CNH Market Guide Vol. 2

Transcription

1 17 September 2012 Globalising the Franchise How did the offshore renminbi (CNH) market come to wield such influence on the onshore foreign exchange (FX) market? Since May 2012, USD/CNY trading onshore has consistently pulled away from the People s Bank of China s (PBOC) daily fixing rate towards the direction of the offshore deliverable USD/CNH. How did the CNH bond market turn from a seller s market to a buyer s market recently? As investors expectations switch from FX to bond gains, issuers have aligned coupons to onshore yields. Higher yields in turn have boosted investors appetite for longer tenors. The market now offers bonds up to 20-year maturity. A confluence of factors FX and monetary policy reforms, market deregulation, private sector initiatives, and global politico-economic events brought about a spectacular transformation of the CNH market in its first five years. Trading Strategy Woon Khien Chia Woonkhien.chia@rbs.com Chiranjiv Sawhney Chiranjiv.sawhney@rbs.com Debt Capital Markets Augusto King Augusto.king@rbs.com Zoie Teng Zoie.teng@rbs.com How will the next five years look? The next phase will be a steeper climb as China attempts to globalise its offshore CNH franchise before it can reach the final goal of becoming a world reserve currency. This guide is a sequel to the CNH Market Guide A precursor to internationalisation of the Chinese renminbi, which was first published in March It addresses the various facets of a market that still stands the chance of becoming the world s next reserve currency; with a focus on the FX, interest rate and bond markets. This guide provides a review of the developments in the first five years of the CNY internationalisation. It contains details of regulations, products types, market depth and market participants. It also contains analysis of how reforms have influenced market trends that have led to the convergence between the onshore and offshore FX, interest rate and bond markets.

2 Content The Roadmap... 4 The first five years... 5 Market size... 5 Market liquidity... 8 Market depth... 9 PBOC s CNY swap lines Onshore market access Offshore-onshore market convergence The next five years Becoming fully convertible Internationalising the CNY FX Market Evolution of the market Spot Forwards Cross currency swaps Options and futures Interest Rate Market Evolution of the market Money market Interest rate swaps Sovereign benchmark curve Repo market Bond Market Evolution of the market Issuer Base Types of issuers Motivations and objectives Issuance outlook Investor base Types of investors Investor outlook Documentation requirements Listing practice Reg S is the current norm Governing law Repatriation rules MOFCOM vs SAFE routes Other RMB schemes Onshore-offshore convergence Globalising the Franchise Building on Asia s strengths Global vs regional hubs Singapore as second CNY clearing centre Hong Kong-London partnership Self-service centres in Taipei, Tokyo, Sydney Shanghai as the ultimate global CNY pricing centre Multilateral platforms Appendix A Chronology of Regulatory Changes and Events Appendix B Cross-border Payments on Current Account Appendix C List of Abbreviations Page 2/68

3 Appendix D List of Government Agencies Page 3/68

4 The Roadmap Five years after embarking on internationalising the Chinese Yuan (CNY), it is clear that the Chinese government now has a full roadmap for realising it plans. Deliverable CNY is now commonly referred to as CNH. The first CNH bond was issued in Hong Kong, receiving mixed responses from market participants. Some saw this as an experiment by the Chinese government to gauge market acceptance of the CNY. A common area of concern was the huge price premium of the so-called dim sum bonds on onshore bonds. At that time, yields were benchmarked against the USD/CNY non-deliverable forward (NDF) market. The NDF curve reflected market expectations for the CNY, which was very strong then. The curve translated into CNY interest rate levels that were well below both the USD and onshore CNY interest rates. Proving sceptics wrong, the Chinese government has opened up the market at a rapid pace in a sequence resembling a roadmap (see Figure 1): : Made CNY deliverable Launched CNH bonds; signed swap lines with selected central banks : Expanded CNH liquidity pool Launched trade settlement scheme; liberalised bond issuance rules; launched CNH interbank market 2011: Looped back to onshore Launched CNH equities; CNY inward investment flows allowed 2012: Go global Partnering Hong Kong and London; setting up second CNY clearing centre in Singapore; setting up dedicated lines for other key markets Figure 1: Roadmap to internationalisation of the RMB Source: RBS Page 4/68

5 Growing liquidity pool, deepening the markets, expanding the geographical reach The first five years The first five years of the CNH market focused mainly on growing the liquidity pool in Hong Kong, and deepening the FX and bond markets. It was only in 2011 that the focus switched to expanding the market outside of Hong Kong starting within Asia, notably Singapore and Japan, and more recently further afield to London. The market has grown multi-fold since its launch in 2007, measured in deposits, trade settlement volume and bond issuance (see Figures 2 and 3). Market size CNY deposits in Hong Kong have grown ten-fold since late With resident deposits at CNY558 trillion (USD88 billion) as of June 2012, deposits account for 8.8% of Hong Kong banks total deposit base or 17.5% of their foreign currency deposit base. However, these account for a mere 0.6% of China s total deposits. There are four basic channels through which CNY cash can flow from onshore into Hong Kong banks: Hong Kong residents conversion of HKD to CNY, subject to a CNY20,000 daily limit. Banks clear the HKD/CNY exchange under a special clearing agreement set up in On 25 Jul 2012, non-hong Kong residents are allowed to open CNY account in Hong Kong with unlimited limit. However, banks are not allowed to clear their HKD/CNY transactions through this special clearing agreement, the Shanghai conversion window or the cross-border remittance channels. Effectively, the non-hong Kong resident accounts would not contribute to the build-up of CNY liquidity offshore. Exports to China settled in CNY. This is subject to an aggregate clearing limit of +/-CNY8 billion at the Bank of China (Hong Kong) Limited for the net total of exports and imports. Over the past two years, the flows between exports and imports have also become more balanced from an earlier 3:1 ratio between Chinese imports and exports (see Figure 4). Chinese corporates outward direct investments. This is subject to individual quotas. Chinese tourists overseas spending. Since the launch of the Individual Visit Scheme in 2003 by the Hong Kong SAR government, which enabled residents of 49 cities in China to visit Hong Kong in their individual capacity, tourists from the mainland have soared 45% on a compounded annual basis from (see Figure 5). There has also been a rapid build-up of CNY deposits in other offshore centres but these remained much smaller than in Hong Kong. This is because these other centres started later than Hong Kong, and had no support of a direct central clearing line with China. In Singapore, CNY non-bank deposits with Singapore banks have reached CNY60 billion as at June 2012; and in London, these deposits reached CNY35 billion as at end Page 5/68

6 The CNY trade settlement scheme in Hong Kong has grown at an even faster pace than deposits after the last regulatory hurdles were removed for Chinese exporters earlier this year (Figure 6 shows the phases of expansion for this scheme). In the 12 months leading up to June 2012, trade settlement volume reached CNY2.32 trillion (USD365 billion). This figure already exceeded 1.2 times of the China-Hong Kong bilateral trade, suggesting that third parties outside of Hong Kong have begun settling their trade with China in CNY via Hong Kong banks. On the other hand, the figure is barely 10% of China s total external trade, suggesting there is still plenty of scope for China to drive the use of CNY for settling its trade with its huge base of foreign trade partners. CNY-denominated bond issuance appears to grow relatively slower but it was still a five-fold increase since The outstanding stock of corporate bonds, certificate of deposits and bonds issued by China s Ministry of Finance (MOF) currently stands at CNY343 billion (USD55 billion). This is already 55% of Hong Kong s total HKD-denominated private sector bond market. The bulk of the CNH issuance is dominated by financial institution issuance, concentrated mostly in tenors three-years and below. Figure 2: CNY-denominated deposits, trade settlement and bonds in Hong Kong (CNY trn) Source: Bloomberg, CEIC Figure 3: CNY-denominated deposits, trade settlement and bonds in Hong Kong as % of Hong Kong s total Source: Bloomberg, CEIC Page 6/68

7 Figure 4: Export vs import with China under RMB trade settlement scheme (CNY bn) Source: Bloomberg, CEIC Figure 5: Chinese tourist arrivals in Hong Kong (mn) Source: Hong Kong Tourism Board Page 7/68

8 Figure 6: Expansion phases of RMB cross-border trade settlement Source: PBOC Market liquidity Liquidity strained by opening of investment avenues back into China To a large extent, the liquidity situation of the CNH market is demand-driven. The demand for CNY liquidity is in turn driven by the relative strength of the CNY against USD and other foreign currencies. The measure of the offshore CNY liquidity pool should be the same as the measure of monetary aggregates. The broad liquidity pool should thus comprise of both non-bank deposits and bonds. As such, the drop in deposits in Hong Kong banks from December 2011 to May 2012 did not reflect a shrinking CNH liquidity pool in Hong Kong as bond issuance continued to rise (see Figures 2 and 3 again). Still, the pace of liquidity growth has slowed since fourth quarter There are three factors behind this: An increase in CNY trade settlement volume for importing Chinese goods since the lifting of restrictions on Chinese exporters to settle in CNY An increase in Hong Kong settlement banks investments into the onshore bond market as more of them get special quotas from PBOC to do so An outflow of non-hong Kong resident CNY deposits to other offshore centres begin to compete for these deposits In response to the third point above, the Hong Kong Monetary Authority (HKMA) has liberalised previously punitive rules on Hong Kong banks risk limits for CNH from the beginning of More recently, the HKMA also allowed non-residents to set up CNY Page 8/68

