China s Different Path Toward Internationalization of the RMB:

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1 China s Different Path Toward Internationalization of the RMB: Hong Kong as an Offshore RMB Financial Center White Paper by Howard Chao, Partner, O Melveny & Myers LLP Hong Kong and Silicon Valley offices and Andrew Hutton, Senior Counsel, O Melveny & Myers LLP Singapore office October 2011

2 This white paper is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal or investment advice, and does not purport to represent the views of O Melveny & Myers LLP or its clients, affiliates, members, principals, partners, employees, agents or contractors. The views expressed in this white paper are those of the authors, except as otherwise noted. Without limiting any rights under copyright reserved within, no part of this white paper may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form, or by any means (electronic, mechanical, photocopying, recording or otherwise), without the prior written permission of the copyright owner and its publisher. Any distribution of this white paper without the express permission of the authors is illegal and punishable by law.

3 CHINA S DIFFERENT PATH TOWARD INTERNATIONALIZATION OF THE RMB: HONG KONG AS AN OFFSHORE RMB FINANCIAL CENTER By Howard Chao and Andrew Hutton * The rise of China has occurred at a pace few had anticipated, and now China s currency is not far behind. The Chinese government has embarked on a comprehensive program to internationalize the RMB, encouraging its use in international trade and finance even while the RMB remains inconvertible for capital account transactions. These steps will lead eventually to open convertibility and to a multi-polar currency world in which the RMB will become one of the key currencies used in international finance, along with the dollar. As part of this initiative, Hong Kong has been established as the world s primary offshore RMB financial center. In internationalizing the RMB, China hopes to accomplish several goals: facilitating Chinese international trade, inserting China and Chinese financial institutions into the mainstream of international financial transactions, and permitting the Chinese government the flexibility to print a currency acceptable to the international community. Of course, prestige is a factor too -- a sense that China s currency s stature should match its growing financial and political clout. 1 An important lesson that China took away from the most recent global financial crisis was that in times of crisis the country with the dominant international currency enjoys a great deal more policy flexibility than other countries; and conversely, not having the ability to print an internationally accepted currency can be a significant disadvantage when there is a liquidity crunch. However, China does not wish for immediate full internationalization of the RMB. One of the lessons that China and many other emerging market countries learned during the Asian financial crisis of 1997 (when China was seriously considering allowing the RMB to become fully convertible) was that in times of crisis open capital accounts permit capital suddenly to exit a country, which can cause a collapse of the domestic financial system and economy. China s stated goal still is to move towards capital account convertibility of the RMB, but clearly China is still concerned about the potential risks to the Chinese financial system and economy if cross-border flows of the RMB are completely free. Thus, China is attempting to move towards internationalizing the RMB without complete convertibility, a chronology which is unusual. China wants the RMB to become a unit of account, a medium of exchange, and a store of value first. * Howard Chao is in charge of O Melveny & Myers Asia Practice and Andrew Hutton leads O Melveny & Myers Asia Debt Capital Markets Practice. The authors would like to thank their colleagues, Bronwen May and Catherine Lam, for their assistance in preparing this article. 1 In an important recent article, two Chinese Academy of Social Sciences researchers listed the following goals for internationalization of the RMB: Reducing foreign exchange risks for Chinese firms by pricing foreign trade in RMB; reducing fluctuation of capital by having a greater proportion of bank assets in RMB; reducing the availability risk of foreign currency and permitting the use of RMB as a lending currency of last resort. Strengthening the competitiveness of Chinese financial institutions because of greater access to a large pool of RMB assets. Boosting cross-border transactions by using RMB to settle trade transactions. Promoting development of border regions inhabited by minority groups. Permitting seigniorage (the difference between the face value of paper currency issued by the government and the cost of printing the money -- the profits from printing money), although this is deemed a secondary benefit. Preserving the value of Chinese savings, by making it more likely that a greater portion of the national balance sheet will be held in RMB denominated assets rather than depreciating foreign currency denominated assets.

