ben expects mini-QFII to be open predominantly, if not entirely, to Chinese fund managers and securities companies having a base in Hong Kong. “Will that program create serious competitive threat to anyone, given that renminbi sitting in Hong Kong savings accounts, while growing quickly, total RMB400+ billion? Probably not,” says Z-Ben. But it contends that the future of mini-QFII will not just be CNH – RMB assets in Hong Kong – but CNY broadly and the ability for approved firms to apply for quota to convert foreign currency into RMB. That’s a very different proposition.

“Imagine China’s top half-dozen asset managers (and, if you want to frighten a colleague in the securities trade, its top half-dozen brokers) as the only government-endorsed domestic gatekeepers licensed to solicit foreign funds for investment in the mainland’s equity markets,” Z-Ben says. “Imagine them splitting a pilot pool of quota roughly equal to the QFII pot. Imagine their four-word marketing slogan, the one no global firm can equal: ‘Real China Access Here.’ Imagine the calls from clients who’ve just heard their first pitch from a mainland asset manager, asking if your firm has 500+ China equity researchers. Now imagine how much havoc Chinese managers will wreak on the Greater China sector, cutting fees, deals and corners as necessary to secure major global clients while they learn how to service them.”

Z-Ben is making a lot of assumptions in setting out this case, and at this stage we’re not even at the first phase of mini-QFII, but it’s true to say that the likely progress is being keenly debated among international (and local) asset managers.

In terms of capital market development, another area with plenty of progress to make is RMB IPOs. One has already happened: Hui Xian’s REIT at the end of April, which raised RMB10.48 billion for parent Cheung Kong. It wasn’t a deal that went especially well, and on top of that, it’s not exactly an equity listing but a real estate investment trust. “The features of a REIT are a mixture of bonds and equity,” says Freda Wong, executive director, corporate finance at CITIC Securities International. “They pay interest, so the regulators in Hong Kong and the PRC were more comfortable to launch it to test the market. We expect some more of these RMB REITs will follow, but a pure equity RMB product will take time.” It is hard to say when. “If it was just micro factors involved, like a deal, that is easy to handle. But there are many macro factors that need to be considered before an innovative product like this is launched. They need to see if liquidity is ready, trade settlement, brokers, intermediaries… there is a lot to do.”

Another next step in the market’s evolution is the development of further offshore centres for RMB. This is a hotly discussed subject in Singapore. “Singapore has to get themselves a central clearing line, otherwise they will just be a sub-centre to Hong Kong,” says Chia. “They are in the process of getting that. Once they’ve announced it, our interbank market can start making a price on CNH.” The Monetary Authority of Singapore does have a CNY swap line – the eighth foreign central bank to receive one – and when it did so, it received the third highest amount in absolute terms, and the highest in proportion to Singapore’s market share of China’s total trade in Asia; this was seen as demonstrating the importance China places on Singapore as a potential offshore centre. In due course, London and New York may become RMB centres in other timezones.

But these are all parts of the bigger picture of RMB internationalization. “We define the RMB internationalization process in three stages that chart its rise as a global trade settlement currency, a global investment currency, and a global reserve currency,” noted HSBC Greater China economist Donna Chan earlier this year. The first stage kicked off in 2009 and should hit critical mass by 2013-15, she says; the second launched in mid-2010 and will develop alongside the first. “The third will be a multi-decade process and won’t be possible without full RMB convertibility.” It’s at that third stage that the CNH and CNY currencies will converge again.

“Beijing’s ultimate aim is to keep the RMB rising as a global trading and investment currency, but at its own pace and in its own way,” concludes Chan. “Arbitrage activities make it difficult to track and control this process, blurring Chinese regulators’ windscreen. Only once RMB trade settlement channels have been adequately flushed and fitted with new filters will Beijing forge ahead with its longer term strategy for internationalizing the RMB. This, clearly, is already happening.”

But there’s another perspective people ought to bear in mind: that a freer currency doesn’t necessarily mean great news for those who are heavily invested in China itself. CLSA strategist Christopher Wood took on this topic in his closely-followed Greed & Fear research note in May, and suggested that China may soon intervene to cool the RMB offshore market. “The first reason for a cooling off is that the political leadership is fundamentally uncomfortable with an open capital account,” he says. “It must already be worried that the capital account is dangerously porous, in the sense that it has long been a practical reality that the wealthy and the connected can get their money out of China.” Wood doesn’t think real liberalization of the capital account is on its way any time soon, but he adds that if it happened, he “would become extremely cautious on the China story.”