9 deposit accounts in Hong Kong with no daily conversion limits. See Figure 7 for a list of rule changes by the HKMA since the start of Figure 7: HKMA regulatory changes to improve RMB liquidity Allow non-residents to convert unlimited daily amount of RMB AIs* can offer RMB services to non-hong Kong resident personal customers, and currency conversion is not subject to corresponding limits for Hong Kong residents (25 Jul 2012) Replace RMB limit with RMB liquidity ratio to include more RMB liquid assets AIs are required to maintain a RMB liquidity at no less than 25% computed on the same basis as statutory liquidity ratio. This update increases flexibility for the inclusion of more RMB liquid assets, and accuracy of matching RMB liquid assets and short-term liabilities (14 June 2012) Introduce a facility to provide RMB liquidity to AIs participating in HK RMB business The facility uses the currency swap arrangement between the HKMA and the People s Bank of China. This facility increases short-term RMB liquidity, reduces potential market disruptions and increases market confidence (14 June 2012) To enable AIs to better assess their RMB needs, the HKMA moved back the time by which AIs may submit their requests for funds from 10am to 1.30pm (25 Jul 2012) Replace RMB Net Open Position (NOP) standard with AIs self-determined mechanism The 20% standard RMB NOP is replaced by a mechanism whereby AIs are allowed to set up their own internal RMB NOP in consultation with the HKMA. AIs should consider the nature and scale of their RMB business. This measure could further increase RMB liquidity and recognise AIs effective RMB exchange and liquidity management practices (22 May 2012) Require AIs to ascertain the genuineness of underlying cross-border merchandise trade transactions This includes know-your-customer (KYC) processes, due diligence procedures. and reviewing supporting documents from clients ( 2 April 2012) * Authorised Institutions or banks in Hong Kong. Source: HKMA, Bloomberg Market depth CNH FX trading volume now on par with NDF market The launch of the interbank market in October 2010 provided a huge boost to trading volumes of FX spot and forward market. The introduction of the FX option market which followed then gradually led to the innovation of structured products. Figure 8 shows the types of FX and rates products, the maturity range and turnover volume for each product type. USD/CNH spot and forward daily turnover is now USD5-6 billion, broadly on par with the USD/CNY NDF market which started to see some slight slowdown in trading volume since Page 9/68

10 The USD/CNY cross currency swap curve is available up to a 10-year tenor but it is only liquid up to a three-year tenor at the moment. USD/CNH options are also available up to a two-year tenor. In the bond market, the maturity has stretched to a 20-year tenor by a Chinese policy bank in July In early 2012, a 15-year tenor was tapped by two Chinese policy banks and China s MOF with their respective inaugural 15-year issues. The most traded part of the curve remains in three-year tenor and below. Page 10/68

11 Figure 8: Range of CNH financial products Product Tenors Turnover Remarks Spot T+2 value spot USD1-2bn Forward O/N - 12m, 18m, 24m USD2-3bn CCS 6m 5y USD300mn FX Options 1m 2y USD70-120mn Illiquid relative to other FX products Better liquidity in shorter tenors FX Futures 1m 1y n.a. To begin trading from 17 September Money Market O/N to 1y CNY2-4bn Repo n.a. n.a. Tripartite platform operated by Euroclear, JP Morgan and HKMA CDs/Notes 3m to 3y n.a Equities n.a. n.a. First and only IPO in April 2011 Structured Products Bonds Up to 3y Sovereign up to 15y; FIs/ corporates up to 20y n.a. Mutual Funds n.a. n.a. Source: RBS CNY50mn PBOC s CNY swap lines The biggest use of the swap lines so far is from foreign central banks diversifying reserves into CNY Since signing the first CNY swap line in December 2008, the PBOC has signed a total of 19 such lines with foreign central banks. Four of these lines have been renewed before expiry in 2012 while another three have expired. All the lines cover a three-year period. The four renewed lines had the quotas increased by at least double from the original amounts for a three-year extension. These swap lines serve multiple purposes which evolved with the expansion of the CNH market. Standby credit facility: When the first line was offered to the Bank of Korea (BOK), the purpose was to provide a standby credit facility for the BOK with no conditions attached, unlike the facilities offered by the IMF, multilateral agencies or the Fed during the height of the Lehman crisis. CNY trade settlement scheme: The lines that came after the CNY trade settlement scheme was expanded in 2009,were aimed at promoting the use of CNY in bilateral trade and investments between China and these countries. CNY as reserve currency: A year later in August 2010, the PBOC started allowing recipient central banks to partially activate these swap lines for them to obtain CNY to invest in China s domestic bond market. This move was designed to promote the holding of CNY in the foreign reserves of other central banks. Since then, several Page 11/68

12 central banks have partially converted their CNY swap lines into investment quotas from the PBOC. Otherwise, these swap lines have never been activated to support any credit event. The total sum of the current 16 CNY swap lines comes to CNY1.67 trillion (USD265 billion). Figure 9 shows the list of recipient central banks and the size of their respective lines and each country s market share of China s total trade. Relative to external trade: The total bilateral trade of the 16 recipient countries with China account for 37% of China s total external trade. The swap quota given to each central bank is not proportionate to the country s relative market share of China s trade. This proved the point that these lines are designed to more than just promote the CNY trade settlement scheme. Relative to foreign reserves: Nearly three quarter of the lines went to reservesrich Asian central banks, which proved the point on promoting the CNY as a reserve currency. On the flip side, the lines also promoted the PBOC s own reserve diversification objective by swapping CNY for the local currencies of these foreign central banks, which could then be invested in the government bonds of the latter group. In this regard, the total swap lines currently account for no more than 9% of China s USD3.2 trillion foreign reserves, suggesting that there is plenty of scope for further expansion. Figure 9: PBOC's CNY swap lines Date of swap line agreement Size of swap line (CNY bn) Bilateral trade as % of China's total trade Korea* 12 December Hong Kong* 20 January Malaysia* 8 February Belarus 11 March Indonesia 23 March Argentina 2 April Mongolia* 6 May Iceland 9 June Singapore 23 July New Zealand 18 April Uzbekistan 19 Apr Kazakhstan 13 June Korea* 26 October Hong Kong* 22 November Thailand 22 December Page 12/68

13 Pakistan 23 December UAE 18 January Malaysia* 8 February Turkey 21 February Mongolia* 21 March Australia 22 March Brazil 22 June Ukraine 26 June Taiwan 31 August 202 to be determined 4.4 Aggregate *Lines renewed. Source: IMF, CEIC, Bloomberg, Reuters Onshore market access Current account fully open/ convertible, capital account still partially convertible Ultimately, the CNH market should be seen as a conduit into the onshore market. Otherwise, the market would never take off, proving the sceptics right that the experiment at making the CNY partially deliverable/ convertible would end nowhere. And the sceptics were proven wrong so far. The rapid deregulation of cross-border trade and investments has now made the CNY fully convertible on current accounts. The bulk of the capital account is partially convertible, guarded by quotas and/or application procedures. Figure 10 distinguishes the currency denomination USD/ foreign currency, offshore deliverable CNH or onshore CNY in which the different current and capital account items are allowed to be settled. We briefly described them below. On current accounts (more details can be found in the Appendix): Merchandise goods: All goods trades can be settled using the onshore CNY exchange rate. Chinese exporters also have the choice to exchange their foreign currency export proceeds in the offshore CNH market before repatriating funds. However, Chinese importers can only use the onshore exchange rate for making payments to offshore counterparties. Services, interest income and transfers: Transactions settled in CNY can only be dealt using the offshore CNH exchange rate. This implies that to settle CNYdenominated payments, onshore Chinese entities must remit foreign currency offshore to exchange into CNH for the payments. On capital accounts: Foreign direct investments: CNY funding is allowed both ways. Inward direct investments are funded through the offshore CNH market, while outward direct investments are funded through the onshore CNY market. Page 13/68

14 Portfolio investments: CNY funding is allowed only one way, by foreign investors through the Renminbi Qualified Foreign Institutional Investor (RQFII) scheme which was introduced in August This is a counterpart of the QFII scheme and mini QFII scheme which allowed foreign portfolio investments to enter China in foreign currency denomination. The difference between the regular QFII and mini QFII is that the latter is open specifically for onshore fund managers to directly tap retail investors overseas. The reverse scheme Qualified Domestic Institutional Investors (QDII) which allows onshore institutions to invest overseas does not have the equivalent CNY counterpart. Loans, trade finance and deposits: Onshore corporations were permitted in June 2010 to borrow CNH from the offshore market for longer-term trade finance and project financing. They are only allowed to extend trade credit in CNY terms for periods of 90 days or less. Special access: This pipeline is open to central banks, sovereign wealth funds and CNY trade settlement banks in Hong Kong to invest directly in the onshore interbank bond market. All the quotas are set by the PBOC on a case-by-case basis. In the central banks case, the quotas are activated from the CNY swap lines offered by the PBOC and hence, only the central banks which have signed such lines are eligible. As at end 2011, a total CNY255 billion of such quotas has been allocated through this pipeline, of which CNY185 billion went to the first two groups, including CNY65 billion to Japan alone. Figure 10: Level of openness of China s borders *Long-term (LT) trade credit refers to above 90d term. Short-term refers to 90d term and below. Source: RBS Goods Current Account Capital Account Offshore Onshore Offshore Onshore USD CNH CNY Goods Foreign Direct Investment Overseas Direct Investment Services, Interest Income, Transfers Services, Interest Income, Transfers Portfolio Investment (QFII, mini QFII) (QDII) (RQFII) Portfolio Investment Loans, LT Trade Credit* (foreign debt quota) (foreign debt quota) Loans, LT Trade Credit* Short-term Trade Credit* Short-term Trade Credit* Foreign currency deposits (foreign debt quota) Foreign currency deposits Trade settlement banks, foreign CBs, SWFs (CNY sw ap line & special quotas) PBOC Page 14/68

15 Recent deregulation on investments favoured domestic bonds The pace of deregulation accelerated from August 2011 when China and the United Kingdom jointly announced that the setup of London as a global offshore RMB centre. In the following 12 months, the deregulation concentrated mainly on inward investments rather than outward investments. Total QFII quotas were increased from USD30 billion to USD80 billion in April Approval time was also cut, leading to a rapid increase in the number of QFII licences and their total quotas (see Figure 11). On 27 July 2012, the PBOC announced the easing of application rules for QFII, such as the opening of multiple securities accounts with different securities companies and direct investments in the interbank bond market from which they were previously barred, being restricted investing in the exchanges. The recent deregulation drive thus clearly favoured the promotion of the domestic bond market. RQFII licences come attached with the condition of a minimum 80% of the quota to be allocated to bonds. Total RQFII quotas are set at CNY70 billion. Total applications approved currently stand at CNY32 billion (USD5 billion). Meanwhile, total QDII quotas currently stand at USD83 billion, nearly four times the total QDII quotas in January 2007 after the scheme was introduced in April 2006 (Figure 12). Figure 11: QFII aggregate quotas (USD bn) and number of licences Source: CEIC Figure 12: QFII aggregate quotas vs QDII aggregate quotas (USD bn) Source: CEIC Page 15/68