4 China s Different Path Toward Internationalization of the RMB 2 China s approach is to create a growing pool of offshore RMB, primarily centered in Hong Kong, which can be transacted freely offshore for capital transactions, but cannot flow back into China except in connection with trading transactions or, if special approvals are obtained, for capital account transactions. This pool of offshore RMB in Hong Kong initially began to accumulate through RMB cash brought to Hong Kong by Chinese tourists and business people. However, the growth of this cash pool began to accelerate when China announced a policy of encouraging trade transactions to be settled in RMB, thus permitting Chinese importers to pay for their purchases from sellers in RMB, cleared through Hong Kong bank accounts. As this offshore pool of RMB grows, the possibilities for more offshore RMB denominated financial products increase, including bonds, loans, equities and derivatives. Development of Hong Kong as a RMB Banking and Settlement Center The Hong Kong government has seized upon these developments as an opportunity to build Hong Kong into the most important offshore international financial center for RMB transactions. While this is not explicit, Hong Kong realizes it is in a competition with Shanghai to become the leading international financial center for China. 2 However, the reality is that until full convertibility of the RMB (targeted for 2020), Shanghai cannot truly play this role. Hong Kong s strategy, as enunciated in a speech by Peter Pang, Deputy Chief Executive on September 27, 2011, is to follow the London model -- build a large and sophisticated financial services infrastructure (consisting of liquidity, financial products and financial intermediaries), and attain enough momentum to withstand future competitive and regulatory challenges and changes. A key driver of the growth of offshore RMB liquidity is the rapid increase of RMB denominated foreign trade transactions with China, particularly imports of goods into China. The growth of RMB denominated trade is shown on the chart below: Quarterly Chinese Total Trade and RMB Trade Settlement Value Source: HKMA 2 The official party line is that China is such a large market that inevitably multiple financial centers will arise.

5 China s Different Path Toward Internationalization of the RMB 3 Already about 9% of China s foreign trade transactions are denominated in RMB, up from 0.5% in early The great majority of these transactions are imports of goods into China, which cause RMB to flow offshore (and dollars to stay onshore). This accounts for a large portion of the rapid growth of offshore RMB cash deposits. Renminbi Deposits in Hong Kong Source: HKMA It is perhaps even more interesting to see RMB deposits in Hong Kong as a percentage of total bank deposits in Hong Kong, shown in the chart below. As can be seen, RMB deposits in Hong Kong now constitute more than 10% of all bank deposits in Hong Kong. At this rate it is possible to envisage that the RMB in the not distant future may even eclipse the Hong Kong dollar as the most widely held currency in Hong Kong. RMB Deposits as a % of all Hong Kong Bank Deposits Source: HKMA

6 China s Different Path Toward Internationalization of the RMB 4 PRC and HKMA Steps towards an Offshore RMB Market The Hong Kong Monetary Authority and PRC government have enacted a series of measures that progressively opened up the commercial banking and financial system to allow RMB transactions in Hong Kong: November 18, 2003: provided clearing arrangements for licensed banks in Hong Kong to conduct personal RMB business including deposit, exchange and remittance services. November 1, 2005: enhanced the personal RMB business conducted by participating banks by: relaxing transaction limits on RMB exchange and remittance services for Hong Kong residents; lifting maximum credit limits on RMB credit cards; and permitting designated business customers to open RMB deposit accounts that could be exchanged to Hong Kong dollars. January 10, 2007: further expanded the scope of RMB business of participating banks in Hong Kong by allowing Mainland financial institutions to issue RMB financial bonds in Hong Kong. July 1, 2009: allowed for cross-border trade settlement in RMB. February 11, 2010: permitted participating authorized institutions to: open RMB deposit accounts for corporate customers to conduct trade settlement transactions and determine the use of their RMB funds, except for flow of these funds back to the Mainland; continue to conduct RMB conversions against other currencies; provide customers with account-opening, bond trading, custodial and financing services; and offer check and credit card services to corporate customers. June 22, 2010: expanded the RMB trade settlement pilot scheme by: extending cross-border RMB trade settlement pilot scheme to cover 20 provinces and cities, including Guangdong Province and Shanghai; expanding scope of trade eligible for RMB settlement to cover service trade and other current account transactions; removing restriction on the transfer of RMB funds between different accounts; and allowing participating authorized institutions to open RMB deposit accounts for any corporate customer for general purpose. August 17, 2011: China Vice-Premier Li Keqiang announced plans to expand the development of Hong Kong s RMB settlement market, including: Hong Kong enterprises will be permitted to use offshore RMB proceeds for foreign direct investment into onshore companies; a trial scheme will be introduced to allow financial institutional investors to invest in China s stock markets with an initial quota of RMB 20 billion; expansion of the cross-border RMB trade settlement scheme nationwide from the current limitation of 20 Chinese provinces and cities; and Chinese enterprises will be permitted to issue RMB denominated bonds in Hong Kong. October 14, 2011: MOFCOM issues circular providing that foreign direct investment into China may be made using offshore RMB: new guidelines allow offshore RMB for FDI transactions (subject to normal MOFCOM approvals), in addition to hard currencies (USD, HKD, etc.); and foreign investors remain prohibited from using offshore RMB to invest in onshore securities or engaging in lending activities without additional SAFE or PBOC approvals.

