Euroweek offshore RMB report: next steps

Euroweek, July 2011

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.”