16 Key deregulations on investments in the past year Following are the key regulatory changes affecting onshore market access made since August 2011 (a full history and details of regulatory changes can be found in the Appendix): August 2011 The PBOC launched Renminbi QFII and pilot scheme for foreign banks to tap CNH to recapitalise mainland operations. Onshore non-fis / corporates were allowed to issue CNH bonds subject to quotas. December 2011 The Chinese government launched the RMB Qualified Foreign Institutional Investors (RQFII) scheme on a trial basis for foreign investors to enter the onshore market. An initial target of CNY20 billion was set for the quotas to be awarded under the scheme. A minimum 80% floor was set for the funds to be invested in bonds. January 2011 Ten investment firms in Hong Kong were granted RQFII licences to invest in China s securities market with a total CNY10.7 billion of quotas. The firms planned to develop RMB wealth management products onshore. April 2012 China announced the expansion of USD50 billion investment quota to both the Qualified Foreign Institutional Investors (QFII) and the Renminbi QFII (RQFII) pilot programmes. This brought the total quota to USD80 billion from USD30 billion for the QFII, and to CNY70 billion from CNY20 billion for RQFII. It will also allow the pilot institutions to use the quota in issuing RMB A-share ETF product, to invest in the A-share index shares and list them in the Hong Kong Exchange (HKEx). July 2012 China and Singapore jointly announced that a second offshore CNY clearing centre will be set up in Singapore, to be operated by the full branch of a Chinese bank in Singapore. This agreement is part of a China-Singapore Free Trade Agreement (FTA) signed on 6 July July 2012 China released new rules for foreign investors, lowering minimum qualification requirement and simplifying the approval process for applicants under the Qualified Foreign Institutional Investor (QFII) programme. The changes allowed QFIIs to invest in China s interbank bond market. The new rules also allowed foreign private equity investment entities to apply for QFII licenses Offshore-onshore market convergence Offshore CNH FX has become leader for NDF and even onshore CNY FX market The wave of rapid regulatory changes from late 2011 paved the way for the convergence between the offshore and onshore markets. In the initial one to two years of its existence until late 2011, the USD/CNH FX market was directionally driven by USD/CNY NDF to the extent that some market participants started mulling over the idea of introducing a NDF version of the CNH market. Since late 2011, the pull of forces has reversed. The NDF market is now driven by the CNH market such that it behaves like a semi-deliverable market with the forward curve tilting upwards to reflect the positive interest rate premium of CNY interest rates over USD rates. Since April 2012, just prior to the PBOC expanding the intra-day trading band, the onshore USD/CNY market has also started to follow the offshore USD/CNH Page 16/68

17 market, deviating from the direction set by the PBOC every morning through its fixing (Figure 13). With the convergence in the FX markets, the bond markets onshore and offshore also began to converge. The yield discount of the offshore issues to the onshore issues is now found mainly in the shorter-dated bonds of three-year tenor and below, and has compressed to no more than 50 basis points (see Figure 14). The pressure for the yield convergence is also coming from the subtle shift in FX policy direction by the PBOC from a strong and stable CNY to a weaker and more volatile CNY. Investors expectations on returns from the CNH bond market have thus shifted from FX gains to yield and/or bond gains. Figure 13: Offshore USD/CNH spot vs onshore USD/CNY spot Source: Bloomberg Figure 14: Offshore China MOF 3y bond vs onshore MOF 3y bond (%) Source: Bloomberg The next five years Becoming fully convertible Partial convertibility at best leads to partial internationalisation Taking a very long perspective, the CNY is just two steps short of becoming fully convertible and three steps away from becoming an international currency. The steps are: 1. Allow all capital account items to be settled freely in CNY both ways inwards and outward of China. 2. Lift all quotas and streamline application and approval processes. 3. Increase the use of CNY for international trade and investments. This is a simplification as the last giant step involves multiple facets. The qualifications of an international currency are much broader than this one-line description (see next section). Logically, one would expect China to make the CNY fully convertible before embarking on the ultimate goal of internationalising the CNY. But China has put the proverbial horse before the cart by creating an offshore CNY market to promote the Page 17/68

18 use of the CNY in international trade and investments before the currency is fully convertible. Inclusion in IMF SDR basket will be a strong endorsement China s actions seem to suggest some degree of time consideration to achieve the goal of internationalising the CNY. The government appears to have its sight for the CNY to be included in the IMF s Special Drawing Rights (SDR) basket by the end of 2015 when the IMF reviews its basket. The current global climate favours the CNY as both the USD and EUR are under pressure and global investors are looking for an alternative reserve currency. In working towards this goal, the Shanghai municipal government released a blueprint in March 2012, setting goals of making Shanghai the global pricing centre for both onshore and offshore CNY financial products by 2015, and a global financial centre by In the next few years, we can thus expect to see more of the following: Expansion of the trade settlement scheme: Trade in goods and services is the smoothest or most consistent way to grow the global CNY liquidity pool, considering especially China s status as one of the world s largest trade partner. Setting up of more direct clearing lines: This will be targeted at strategic trade partners. Jointly with China, Singapore has announced that it will set up an offshore CNY clearing centre, while Taiwan and Japan are believed to be in negotiations with China for their own dedicated clearing lines. Joint ventures with international financial centres: London was announced as the global offshore CNY centre and this is in partnership with Hong Kong. Getting the second CNY clearing line will make Singapore a regional satellite centre. Getting Hong Kong to partner with London may thus be China s assurance to Hong Kong that it retains the lead as the main offshore CNH centre above Singapore and London. In the background, Shanghai is preparing to become the global pricing centre for all CNY financial products onshore and offshore by 2015, as spelt out in its blueprint which names Hong Kong as a partner in achieving this goal. Can Shanghai achieve this goal without the CNY becoming fully convertible? Internationalising the CNY BIS s seven criteria to qualify as an international currency There are many shades of the definition of an international currency. A short definition is a currency that is widely held as a reserve currency. The US dollar and the euro fit this definition as they currently account for 62.2% and 24.9% of world foreign reserves (see Figure 15). By far the most concise definition of an international currency are the following seven criteria 1 : 1. Freely traded: Removal of all restrictions on trading the currency 2. International trade invoicing: Ability for both foreign and domestic firms to invoice trades in the currency 3. Readily accessible: Ability of domestic and foreign institutions to hold currency in amounts they deem fit 1 Peter Kenen, Princeton University, Currency internationalisation: an overview, BIS Papers No. 61, December 2011 Page 18/68

19 4. Used for securitisation by private sector: Both domestic and foreign institutions are able to issue marketable securities in the currency 5. Used for securitisation by multilateral agencies: International financial institutions such as the World Bank are able to issue debt instruments in the country s market and use the currency in their financial operations 6. Reserve currency: Currency may be included in currency baskets of other countries 7. International confidence in the issuing country CNY currently ranks as 15 th most used payments currency globally Based on the above criteria, only the USD and the EUR are fit to be called an international currency while none of the other G7 currencies could. The key criterion which most currencies are unable to fulfil is that on international trade invoicing. The CNY currently falls short of more than half the criteria above. The CNY currently ranks 15 th as a payments currency globally with a market share of 0.45%. To be part of the top five payments currencies, the CNY market share has to reach at least 2%. EUR and USD s market shares are 43% and 31% respectively. Hence, the ultimate goal to become an international reserve currency is still a giant step away. USD took 30 years to be accepted as international currency through economics and politics EUR took less than 10 years through economic union The USD took about 30 years to achieve the status of an international currency from the end of the World War II in the mid-1940s to the early 1970s. The collapse of the Bretton Woods Agreement saw central banks around the world switch from holding gold reserves to holding USD as their reserve currency. In 1975 when OPEC accepted USD as the sole pricing and settlement currency for oil, this propelled the USD to become the currency denomination for all other major commodities, sealing its status as a world reserve currency. The EUR was introduced in With the combined strength of its 12 founding members, its share of world reserves was set at 18% from the start. As the Euro zone expanded, its share of world reserves has grown, reaching about 28% by third quarter The EUR s ascent as an international currency was also bolstered during this period by the bursting of the dot.com bubble and the September 11 terrorist attacks on the US which shook international confidence in the US economy and the dollar. The last chapter of this guide discusses the chances for China achieving the international currency status for the CNY. The conclusion is that current efforts to globalising the offshore CNH market franchise will lead at best to partial internationalisation without full convertibility. Page 19/68

20 Figure 15: Distribution of world foreign reserves (%) Source: IMF Page 20/68

21 FX Market Evolution of the market CNH FX market is now driven by corporate flows The CNH FX market officially came into existence in July 2010 when the PBOC and the HKMA signed a Supplementary Memorandum of Cooperation that allows Hong Kong banks to directly settle CNY trades among each other. This led to the creation of the CNH interbank market. In its brief history, the market evolved from one that is purely driven by regulations to one that is increasingly driven by flows from foreign multinational corporations (MNCs) and Chinese corporations. There were major regulatory changes by both the PBOC and HKMA to directly deepen the FX market. Expanding the central clearing line: The CNH FX market had a rather turbulent first two years, caused primarily by the tight cap imposed on the Bank of China (Hong Kong) Limited for centrally clearing any long/short CNY positions offshore. Also, the build-up of liquidity through the trade channel was not fast enough to cope with a rapidly growing demand from bond investors. The central clearing limit was breached twice the first time on 28 October 2010 from the short side and the second time on 23 September 2011 from the long side. Both times caused huge dislocations between the CNH and onshore markets. In the first episode, the HKMA stepped in to assure the market that it was standing by to activate its CNY swap line with PBOC. In the second episode, the PBOC eventually had to temporarily double the quota. A second central clearing line is on the way to be set up in Singapore, as announced in July Introducing a daily USD/CNH spot fixing: The introduction of a daily USD/CNH spot fixing at 11.15am by the Hong Kong Treasury Markets Association (TMA) in June 2011 was an important turning point. This was a boost to the FX derivative and option markets as the fixing provides transparency and also a pricing source for switching to USD settlement in the event of any market disruption that renders the CNH non-deliverable. This was formalised in October 2011 by a working group of banks and the International Swaps and Derivatives Association (ISDA) to include a standard fall-back clause for CNH FX OTC products. However, other products including CNH bonds have yet to standardise the choice of FX fixing and/ or the adoption of a market disruption clause. Increasing Hong Kong banks risk limits: In January 2012, the HKMA increased banks CNY net open positions from the 10% cap imposed since July 2011 to 20%. In May 2012, the cap was lifted. Banks statutory liquidity requirement on CNY deposits was also liberalised twice, in February and June Widening the onshore intra-day trading band: In April 2012, the PBOC widened the intra-day trading band on USD/CNY spot from +/-0.5% to +/-1% and lifted the short-selling ban on USD by onshore banks. This easing of FX rules onshore further Page 21/68