7 China s Different Path Toward Internationalization of the RMB 5 The Market for CNH A consequence of the increased availability of RMB offshore in Hong Kong is the creation of a separate currency trading market, with the same currency trading at different rates in Hong Kong than onshore in China. Differing supply and demand conditions offshore have led to separate market clearing rates and even the introduction of a new currency code CNH to represent the exchange rate of RMB that trades in Hong Kong. In addition, and indicative of the growing complexity of the RMB currency market, there is the separate dollar settled nondeliverable forward NDF which trades offshore independently of the CNH, as well as the separate CNT trade-settlement exchange rate for offshore corporate customers. Interestingly, according to Bloomberg - Bank of China in early October 2011, the CNH (offshore RMB) discount to the onshore RMB CNY grew to 2%, the widest discount since the deliverable CNH market began in August Throughout most of the preceding year the CNH generally had traded at a premium to the CNY, reflecting the huge appetite of foreign investors for exposure to RMB as well as the difference in offshore and onshore interest rates. The Growth of RMB Financial Assets The growing pool of RMB liquidity in Hong Kong has permitted a progression of new financial products denominated in RMB to be rolled out in China over the course of the past few years: Timeline of Offshore RMB Products Available in Hong Kong Type RMB bank accounts for HK personal customers RMB bank accounts for HK Designated Business Customers ( DBCs ) RMB corporate bonds (Chinese issuer) Date of First Deal Feb-04 Oct-05 July-07 Example 40 banks in HK offered personal RMB deposit and checking accounts, credit/debit card and remittance services. Permitted DBCs to open RMB deposit accounts that could be exchanged into HKD. China Development Bank Corporation, Coupon: 3.0% p.a. Maturity: 2 years. RMB sovereign bonds Oct-09 Ministry of Finance of the PRC issued RMB6bn in 2, 3, and 5 year tranches, paying coupons of 2.25%, 2.7% and 3.3%, respectively. RMB insurance products RMB capital accounts for foreign direct investments ( FDIs ) Late-09 Mar-10 RMB insurance policies from Bank of China Group Life and China Life Insurance (Overseas). Maturity: mostly 5-10 years, some for life. Premium payments for RMB-denominated savings insurance plans could be settled in RMB as of July Vision Finance Group opened an RMB capital account with the Bank of China (HK) to make FDIs in HK. Certificates of deposit Jul-10 Citic Bank: Coupon: 2.68%, p.a. Maturity: 1 year RMB corporate bonds (foreign issuer) Jul-10 (1) Hopewell Infrastructure issued RMB1.38bn, coupon: 2.98%. Maturity: 2 years. (2) McDonalds issued RMB200m. Coupon: 3.0% p.a. Maturity: 3 years.