22 deepened the offshore market as it broadened the scope for Chinese companies to arbitrage between the two markets. Other deregulation steps which indirectly helped boost the FX market trading volume included those which opened up the inward investment routes into China, and the lifting of restrictions for Chinese exporters to settle in CNY. On 27 April 2012, the HKMA extended the real time gross settlement (RTGS) system by an additional five hours to close at 11.30pm. The aim is to facilitate the settling of trades as a step to help deepen the market in London. However, the extended RTGS hours may have limited use as banks are still unable to access their fiduciary accounts at the PBOC Shenzhen branch whose hours have not been extended. The fiduciary account channel was set up in early 2011after the first breach on the central clearing cap in October 2011 so as to reduce banks counterparty risks with the sole central clearing bank, BOC (Hong Kong) Limited. Clearly, banks would favour the PBOC counterparty risk to the BOC risk. Figure 16: Types of FX markets in the offshore deliverable, offshore non-deliverable forward and onshore deliverable markets Offshore CNH Offshore NDF Onshore CNY Fx Spot Tenors T+2 value spot n.a. T+2 value spot Daily volume (USD bn) 1-2 n.a. 20 Ticket size (USD mn) 5-15 n.a Bloomberg/ Reuters CNH TMAF/ CNHFIX= n.a. CNY/ CNY=CFXS FX forward Tenors O/N - 12m, 18m, 24m T/N - 12m O/N - 12m, 24m, 36m Daily volume (USD bn) Ticket size (USD mn) Bloomberg/ Reuters CNH+1M/ CNH1MOR= CCN+1M/ CNY1MNDFOR= CCO+1M / CNY1MOR= Cross currency swap Tenors 6m - 5y 1y - 5y 1y - 5y Daily volume (USD mn) inactive Ticket size (USD mn) inactive Bloomberg/ Reuters CGUSSW2 / CNHUSCS=TRHK CCSWN2 / CNUSNDS2Y= CGYSSW2 / CNUSCS FX option Tenors O/N-2y O/N-3y O/N-2y Daily volume (USD mn) Illiquid Ticket size (USD mn) n.a. Bloomberg/ Reuters USDCNHV1Y / CNH1Y0=BRKR USDCNYV1Y / CNY1YO=W USDCNYOV1Y / CNY1YO=CN FX futures 1m-1y (CNYUSD) 1m-1y (to start on 17 Sep 12) Tenors 1m-3y (USDCNY) n.a. Daily volume n.a. Illiquid n.a. Ticket size (USD mn) n.a. 0.1mn per contract n.a. Bloomberg/ Reuters n.a. n.a. n.a. Source: Bloomberg, RBS Page 22/68

23 Spot Market vs fixings Spot market liquidity has picked up significantly since its inception. Daily volumes for CNH spot are now about USD2 billion, more than a ten-fold increase from inception. In comparison, the onshore CNY daily trading volume is about USD10 billion. The average transaction size is around USD10 million (see Figure 16). Offshore CNH and onshore CNY spot rates have converged although the two fixings continue to diverge The direction of USD/CNH is ultimately set by the PBOC s FX policy through its daily fixing. However, there are still long stretches of deviations from the onshore market for which the comparison can be made in terms of two spot fixings and the real-time trading. Prior to the recent deregulations which allowed more two-way flow of funds for trade and investments, the deviations between USD/CNH and the onshore market were in both the fixings and real-time trading (Figure 17). Since May 2012, the deviations in the fixings on both sides continue to deviate. However, real-time spot trading of the two markets has converged (Figure 18). This has come about with the onshore realtime spot rate converging to the offshore deliverable CNH rate rather than its own onshore fixing set by the PBOC. In other words, the CNH market has taken the lead over the onshore market. One can say that the PBOC s widening of the intra-day trading band in April 2012 from +/-0.5% to +/-1% marked the turning point for market convergence between offshore and onshore. At about the time of the PBOC s move, the country s top leaders and the PBOC governor issued statements on allowing the CNY to be more freely trading so as to see more two-way fluctuations on the basis that the currency is fair-valued and the country s exports have come under pressure. This seems like a subtle message for a switch from a strong FX policy to a neutral or even slightly weak FX policy. The PBOC s fixing for USD/CNY has risen by 0.8% since the band widening. The offshore USD/CNH fixing has risen by 1.1% during the same period. Deliverable CNY/JPY cross now quoted in Tokyo; expect more crosses to follow On 1 June 2012, the Tokyo interbank market started directly quoting the deliverable CNY/JPY cross rate with the PBOC endorsement. As upcoming offshore CNY centres, we believe that London and Singapore will launch more of the deliverable CNY crosses, starting with crosses against their own respective local currency units. Page 23/68

24 Figure 17: USD/CNH fixing vs PBOC USD/CNY fixing and PBOC intra-day band Source: Bloomberg Figure 18: USD/CNH spot vs USD/CNY spot and PBOC intra-day band Source: Bloomberg Forwards Combining spot and forwards, the CNH FX market is broadly on par with the NDF market Market participants are increasingly migrating from NDF to deliverable CNH forwards The daily volume for CNH FX swaps and forwards is estimated at USD3 billion. Tenors are available up to three years, with liquid better in one year and below. CNY NDF daily transaction volume is estimated at USD6.5 billion. Combining spot and forwards, the deliverable CNH FX market is now broadly on par with the NDF market. Onshore, the daily volume of CNY FX swaps and deliverable forwards is estimated at USD10 billion. Combined with spot trading, the total trading volume of the onshore FX market is about USD20 billion (see Figure 19). There is increasing pressure for the onshore market to trade in line with the offshore deliverable market and away from the onshore fixing. Given this, we expect market participants to increasingly migrate to the deliverable CNH market from the NDF market which takes an onshore fixing. In fact, the behaviour of the USD/CNY NDF market has long stopped behaving like a normal NDF market, behaving more like a deliverable market. Well before the PBOC s subtle shift to a weaker FX policy, the NDF curve has moved upwards steeply. It was dragged up by the steepening pressure from the deliverable USD/CNH forward curve (see Figure 20). As a typical NDF market reflects market expectation for the strength or weakness of the currency to USD, USD/CNY NDF had been inverted to reflect market expectation of a strong CNY before the deliverable CNH market became deep and active. Page 24/68

25 Figure 19: USD/CNH 12 mn outright vs USD/CNY NDF 12m outright and onshore USD/CNY 12 mn outright Source: Bloomberg Figure 20: Implied 12 mn CNY appreciation by USD/CNH forward vs USD/CNY NDF and onshore USD/CNY forward Source: Bloomberg Cross currency swaps Cross currency swaps are offered by major interbank players with tenors from six months to five years, although liquidity is poor above three years. The daily turnover is reasonably big at around USD300 million, with an average ticket size of USD10-20 million. Liquidity has been gradually improving as market participants increasingly switch from ND-CCS to the deliverable CCS for hedging trade and investments. For trade, transactions are mainly confined to tenors one-year and below. On the investment channel, the flows currently tend to come from investors paying CNY CCS rather than issuers receiving CNY CCS. However, as the CNY CCS basis becomes less negative (see Figure 21) and the market gets deeper, USD-based issuers might be increasingly attracted to come to the CNH bond market to raise funds and swap them into USD. Page 25/68

26 Figure 21: 1y CNH CCS vs CNY ND-CCS and onshore CNY CCS Source: Bloomberg Figure 22: 3m USD/CNH vol. vs USD/CNY NDF vol (%) Source: Bloomberg Options and futures CNH options now trade up to 2- years Futures to be available from September 2012 Still in a relatively nascent stage of development, the CNH options market is growing at a brisk pace. The first OTC RMB option was traded in November The liquidity has since picked up, averaging around USD million, reaching USD300 million on busier days. Tenors of up to 12 months are fairly liquid (see Figure 22). Two year options are not as liquid but not uncommon. On 22 August 2012, the Hong Kong Exchanges and Clearing Limited announced that it will introduce the first deliverable CNY currency futures on 17 September The USD/CNH contract would be the first deliverable CNY currency future. The final settlement price will be based on the spot USD/CNH fixing published by the Treasury Markets Association at am. The first batch of contract months that will become available are October 2012, November 2012, December 2012, January 2013, March 2013, June 2013 and September Page 26/68

27 Interest Rate Market Evolution of the market Starting a money market, IRS still non-existent Until the end of 2011, the CNH interest rate market comprised only a thinly traded deposit market and a vibrant bond market (see Figure 23). Since January 2012, Hong Kong banks have started to activate a money market by providing a daily fixing on a CNY Hibor curve. There are three reasons which remain today as to why Hong Kong banks struggled to activate an interest rate swap curve in the CNH market: Lack of a policy interest rate target: The PBOC s interest rate policy targets are Chinese banks commercial deposit and lending rates. Hence, the onshore money market of repo and Shibor are driven entirely by liquidity factors, including the PBOC s open market operations (bills, repos and reverse repos), required reserve ratio (RRR) moves and FX fund moves. Given the vastly different liquidity condition in the CNH market from the onshore market, the onshore Shibor is thus highly inappropriate for setting the CNH interest rate swap market. Lack of access to onshore Shibor: As the CNH IRS is a deliverable market similar to the FX market, market makers for the IRS curve would require access to the short-end fixing to be able to manage their interest rate risks. However, there is no access to the onshore Shibor market. Onshore market is highly speculative: There are several different IRS markets onshore, the most heavily traded being that fixed on the seven-day repo rate with a daily turnover of CNY3-4 billion. The Shibor-fixed market is the second most traded market with daily volume barely half of the former. Other IRS curves have fixings on the PBOC s one-year lending and one-year deposit rates, These are used by corporate borrowers on a case-by-case basis. Until recently, the onshore sevenday-fixed and Shibor-fixed IRS market is highly speculative as both borrowers and investors do not use the market for hedging interest rate risks. More recently, corporate bond issuers have begun using the IRS curve to do hedging. PBOC monetary policy overhaul underway For all the above points, it is clear that the offshore market cannot use the onshore money market to start an offshore interest rate swap market. This was the reason why Hong Kong banks have come together to start an interbank CNY Hibor curve in January this year. Meanwhile, the PBOC has started managing interest rate policy changes. OMO becomes two-way with regular reverse repos: Firstly, the PBOC has replaced the use of RRR tool with reverse repurchase operations, regularising the reverse repos in the twice-weekly open market operations (OMO) since the beginning of June Previously, the OMO comprised only repos and the central bank bill auctions while reverse repos were conducted on a discretionary and bilateral basis with banks in need of liquidity. Page 27/68

28 Subtly deregulating commercial lending and deposit rates: Secondly, the PBOC has started to use the interest rate tool more frequently, cutting the policy targets on banks commercial lending and deposit rates twice on 7 June and 5 July 2012 (see Figure 24). These cuts were accompanied by a softening of the hard corridor by allowing banks to give discounts to their lending rates below the policy targets and premiums to their deposits rates above the policy targets. In the last move, the discount on lending rates is allowed up to 30% while the premium on deposit rates is allowed up to 10%. Possible switch in interest rate targets coming up The second move clearly reduced banks protected interest rate profit margin. While intending to make banks more competitive, it is possible that the PBOC is also looking at changing its interest rate policy targets. Specifically, we believe the central bank might introduce a repo and reverse repo corridor target as its interest rate policy and move away from targeting banks commercial lending and deposit rates. The country s top leaders and the central bank governor have openly talked about interest rate reforms at about the same time they have spoken about FX reforms. Hence, a regime shift could be underway which will switch the PBOC s monetary policy from an active quantity-based approach using the RRR tool to a price-based approach using market interest rate tools. If so, this would create a more policy-driven and deeper Shibor market onshore from one that is currently liquidity-driven and often speculative. Figure 23: Types of interest rates markets in the offshore deliverable, offshore non-deliverable forward and onshore deliverable markets Offshore CNH NDF Onshore CNY Interbank borrowing Tenors O/N, T/N, term deposits(to 1y) n.a. O/N, T/N, term deposits to 1y Daily volume CNY2-4bn n.a. CNY bn Ticket size CNY50-500mn n.a. CNY300mn Bloomberg/ Reuters CGDR1 / CNHIBOR n.a. CCDR1 / SHIBOR Interest rate swaps Tenors inactive 1y-10y 1y-10y Daily volume inactive CNY1-2bn. CNY3-4bn Ticket size inactive CNY50-300mn CNY mn Bloomberg/ Reuters CGSW1 / CNHIRS=BRKR CCSWNI1 / CNNDIRS= CCSWO1 / CNYIRS7R=CN or CNYIRS3S-CN MOF bonds Tenors (benchmarks) 2y, 3y, 5y, 10y, 15y n.a. 1y, 3y, 5y, 7y, 10y, 20y (longest 50y, not benchmark) Daily volume CNY50-200mn n.a. CNY300bn Ticket size CNY5-10mn n.a. n.a. Bloomberg/ Reuters n.a. n.a. GCNY2YR / CN2YT=RR Source: Bloomberg, RBS Page 28/68

29 Figure 24: PBOC 1y deposit-lending rate policy corridor, 7d repo rate and 3m Shibor rate Source: Bloomberg Figure 25: 3m CNH Hibor vs CNH FX implied rate, CNH deposit rate and onshore Shibor (%) Source: Bloomberg Money market The daily transaction volume of CNH deposits and loans is estimated to be CNY2-3 billion. For overnight (O/N) and tomorrow-next (T/N) deposits, the size per transaction is around CNY100 million-1 billion while the size for term deposits is usually smaller around CNY million (See Figure 23). On 3 January 2012, Hong Kong TMA announced it would establish a CNH Hibor curve by getting three banks to commit to publishing their interbank offered rates at 11am daily. Based on their customer flows, the rates from the three banks were initially wide apart from each other. More members were added subsequently. The number of contributing banks stands at 13 as of August Although the rates posted by banks have become less disperse, the curve remains illiquid and is hardly traded. From overnight to three months, the rates are fixed at about the same levels as the rates implied from the USD/CNH FX forward curve (see Figure 25). For the longer tenors, the rates vary according to the fixing and banks funding requirements. Interest rate swaps As said above, the CNH interest rate swap market practically does not exist at all. The rates posted by Hong Kong banks basically are taken from the onshore market and there seems to be a tacit agreement among interbank market players not to trade the curve. The best alternative is to create a new IRS curve using the CNY Hibor as fixing once the latter becomes more tradable. An IRS curve would help to deepen the CNH bond Page 29/68

30 market, especially for secondary trading of the bonds, by allowing issuers and investors to hedge their interest rates. Sovereign benchmark curve Only the Chinese government can set the sovereign CNH bond benchmark curve as the CNY is the sovereign currency of China. China s MOF launched its first bond issuance in September 2009 in tenors of two-years, three-years and five-years, with tranches for retail and institutional investors. Since then, it has issued three more batches of bonds, with roughly six to nine-months frequency in December 2010, August 2011 and most recently in June In the last issuance, the MOF extended the duration of the sovereign benchmark curve from 10-years to 15-years. Similar to the CNH corporate bond market, the MOF s bonds in the offshore CNH market used to command significant coupon discounts over the onshore bonds. In fact, the yield discounts were wider than those issued by regular Chinese bank issuers. These premiums have since evaporated as investors expectations have switched from FX gains to bond gains (see Figures 26 and 27). Figure 26: Offshore MOF benchmark curve vs onshore benchmark curve as at 1 Sep 2012 (%) Source: Bloomberg Figure 27: 3y MOF offshore CNH bond vs onshore bond (%) Source: Bloomberg Repo market One of the initiatives which emerged from the Hong Kong-London RMB Forum was a tripartite repo arrangement jointly set up by the HKMA central money market unit, Euroclear and J.P. Morgan in late June The system is designed to facilitate CNH repurchase transactions involving a wider choice of international securities through the Euroclear and J.P. Morgan platform. It can be a start to a full repo market for CNH bonds which would help to boost the extension of bank lending using the limited pool of CNH liquidity. The system also helps to reduce the settlement risks among banks. Page 30/68

31 Page 31/68

32 Bond Market Evolution of the market There are broadly three phases of development in the CNH bond market over the past five years: a sellers market; the Big Bang paving way for global issuers and investors; and 2012 a buyers market. We briefly document below the important milestones in each phase. The expansion outside of Hong Kong took off from 2010 after the central banks, investors and corporations increasingly showed support for CNY trade settlement and investment. It became a case of supply creating its own demand the issuance of CNH bonds by global MNCs attracted global investors outside of Hong Kong and Asia. We briefly document the important milestones in these three phases : Sellers market Jun 2007 first CNH bond issued by CDB Dec 2008 first CNY swap line signed with Korea Jul 2009 CNY trade settlement pilot scheme launched In January 2007, the PBOC and the National Development and Reform Commission (NDRC) jointly announced that the country s banks would start to issue CNYdenominated bonds outside of the mainland, specifically in Hong Kong. In June 2007, China Development Bank (a state-owned policy bank) became the first issuer, followed by other state-owned commercial banks. In the beginning, these issuances were primarily targeted to absorb the excess offshore RMB in circulation in Hong Kong and route them back into China. The playing field was confined largely to the Hong Kong marketplace. Motivated by FX gains rather than yields, Hong Kong-based investors facing a weak USD currency peg and low USD interest rates were willing to accept yields as much as basis points below the yields of bonds issued by the same banks onshore. This made the market very much in favour of sellers or issuers. The trade-off was that the maturity of the bonds was mostly capped at a three-year tenor because of the investors motivation for FX rather than yield gains. In September 2009, China s MOF issued its first offshore bonds in three tranches for both retail and institutional investors. This further spurred issuance from bank issuers, which had by then broadened to China-incorporated foreign banks subsidiaries, namely HSBC Bank (China) Company Limited and Bank of East Asia (China) Limited as the first two non-chinese bank issuers. The MOF bonds also extended the CNH bond curve from three to five years, setting a sovereign benchmark. This period also marked a critical phase of the RMB internationalisation process, which involved two important developments. First was the signing of bilateral CNY swap lines between the PBOC and the central banks from China s strategic trade partners. These lines were designed to promote confidence in the use of CNY for trade settlement. Another critical development was the launch of the CNY trade settlement scheme on a pilot basis in July 2009 for selected Chinese coastal cities with Hong Kong and ASEAN member countries. Although the limitation of the scheme did not help much to boost CNY liquidity or deposits in Hong Kong (not fast enough to cope with the increasing Page 32/68

33 demand for the CNH bonds), it signalled Chinese Government s efforts to facilitate the RMB internationalisation process by developing the offshore RMB bond market. Page 33/68

34 : Big Bang issuers and investors go global February 2010 all forms of CNH fund raising allowed in Hong Kong July 2010 CNH interbank market launched October 2010 first supranational issue by ADB, also first 10-year issue and first bond traded on the Hong Kong Stock Exchange December 2010 first non-asian EM issuer, VTB Bank This period was marked by rapid liberalisation steps by China, paving way for Hong Kong to aggressively promote the market to global issuers, drawing in global investors. The first step came in February 2010 with the HKMA announcing that all forms of CNH fundraising by any Hong Kong or non-chinese entities are allowed without prior approval in the Special Administrative Region (SAR) if the proceeds are not to be repatriated into China. In the latter event, repatriation would require the Chinese regulators approval. This was followed by the signing of a Memorandum of Cooperation between PBOC and HKMA in July 2010 that allows the Hong Kong banks to set up an interbank market for CNH FX and interest rates. Hopewell was the first non-chinese corporate issuer in July This was followed by McDonald s issue in August 2010 which became the first MNC issue. The McDonald s issue set the precedent for MNCs with substantial business in China to look at the CNH market as an alternative funding source for their Chinese operations. By this time, the market had grown four-fold since its launch in 2007 to CNY41 billion at the end of The demand for CNY liquidity to invest in the bond market became so great that it breached the central clearing quota managed by Bank of China (Hong Kong) Limited in October This activated the HKMA to announce that it would tap the CNY swap line facility from PBOC to ease the market pressure (see FX section). June 2011 HK TMA started daily 11am fixing for USD/CNH September 2011 Chinese Vice Premier visited London to promote London as a RMB centre The October 2010 episode prompted the Hong Kong TMA to start its own USD/CNH daily spot fixing at 11am in June This indicated China s commitment to allow market forces to play a greater role in determining CNH exchange rate, without being pressured by the PBOC s onshore daily fixing for the CNY. In addition to improving the stability of the CNH FX market, it reduces the FX spot basis risk for CNH-denominated products and in turn, provided more comfort for bond investors. In September 2011, China s Vice Premier Wang Qishan visited London to promote London as a global offshore RMB centre. Preceding that visit, in August 2011, Chinese corporates which had been kept out of the CNH bond market were allowed to tap the market. The PBOC launched the RMB QFII scheme and a pilot scheme to allow foreign banks to use CNH funds for recapitalising their Chinese operations. In 2011, the market reached CNY225 billion, which was nearly a 23-fold increase since its 2007 launch. Despite the market opening up, the supply and demand imbalance remained in this phase. The low yields on CNH bonds reflected strong investor demand and showed that investors investment decisions were motivated by FX gains rather than return from yields. With the shift in RMB appreciation expectations, we have seen that investment in RMB bonds has come under greater scrutiny and requires more rigorous credit analysis. 2012: buyers market Page 34/68