8 China s Different Path Toward Internationalization of the RMB 6 Type Date of First Deal Example Structured deposits Jul-10 BOC (HK) RMB leveraged structured deposit; HSBC equity linked note. Various maturities and coupons. RMB loans Aug-10 ICBC extended RMB2bn to PT Bakrie Telecom Tbk in Indonesia. RMB investment funds Aug-10 Hai Tong Asset Management (HK) Limited launched the Haitong Global RMB Fund with a RMB5bn ceiling, to be invested into overseas fixed income RMB products including notes and bonds. IPOs Apr-11 Hui Xian Real Estate Investment Trust (87001.HK: HUI XIAN REIT) sold 2 billion units at 5.24 CNY each. Gold contracts Oct-11 Hong Kong Chinese Gold & Silver Exchange Society officially allows trading gold denominated in RMB. Source: HSBC report and media reports Dim Sum Bonds The rapid growth of the offshore RMB bond market, particularly within the last 12 months, has been remarkable and robust. So much so that currently while other global debt and equity markets appear to be frozen or in one kind of crisis or another, the offshore RMB bond market continues to experience strong growth with recent issuances by a variety of foreign multinational corporations, Chinese companies, and the PRC government. RMB denominated bonds issued outside of China (also referred to as CNH bonds or Dim Sum Bonds ) amounted to approximately RMB40 billion in 2010 and approximately RMB69.4 billion in the first six months of Outstanding volume reached approximately RMB135 billion in July 2011 and is expected to reach the RMB200 billion mark by the end of 2011, according to a recent IFR Asia report. Prospects for the offshore RMB market were enhanced further during the recent visit to Hong Kong by Chinese Vice Premier Li Keqiang and People s Bank of China Governor Zhou Xiaochuan who made statements of encouragement to Chinese companies to issue offshore RMB bonds and indicated that a smoother process can be expected for the repatriation of the RMB funds raised offshore back into China. While the market for offshore RMB bonds began in 2007 with issuances mainly by Chinese commercial banks and quasi-government policy banks, the market grew slowly but steadily during its early years under PRC government policy which limited the types of issuers for which approvals would be given. 3 However, since September 2010 s RMB200 million bond offering by McDonalds Corporation (the market s first foreign MNC issuer) the market has grown significantly in line with the increase in RMB deposits held by institutions and individuals in Hong Kong bank accounts. During the past year, issuers of offshore RMB bonds have ranged from sovereign (the PRC government), supra-national (Asia Development Bank), foreign investment grade MNCs (Caterpillar, Volkswagen, CJ Corp, Orix, Tesco), Chinese SOE s (China Eastern Airlines) to high yield issuers with significant PRC operations and assets (Powerlong Real Estate, 3 State Administration of Foreign Exchange (SAFE) and Peoples Bank of China (PBOC) approvals were required to remit RMB proceeds obtained offshore back into China and to later make payments of principal and interest in RMB to offshore holders.

9 China s Different Path Toward Internationalization of the RMB 7 Guangzhou R&F Properties, China Shanshui Cement). Notably this also has been a significant development in the Asian high yield bond market generally, with new offshore RMB bond high yield issuances outpacing new issuances of traditional US dollar denominated high yield bonds by Chinese issuers. Foreign MNC issuers including those from the United States, Japan, Korea, United Kingdom, Russia, Germany and France have issued offshore RMB bonds during The following chart indicates the growth of the offshore RMB bond market in HK. Cumulative RMB Bonds Issued Source: Bloomberg A consequence of the quick growth in supply and number of offshore RMB bond issuances by companies of varying types and credit worthiness is that investors have become increasingly selective, demanding higher yields from non-investment grade issuers. Conversely, stronger investment grade credits such as Caterpillar, McDonalds and more recently Tesco, were able to achieve favorable pricing on their recent issues. Advisors, regulators and investors all agree that the offshore RMB bond market will continue to grow along with growth in the Chinese economy and further support from the PRC government. China s 12th Five-Year Plan supports development of Hong Kong as an offshore RMB business centre. Furthermore, PRC Vice-Premier Li announced during his visit to Hong Kong in August 2011 that China will allow foreign direct investment on the mainland using offshore RMB instead of the current policy of only allowing US dollars or other foreign currencies. Companies which previously were reluctant to issue offshore RMB bonds because of uncertainly in repatriating the RMB raised offshore back into China now have encouragement to issue. Foreign companies with investments in China also are expected to take advantage of this new policy as they would avoid currency risk by raising funds in RMB and directly investing RMB in their China projects, rather in investing using US dollars or other foreign currency. As internationalization of the RMB accelerates and more and more potential issuers and investors globally have access to RMB in their bank accounts and are able to use RMB for both trade and investment, RMB bond issuers from other overseas jurisdictions will join the existing US, Japanese, Korean, UK, German, Russian and other foreign issuers in a truly global market.