35 Euro crisis and subtle shift in PBOC s FX policy The concerns on China s growth and the subtle shift in the PBOC s FX policy stance from the beginning of this year combined to turn this market from a sellers market to a buyers market. The yield premium has now almost completely closed up. Considering that onshore and offshore CNY bond markets have their inherent risks, the question now is whether there should be any yield differentials between the two markets. For the onshore market, the basic issue is market access and the risk of capital controls. For the offshore market, the issue is currency convertibility. Until the CNY becomes fully convertible, there is still a chance, however remote, that China decides to backtrack to a full non-convertibility status. In a way, the risks onshore and offshore are in fact not dissimilar, stemming from the FX angle. Moreover, the CNH DF market has priced in the shift in RMB appreciation expectations, and has moved the basis swaps in favour of foreign issuers who would issue CNH bonds and swap the proceeds into other major currencies like USD. These market developments have provided favourable arbitrage opportunities for issuers who do not have imminent needs in RMB. January 2012 HK TMA launched CNY Hibor fixing January 2012 HKMA eased banks CNY open risk limits February 2012 HKMA eased banks SLR for CNY deposits February 2012 Shanghai sets 2015 target to be global CNY pricing centre for both onshore and offshore markets April 2012 PBOC widened onshore USD/CNY intra-day trading band April 2012 City of London launched London-Hong Kong forum June and July 2012 PBOC cut interest rates twice and softened policy rate corridor Despite market pressure, issuance volume continues to go up and investors interests remain sturdy as issuers were willing to adjust to higher yields. To a large extent, this was aided by further market reforms and liberalisation of rules. In January 2012, the HK TMA launched CNY Hibor fixing. In January and February 2012, the HKMA consecutively eased Hong Kong banks risk limits and statutory liquidity requirements (SLR) on their CNY exposure. Onshore, reforms took the form of a widening of the USD/CNY intra-day trading band in April 2012, and two rounds of rate cuts in June and July 2012 which came with a softening of the corridor on banks interest rate margin. The rate cuts in particular helped to further tighten the yield premiums of the onshore bonds to the offshore CNH market. Two other developments also surfaced in parallel. In February 2012, the Shanghai municipal government released a blueprint, setting a 2015 target for the city to become the global pricing centre for all CNY-denominated financial products onshore and offshore. In April 2012, the City of London followed up on the Chinese Vice Premier s visit in September 2011 to London by launching a London-Hong Kong forum on the global offshore RMB market. These are very subtle manoeuvres going on here which we will discuss in a later chapter. While Shanghai has its long-term ambition to become the country s key financial centre, including taking over the current role of Hong Kong as the main offshore RMB pricing centre, Hong Kong has been given the chance to tap on the global financial centre strengths of London to advance its RMB business in the interim. How the future of the two cities pan out would be something to watch out for. Meanwhile, in the pipeline, a second central clearing line will be set up in Singapore, to be operated by a Singapore branch of a Chinese bank. Tokyo and Taipei are also separately discussing their own respective direct clearing lines into China. All these clearing lines would bypass Hong Kong, which as we said in the last chapter, has now become a more mature market in our opinion. Page 35/68

36 Shift in investors expectations from FX gains to yield or bond gains At this point, we see the market has evolved from a seller s market, where investors continuously seek returns on FX appreciation, to a buyer s market, where investors would treat CNH bonds as a credit product and begin to evaluate the credit-worthiness of the bond and not only the FX gains. The imbalance between demand and supply has improved but not quite yet to demand-supply equilibrium, as shown by the narrowing of the offshore/onshore premiums/discounts. The biggest uncertainty now is the PBOC s FX policy direction as investors adjust their expectations from chasing FX gains to chasing yield or bond gains. Issuer Base The CNH market has experienced an exponential growth since As of August 2012, total new issues (including CDs) in 2012 amounted to CNY199 billion. Issue volume for financial institutions (FIs) grew at a CAGR of 155% in August 2012 while the issue volume for corporates increased at a CAGR of 54% in the same period. In its early stages of development, CNH issuance was dominated by Chinese Government (Ministry of Finance), Quasi-government (policy banks) and China/Hong Kong FIs. Since the landmark reforms in July 2010, which paved the way for offshore entities to issue CNH bonds in Hong Kong, the issuer base has expanded greatly in terms of issuer type, credit quality, geography, sector and tenor. Types of issuers Chinese FI are the leading issuers in the CNH market; foreign FIs and corporates gained market share since the opening of CNH bond market to offshore entities in July 2010 CNH bond issuers consist of state-owned enterprises, MNCs, Hong Kong branches of Chinese banks and foreign banks, and onshore banks direct issuance. The CNH market is still dominated by Chinese FIs (both policy banks and commercial banks), which accounts for 70% of total market share as of August China/Hong Kong corporates represents the second largest category of issuers (apart from MOF issuance), accounting for 8% of total market share as of August Figure 28: Issuance by issuer type (CNY bn) Source: Bloomberg; includes both bonds and CDs issuance Page 36/68

37 From 2010 to August 2012, non-chinese issuers accounted for over 14% of total CNH issue volume, of which, corporates made up 50% of the issuer base and FIs took up 47% of the market share. Figure 29: Increasing participation by non-chinese issuer (CNY bn) Source: Bloomberg; includes both bonds and CDs issuance but excludes China MOF issuance Figure 30: Issuance by Chinese issuers (CNY bn) Source: Bloomberg; includes both bonds and CDs issuance Figure 31: Issuance by non-chinese issuers (CNY bn) Source: Bloomberg; includes both bonds and CDs issuance The geographical composition of the issuer base has also changed over time. Since the first MNC issuance by McDonald s in August 2010, we have seen a growth in issuance by non-chinese companies, notably Europe, North America and other parts of Asia. In particular, CNH bond issuance by European issuers increased from a share of only 1% in 2010 to 7% and 6% in 2011 and 2012 August YTD respectively. We have also seen an issuer testing the new market with alternative issuing structure, namely Khazanah Nasional, as the first issuer to sell an Islamic bond in the offshore RMB market. The success of this transaction demonstrates the readiness of the market to accept innovation. Page 37/68

38 In addition, Korean frequent issuers have also access the market leveraging on the window in the swap market. Figure 32: Issuance by country (2010) Source: Bloomberg; includes both bonds and CDs issuance but excludes China MOF issuance Figure 33: Issuance by country (2011) Source: Bloomberg; includes both bonds and CDs issuance but excludes China MOF issuance Figure 34: Issuance by country (2012) Source: Bloomberg; includes both bonds and CDs issuance but excludes China MOF issuance In terms of tenor, the majority of the issuances are concentrated in the shorter end of the curve three years or less where issuers enjoyed the deepest investor pool. Traditionally, investors involvement was driven by an anticipation of RMB appreciation and investors tended to have a directional view in the shorter maturities. As the market evolves further where there are new entrants to the market, issuers were successful in closing transactions with longer maturities. The most notable was when China Development Bank raised CNY1.5 billion for the first 15-year CNH offering in January 2012 where insurance companies supported the transaction. China Development Bank did another CNY1 billion 20-year trade in July Figure 35: Issuance by tenor Source: Bloomberg; includes both FI and Corp bonds and CDs issuance but excludes China MOF issuance Figure 36: Issuance by tenor Source: Bloomberg; includes only Corp bonds Size-wise, 33% of CNH issuance has an issue size of CNY500 million-1 billion, reflecting investors preference for liquidity. As of to date, the record of the largest single issue volume is kept by the China Development Bank (CNY5 billion issue) in the Page 38/68

39 FI space, and the New World China Land s CNY4.3 billion issue in the corporates space. Figure 37: Issuance by issue size Source: Bloomberg; includes both FI and Corp bonds and CDs issuance but excludes China MOF issuance Figure 38: Issuance by issue size Source: Bloomberg; includes only Corp bonds Motivations and objectives Chinese corporates and banks CNH market is an important option for Chinese companies given the tight bank credit environment in China We see the following incentives for Chinese corporates/banks entering the CNH bond market: 1. Bank credit environment in China remains tight As discussed in the earlier sections on FX and Interest Rates, the recent PBOC cuts in both the benchmark lending and deposit rates, in our view, were moves to liberalise interest rates rather than to ease policy. Credit environment remains tight and unsecured term funding is not readily available. New loans extended by Chinese banks in July 2012 fell to the lowest level since September Chinese banks lent nearly CNY540 billion worth of new loans, considerably lower than that of the previous six months. Although this can be partly explained by the weaker overall macro economic situation in China, policy control over lending was still underplayed. For example, there are still considerable policy measures against lending to real estate developers in China. On the contrary, Chinese banks overseas subsidiaries in Hong Kong or branches continue to remain active in supporting their clients overseas activities. These Chinese lenders constitute an important source of CNH investment pool servicing their clients overseas ambition. Page 39/68

40 Figure 39: China s new loan growth in July reached lowest in 2012 (CNY bn) Source: PBOC, Bloomberg 2. Previous and ongoing development of the offshore bond market as supported by the Chinese and Hong Kong governments In light of the Chinese government s initiative to internationalise RMB, a realistic strategy would be to open the RMB bond market to international investors as soon as the offshore bond market becomes mature. In 2012, Chinese and Hong Kong regulators have taken numerous policy initiatives to promote the depth and breadth of the CNH market. As a result, the CNH market has developed substantially with a wide range of products: HKMA boosted RMB liquidity and expanded the assets range which can be computed in RMB liquidity, enabling RMB deposits in Hong Kong to increase and boost the diversification of issuers of CNH bonds Chinese government expanded QFII and RMB QFII quotas and simplified the approval process, promoting more RMB backflow channels Chinese government liberalised trade settlements which significantly expanded the RMB deposit base in Hong Kong to buy CNH bonds Allowing offshore RMB loans (by banking institutions operated in Qianhai) Further development of offshore RMB products and Exchange-traded Funds (ETFs) listed in both China and Hong Kong Encourage two-way movements of RMB to support RMB internationalisation We have seen more RMB inflows into and outflows from China through Hong Kong, and diversified offshore RMB financial products with these policies. We anticipate the pool of RMB to expand further and enhance demand for offshore RMB products. 3. Expanding Chinese borrowers overseas activities and their use of RMB Chinese companies have expanded overseas and we continue to see growth here. These overseas activities would need to be funded by borrowing offshore. Given the Page 40/68

41 restrictions mentioned earlier, we expect to see more offshore funding through the issuance of bonds in the offshore market. Some of these companies may find the offshore RMB bond market a forum for their fundraising. Multinational corporations / overseas subsidiaries of Chinese companies For MNCs or overseas subsidiaries of Chinese companies, the CNH market is an important funding channel for their onshore companies in addition to bank lending For large global companies, MNCs, that have investments and operating subsidiaries in China, the primary channel for funding working capital is bank lending unless their onshore establishment is large enough to access the domestic bond market. Bank borrowing, however, has certain restrictions which makes borrowing cost high and maturity short term. The recent PBOC rates cut reduced the burden somewhat, however, bank credit conditions continue to remain tight. Therefore, the offshore RMB bond market offers term RMB funding at competitive rates. When the authors visited potential issuers in Europe and North America, there were no shortage of interest in this market. The challenge for these companies to issue, which hinders the growth of MNC issuance volume, is the limitation of channels for the CNH to flow back into their China operations as CNY. We will discuss the repatriation rules in later sections. Apart from repatriation matters, there are also two other opportunities for MNCs to consider a potential issuance: Visibility: For many issuers, the offshore RMB market is the only platform for them to gain access to the growing influence of the RMB currency as the domestic capital market is currently closed to foreign issuers. Arbitrage: The development of the cross currency swap market (although for the shorter end of the curve) provides opportunities for issuers to raise CNH and swap into major currencies if there is no intention to move the bond proceeds to onshore. Issuance outlook FI issuers will continue to dominate while we expect to see more diversified names from corporates; longer maturities and larger issue sizes Based on the above-mentioned incentives, we expect the composition of CNH issuer base to continue to evolve over time. Continued strong supply from onshore financial institutions and corporates We expect China will continue to use the offshore platform as a means to promote the development of the offshore RMB market. This strategic initiative enhances opportunities for Chinese policy banks, commercial banks and SOEs to issue CNH bonds outside China. Hence we expect Chinese policy banks will continue to use the CNH market as a stable wholesale funding source in addition to the onshore market, and overseas subsidiaries and branches of Chinese commercial banks will use this market to meet the demand of CNY loans outside China. We also expect more onshore companies to issue CNH bonds, following the cases of Baosteel and China Datang, that have been granted approvals by the NDRC to issue CNH bonds in Hong Kong. Page 41/68

42 Increasing issuance by non-chinese issuers MNCs with a significant presence in China will increasingly be using this market, especially when repatriation process has proved to be more accommodative than before. Moreover, the latest development where PBOC has widened the fluctuation band of CNY (from 0.5% to 1.0%) has helped to support the development of the swap market. As the liquidity of the swap market improves, we expect to see more international issuers who do not have natural needs in CNH tapping the CNH market, as they could potentially achieve more competitive pricing compared to direct USD funding. Longer maturities for CNH bonds As the CNH market develops, investors are more receptive to longer tenor issuance. This is evident by the recent China Development Bank s 20-year offering, which has received strong support from Taiwanese life insurance companies who look for longdated CNH assets to match their portfolio of liabilities. Investor base The composition of investor base has been more diversified over time Types of investors The investor community in the CNH bond market has evolved rapidly since its inception a few years ago. There is diversification in the composition of the investor base both by investor type and by investor geography. In the beginning, the pool of CNH liquidity resided predominantly with commercial banks as retail CNH deposits. As the CNH market evolves over time, the composition of the investor base has become more diversified fund managers, insurance companies, private banks and central banks have started to participate in larger proportion than they did a year ago. In the beginning when there was a strong RMB appreciation play, hedge funds participated in the appreciation story. As the market changed, where there is now an equal balance between the appreciation and depreciation story, we have seen a reduced involvement of hedge funds in this market. Geographically, we have also seen wider investor participation. In the beginning, Hong Kong-based investors were the main drivers of this product. We have seen strong interest from Singapore-based investors who took up significant portion of the order book of any single transaction. In the region, we have seen secondary market activities involving investors from Southeast Asia. And the latest interests came from the Taiwanese insurance companies who have contributed significant investor demand for long-dated CNH bonds. Outside of Asia, we have seen interest from European investors. Lanxess s three-year bonds were allocated 44% to European investors while 25% of Veolia s three-year bonds were was sold to European investors. Obviously, the issuers in the examples above are well-known European blue-chip borrowers and European investors are very familiar with their credit stories which made the investment decision more Page 42/68

43 straightforward. Nevertheless, we have seen European interest in some pure-asian play too. As the RMB appreciation story fades away, the CNH bond market has evolved from a currency play to a credit play. Depending on the credit story, the yield demanded by investors would reflect the underlying risk and the tenor of the bonds on offer, leading investor composition to vary. The following charts show the investor composition of some recent transactions in four categories of issuers namely, MNCs, SOEs, commercial banks and policy banks. Figure 40: Investor base breakdown by geography - MNC issuers Source: RBS, IFR Asia, The Asset Figure 41: Investor base breakdown by investor type - MNC issuers Source: RBS, IFR Asia, The Asset Figure 42: Investor base breakdown by geography - SOE issuers Source: RBS, IFR Asia, FinanceAsia Figure 43: Investor base breakdown by investor type - SOE issuers Source: RBS, IFR Asia, FinanceAsia Page 43/68

44 Figure 44: Investor base breakdown by geography Commercial Banks Source: RBS, IFR Asia, The Asset Figure 45: Investor base breakdown by investor type Commercial Banks Source: RBS, IFR Asia, The Asset Figure 46: Investor base breakdown by geography Policy Banks Source: RBS, IFR Asia Figure 47: Investor base breakdown by investor type Policy Banks Source: RBS, IFR Asia Investor outlook By type and by geography We expect the investor base to become more diverse over time for the following reasons: Growing importance of RMB attracts more investors The pace of RMB internationalisation has come at a faster pace than expected. The Chinese government has broadened the investment channels for offshore RMB, including the launch of offshore RMB products such as RMB IPOs and RMB bond ETFs. The opening up of more channels for RMB will increase investor interest in CNH bond issue. Page 44/68

45 We expect to see an expansion of these schemes, considering the Chinese government s objectives to internationalise RMB in the future. Moreover, as RMB become more internationalised, global fund managers are expected to set up more RMB funds to tap the growth opportunities in China. Opening up of additional offshore RMB centres With policy support from the Chinese Government and the importance of trade, Europe is becoming a significant growth area for the RMB business. The push to make London as the European centre for RMB would further enhance the development of the European liquidity for RMB. In the Asia time zone, Singapore s position is further enhanced by its ability to settle offshore RMB trade outside of Hong Kong. As interest continues to grow from other Southeast Asian countries, Singapore s role for pooling demand from its neighbours will continue. Increasing participation from central banks In recent CNH deals, we have seen an increase in central banks participations. Export- Import Bank of China s CNH bonds received anchor interests from central bank accounts, while 17% of Sinotruk s bond was sold to central banks accounts. Moreover, for the first time ever, China s MOF has set aside a central bank tranche for central banks of countries that have no quota to invest directly in China s onshore bond market. With RMB becoming more internationalised, we expect central banks to hold more RMB funds for trade settlement and potentially as part of their reserve currencies. Going forward, we expect to see more participation from central banks. Documentation requirements In the CNH market, eurobond style documentation is well accepted by the investors. For frequent issuers that have MTN programmes in place, it is also common for them to issue through these programmes. In the early stage of market development, investors were keen to look at a variety of credits and paid less attention on structures and covenants. Most recently, covenants requirements have become more common and customary for unrated and high yield issuers. Listing practice Page 45/68

46 Reg S is the current norm. Increasing penetration into US market creates need for 144a deals Reg S is the current norm Most of the CNH bonds are not listed, although some of them chose to be listed in Hong Kong, Singapore and Luxembourg for example (see Figure 48 below). For existing listed entities, the listing norms should be simpler they should be allowed an abridged version of disclosure. For issuers that have their MTN programmes listed, they simply list their bonds accordingly. Figure 48: Issuance by listing venue Source: Bloomberg; includes both FI and Corp bonds and CDs issuance but excludes China MOF issuance Figure 49: Issuance by listing venue Source: Bloomberg; includes Corp bond and CDs issuance but excludes China MOF issuance CDs issuance but excludes China MOF issuance Hong Kong and Singapore exchanges are the most popular listing venues as the listing process in these exchanges is easy and straight forward. Generally speaking, investors are not fixed on listing venue although listing is preferred by some investors. In terms of secondary market liquidity, being listed or not does not affect the liquidity of the bonds, as CNH bonds are traded primarily Over-The-Counter (OTC) in the secondary market. In many situations, the purpose of listing a CNH bond is to enhance the marketability of the bond, as some institutional investors are restricted to investing only in listed securities. Given the general acceptance of eurobond documentation by the market, Reg S format is the current norm. Reg S limits US investors participation in the primary market. Based on our discussions with some US investors, there is a growing interest from them to invest in CNH bonds. However, we have not seen any issuance done through the 144A format. To date, there was only one CNH deal that came with a SEC registration format America Movil s CNY1 billion three-year bond. The deal attracted close enough US onshore investors to take up 26% of the deal. With growing interest from US investors, we expect to see more deals structured to cater for their demand in the future. More rated issuers coming to the market In the early days of the market development, investors primarily focused on the potential FX gains when investing in a CNH product. Investors paid less attention to the underlying credit quality of a bond and in fact were prepared to do all their own credit work. As the RMB appreciation story shifted, investors have begun to pay attention to the credit quality and hence have developed a preference for rated issuers. From statistics, over 50% of the corporate issuers were unrated. Page 46/68