10 China s Different Path Toward Internationalization of the RMB 8 RMB Loans The market s second offshore RMB loan, or Dim Sum Loan, was completed in September 2011 and several currently are being marketed by Japanese, Swiss and other international banks. While still comparatively rare, offshore RMB loans by financial institutions now are available to borrowers as international banks themselves accumulate offshore RMB that can be accessed for lending transactions. However, the development of the Dim Sum Loan market to date has been slowed by market preference for offshore RMB bonds which have achieved favorable pricing for issuers and have experienced high yields for investors throughout 2011, as well as by the lack of a common benchmark lending rate for pricing offshore RMB loans in Hong Kong. Should such a common benchmark lending rate be established, the Dim Sum Loan market likely will experience exponential growth, perhaps similar to that in the offshore RMB bond market beginning in late RMB-Denominated Over-the-Counter (OTC) Derivatives Prior to the development of the offshore RMB market, investors in the OTC derivatives market had limited choices to gain exposure to RMB. Many investors traded only RMBdenominated Non-Deliverable Forwards (NDF) products which do not require physical delivery of RMB (as settlement is in USD). However, as offshore RMB trade further expanded in mid-2010, what is believed to be the first offshore USD/RMB deliverable forward trade in Hong Kong was completed between Standard Chartered and DBS, with Bank of China (HK) as the settlement bank. Other deals followed and within the first month the notional value of the market reached US$28 million. As deliverable deposits and spot offshore RMB transactions in Hong Kong grew, so did trading activity and volumes, reaching levels that remain at their highest today. The range of products available also developed quickly. November 2010 saw the first OTC RMB option traded, and since then the options market has become actively traded, with HSBC last month reporting a turnover of approximately US$400m per day. Today many market participants offer a range of RMB OTC products - deliverable forwards, swaps, cross currency swaps, FX options and interest rate swaps (as well as NDFs). For some products (such as currency swaps) the market is still relatively new and liquidity is limited, but this is expected to change as the market matures. The appetite for other products is affected by other factors but this too may change in time (for example, the demand for interest rate swaps is affected by the current interest rate differential - RMB funds are relatively expensive compared to HK$ or US$, although the rates may converge when the offshore RMB bond market develops further or when market participants can access onshore RMB bond markets). The future development of the RMB-denominated OTC derivatives market in Hong Kong also will continue to be driven to a large extent by the size of the underlying RMB deposit base, which is growing rapidly, and investor demand, as investors are currently hungry for more vehicles in which to invest. The framework for this is being assembled. For example, in October 2011 the International Swaps & Derivatives Association (ISDA) published its Additional Disruption Event Provisions for an Offshore Deliverable CNY Transaction and the Fallback Matrix. These reflect the unique features of the OTC deliverable CNY transactions conducted in Hong Kong, covering matters such as CNY illiquidity and CNY inconvertibility. Hong Kong as a Clearing Market for Global RMB Transactions With the establishment of the RMB bank clearing system in Hong Kong international banks outside of China now can choose between either mainland banks in China or Hong Kong based banks when choosing correspondent bank relationships through which they can offer