47 In addition, investors have also developed a preference for the need of covenants for weaker credits or unrated issuers. Maintenance/bank-style covenants were used in most recent transaction for this category of issuers and high yield covenants are less common. Figure 50 Issuance by rating Source: Bloomberg; includes both FI and Corp bonds and CDs issuance but excludes China MOF issuance Figure 51: Issuance by rating Source: Bloomberg; includes Corp bond and CDs issuance but excludes China MOF issuance Governing law The common documentation practice for CNH transactions follows the eurobond process. For most CNH bond issues, Hong Kong or English laws are generally acceptable by investors. Based on our statistical analysis, 43% of corporate issuers used Hong Kong law, followed by 38% who used English law. Figure 52: Issuance by governing law Source: Bloomberg; includes both FI and Corp bonds and CDs issuance but excludes China MOF issuance Figure 53: Issuance by governing law Source: Bloomberg; includes Corp bond and CDs issuance but excludes China MOF issuance Page 47/68

48 Repatriation rules Regardless of the issuers identity MOFCOM and SAFE are the gatekeepers for CNH repatriation, by way of equity injection and shareholder s loan MOFCOM vs SAFE routes Use of proceeds and approval process The Chinese regulators do not regulate the issuance of CNH bonds by foreign companies. In other words, no pre-approval is needed for the issuance of CNH bonds by offshore institutions. Typically, the use of proceeds as stated in the offering document is kept general. Since October 2011, PBOC ceased to become the primary regulator to approve repatriation of CNH proceeds. Regardless of the issuers nationality of incorporation, the State Administration of Foreign Exchange (SAFE) and Ministry of Finance (MOFCOM) have become the gatekeepers to accept CNH repatriation applications. CNH repatriation generally takes two routes equity injection and shareholder s loan. Under the current regulatory regime, the shareholder s loan arrangement is regulated by SAFE and there is a prerequisite for the onshore entity in China to have sufficient, unused foreign debt quota. The onshore subsidiary receiving the shareholder s loan would need to register with local SAFE where the use of proceeds would be discussed. Based on the existing rules, SAFE would treat repatriation of CNH loan proceeds just like any foreign debt in other currencies such as EUR or USD. Under existing SAFE regime, long-term loans (one year or shorter), no matter in which currency (ie, in RMB or other foreign currencies like USD or EUR), would consume permanently into the debt headroom. For short-term loans (less than one year) in foreign currencies, the foreign debt quota can be revived once the debt is fully repaid. However, RMB cross border loans, regardless of what loan tenor, the debt quota is utilised once it is drawn down and cannot be revived. This move is viewed as a means to discourage short-term speculation on RMB. It is worth noting that the rules governing the repatriation of proceeds in RMB are not dissimilar to those governing the repatriation of proceeds in other currencies such as EUR or USD. MOFCOM is the primary gatekeeper on approving equity-related foreign direct investment (FDI). Under RMB FDI regime, MOFCOM will treat RMB as a preferred currency for FDI. The approval for RMB FDI shall be granted by the MOFCOM at the local level, but for the investments involving special industries like micro-finance and leasing or industries under tight control by the Government like iron and steel or investments exceeding a certain amount (ie, CNY300 million) must still be approved by MOFCOM at the head office level. A brief overview of current regulations on CNH bond repatriation is illustrated in the tables below. Page 48/68

49 Figure 54: CNH repatriation into onshore By equity injection By foreign debt / shareholder s loan By trade settlement Route Through establishment of a foreign invested enterprise (FIE) or acquisition of equity in an existing onshore company Through loans granted to an onshore FIE by its shareholder(s), group affiliate(s) or an offshore financial institution Settlement of import and export of good and services Approving entities MOFCOM SAFE No pre-approval needed Approval MOFCOM is primary gate keeper Cross-border foreign debt PBOC along with other process for approving RMB funds by equity arrangement is processed by local competent authorities and by debt; the approval for RMB SAFE where the onshore entity is announce that all parts of FDI shall be granted by the incorporated China are opened for RMB MOFCOM at the local level, but the investments involving special industries (e.g. microfinance and leasing) or exceeding a specified amount (ie, CNY300 mn) must still be approved by MOFCOM at the head office level Registration of funds with PBOC FIEs receiving RMB investment should register with PBOC local branch and open RMB capital accounts with a settlement bank for remitting the upfront fees and capital contribution under RMB FDI Pre-requisite for the onshore entity to have sufficient foreign debt quota for incremental borrowings from its overseas parent Foreign debt quota is predetermined and calculated as the gap between total investment and registered capital. Actual amount of funds to be raised is the unused foreign debt quota, free from any outstanding foreign debt Cross border RMB loans, regardless of their terms, consume permanently into the headroom, ie, the headroom will not be restated even after the settlement for cross border trades debt has been repaid Use of repatriated proceeds Funds repatriated into China under RMB FDI must not be invested in securities and financial derivatives (unless approved as a strategic investor of listed company), wealth management products, real estate (other than for own use) or extend entrustment loans Not applicable Approval timeframe 3-6months* 4-8 weeks* Not applicable *Approval process depends on the sufficiency of foreign debt quotas of the onshore entity, as well as the industry or nature of the investment the proceeds would be used for. Page 49/68

50 Increased channels for funds to be moved to China and elsewhere will allow for easier CNH repatriation Other RMB schemes RMB FDI and RQFII As announced by Chinese Vice Premier Li Keqiang during his visit to Hong Kong in August 2011, the Chinese Government has created more channels for CNH funds to flow back into China. The RMB FDI channel is one such channel which allowed foreign enterprises to use CNH for foreign direct investment. This has opened a new door for RMB lending as customers may now also borrow RMB funds for investment in China. The implementation of RQFII also provided more channels for institutions to invest its CNH deposits in China. Going forward, we would expect the continued development of CNH usage channels will allow for easier repatriation of funds back into China. Onshore-offshore convergence Since August 2011, CNH bond yields have been on an upward trend, shrinking their differences with onshore bond yields. MOF s sovereign bonds in the offshore market trade at a slight discount in yields to the onshore issues. The discount currently is much less than what it was a year ago (see Figure 55). The surge in yields of CNH bonds reflects the investors reassessment of RMB appreciation prospect, greater emphasis from investors on issuers credit quality and the growing supply of new CNH bonds. We have also seen an increase in average yields of Chinese banks CNH CDs (see Figure 56). Figure 55: Historical trends on offshore CGB bonds vs onshore CGB bonds (%) Source: Bloomberg Page 50/68

51 Figure 56: Trends on CD issuance yields for China Construction Bank HK (%) Source: RBS According to our analysis, yields for three-year CNH bonds across the rating spectrum have widened by an average of % since January 2011 (see Figure 57), partly due to the softening of the RMB appreciation. In the onshore market, concerns over China s economic slowdown have driven down the onshore bond yields. These factors have caused the price premium of the CNH bonds and onshore bonds to converge. Figure 57: CNH bond yields (3-year) per rating category (%) Source: Bloomberg The offshore CNH bond market has now emerged as another platform for RMB funding for Chinese FIs and corporates. The onshore market, albeit allowing greater market access than before, still has certain regulatory restrictions that continue to make the offshore market attractive in the short term. The figure below illustrates the onshore and offshore yield curves of CDB. There exists a larger price premium of the CNH bonds to onshore bonds at the shorter end of the curve than the longer end of the curve. However, we expect the spread between the offshore and onshore bond Page 51/68

52 yields to further narrow, considering the possibility that the CNY will become fully convertible in the longer term. Figure 58: Offshore CDB bonds vs onshore CDB bonds (%) Source: Bloomberg, RBS Page 52/68

53 Globalising the Franchise A two-prong approach China employs a two-prong approach in globalising the franchise of the offshore deliverable CNH market: using Asia as a launch pad at the private sector level; and engaging G7 countries, BRICS partners (Brazil, Russia, India and South Africa) and multilateral agencies bilaterally and on multilateral platforms. We discuss both approaches below. Building on Asia s strengths Asia s strengths come through trade and savings which together amassed for the region a huge stockpile of foreign reserves. The Fed s quantitative easing has further enriched the region s reserves positions in more recent years. Hence, not only for the reason of geographical proximity, Asia is the natural starting point for China to promote the use of the CNY as a trade settlement currency and for reserves diversification. Amid its strong trade growth, the region has seen a gradual increase in intra-regional trade in the past one to two decades after China switched to an export-growth model in the early 1990s. Of the USD10.5 trillion stock of world foreign reserves, USD6.5 trillion (62% of world total) are held by central banks in Asia within which China holds nearly at USD3.24 trillion (31% of world total). China s reserves have grown more than 10 times in the past 10 years. Over the same period, reserves for the rest of the region excluding Japan have grown by more than 6.5 times (see Figure 59). China s share of world trade has risen from 3.5% at the start of this millennium to 10.5%. During the same period, US s share of world trade has dwindled down from 15% to 10.7% (see Figure 60). China has been the primary force behind Asia s increasing intra-regional trade dependency. More than a quarter of China s external trade is with Asia ex-japan, well above its trade with EU (14%), Japan (12%) and the US (8%). Vice versa, the region s dependence on China is also significant at 21% (see Figures 61 and 62). Asia s trade with China has doubled in the past 10 years at the expense of US and Japan as Asian manufacturers relocate their production bases to China which provides a vast labour pool and domestic consumer market. Page 53/68

54 Figure 59: Breakdown of world foreign reserves (%) Source: Bloomberg Figure 60: Market share of world trade- China vs US, EU and Japan (%) Source: IMF Figure 61: Breakdown of China s total trade (%) Source: CEIC Figure 62: Breakdown of Asia 9 s (ex Japan, China) total trade (%) Source: CEIC As Asian countries reserves have grown well above comfortable levels, the need to seek greater reserves diversification has grown. After going through a string of banking and sovereign crises in the developed markets, Asian countries turn inwards in the same way that their trade has become more intra-regional. Consequently, although the CNY does not qualify as a reserve currency because it lacks full convertibility as defined by the International Monetary Fund (IMF), many central banks have started to diversify reserves into the CNY. Vice versa, China has also diversified into many other Asian regional currencies. Holding CNY in excess reserves: Malaysia was the first central bank to openly announce that it was adding CNY to its FX reserves in Since then, several central banks such as Korea, Thailand, Chile, Saudi Arabia, and Nigeria have all Page 54/68