11 China s Different Path Toward Internationalization of the RMB 9 services in RMB. In addition, the Hong Kong government has launched an initiative to market this function for Hong Kong, with the hope that as the RMB achieves greater international recognition, overseas banks will prefer the better known financial infrastructure established in Hong Kong over mainland China s newly developing systems. Hong Kong intends to capitalize on the fact that there are approximately 180 participating banks in Hong Kong s RMB clearing system (including more than 150 foreign banks) with access to the largest offshore pool of RMB funds, located in Hong Kong. Using RMB for Foreign Direct Investment into China As yet another recent example of the internationalization of the RMB, in October 2011 China s Ministry of Commerce (MOFCOM) published new guidelines allowing foreign direct investment (FDI) to be made in offshore RMB, provided that the FDI satisfies existing MOFCOM and SAFE procedural requirements and approvals (which typically are readily obtainable except for FDI in certain restricted or prohibited categories). The new guidelines added RMB to the list of approved currencies, including the US dollar and Hong Kong dollar, that can be used for capital account investments into China. Foreign companies remain prohibited from using offshore RMB to invest in onshore stocks or other securities or from extending loans to onshore companies (except with prior SAFE and PBOC approvals). These new MOFCOM guidelines allowing RMB denominated FDI are another meaningful step towards an open capital account and recognition of the efficiency in allowing investors access to their ever growing pool of offshore RMB to make their investments in China. Conclusion Many have questioned whether it is truly feasible to attempt the internationalization of a currency before it is fully convertible for all capital account transactions. A recent BIS study lends support to the Chinese approach, finding that for emerging market economies that are interested in seeing a larger share of their international balance sheets denominated in their own currencies, offshore markets can help increase the recognition and acceptance of the currency among exporters, importers, investors and borrowers outside the country. This process can begin (but not end) while substantial capital controls are still in place, allowing the authorities to retain a measure of control over the pace of capital account liberalisation. Of course, full internationalization of the RMB will require an open capital account. The BIS study acknowledges that when this happens, a fully developed offshore RMB market will pose some risks to monetary and financial stability in the domestic Chinese economy (such as more difficulty controlling domestic interest rates and credit levels), but concludes that these issues can be managed. There is little doubt that with the growing size of the Chinese economy and the importance of China in international trade and finance, the RMB will eventually become an international currency, and even a reserve currency. The only question is how and how quickly this will all happen. China and Hong Kong are clearly determined that this happen sooner rather than later.

12 About the Authors Howard Chao Asia Practice Chair, O Melveny & Myers LLP Hong Kong and Silicon Valley offices Howard Chao is the partner in charge of O Melveny & Myers LLP s Asia Practice. He was responsible for establishing O Melveny s market-leading practice in China, and was stationed in the firm s Shanghai office for many years. During his three decades with the firm he has been engaged in a wide range of transactional matters, with an emphasis on cross-border and Asia matters for financial institutions, investors, and multinational corporations. Howard is a recognized authority on doing business in China. In 2009, Chambers and Partners named him the sole occupant of its top tier of lawyers engaged in deals in Asia, and awarded him its prestigious award for Outstanding Contributions to the Legal Profession for establishing a gold standard in Chinese cross-border transactions. Howard received a J.D. from the University of California, Berkeley, and a B.S. in Mathematics from Purdue University. Andrew Hutton Senior Counsel, O Melveny & Myers LLP Singapore office Andrew Hutton leads O'Melveny & Myers LLP s Asia Debt Capital Markets Practice. He represents both underwriters and corporate issuers in debt and equity offerings, including highyield, convertible and straight corporate debt offerings, initial public offerings, secondary and follow-on equity offerings and listings of American Depositary Receipts and Global Depositary Receipts in SEC registered transactions, Rule 144A, and Regulation S offerings. Andrew's practice also includes representing issuers, underwriters and purchasers in RMB denominated bond offerings. His clients have included major investment banks, public company issuers, and other multi-national corporations and funds. He also has represented a variety of Indonesian, PRC, Hong Kong, Japanese, Singaporean, and Indian private issuers, as well as emerging and growth ventures, in financing and general commercial matters. Prior to joining O Melveny, Andrew practiced at international law firms in Singapore, Hong Kong, and the United States. He also served as general counsel of a NASDAQ-listed resort development company.