Institutional Investor: The explosive growth of offshore RMB

Institutional Investor, June 2011

Rarely has there been a more explosive pace of development in a new market as has taken place in offshore RMB in the last 12 months. In debt capital markets, foreign exchange and trade finance, the impact has been truly transformative.

The CNH market – the accepted term for RMB outside of China – dates back to 2003, when Hong Kong and China first authorised personal RMB services in Hong Kong, and has gone through various pilot programs and other landmarks since. Among them were the first RMB bonds in Hong Kong in 2007, from China Development Bank, followed by a broadening of potential issuers to include foreign banks incorporated in China from December2008; and a pilot trade settlement scheme allowing five coastal cities to settle their trade with Hong Kong, Macau and Asean countries in RMB in July 2009.

But the real landmarks took place last year. In February 2010 the Hong Kong Monetary Authority announced that any institution permitted to issue a bond in Hong Kong could also do so in RMB. Then limits on Hong Kong-based companies converting RMB were removed in July (RMB investment products were liberalised at the same time). These measures extended the issuer base to pretty much anyone, and marked the birth of what quickly became known as the dim sum bond market.

On the trade settlement side, in June 2010 the pilot scheme was extended to 20 Chinese cities for all foreign trade partners, and was then broadened again in December when the number of eligible Chinese participating firms was lifted at a stroke from 365 to 67,359. Also, in August, several foreign banks – including RMB clearing banks in Hong Kong and Macau, overseas banks involved in RMB trade settlement, and foreign central banks holding RMB – were permitted to invest their RMB holdings into the China interbank bond market, with Standard Chartered, HSBC and Bank of China International marking the first wave to be given quota in October.

The effect of these initiatives has been immense in every relevant area of finance, but it’s the dim sum bond market that has really caught the eye. A handful of issues had taken place in the three years between July 2007 and July 2010, chiefly from Chinese policy institutions (China Development Bank, Export-Import Bank of China, Ministry of Finance), big state Chinese banks (China Construction Bank, Bank of China, Bank of Communications) and foreign banks incorporated in China (HSBC and Bank of East Asia). But according to Dealogic, the combined deal value of every deal up to June 2010, the month before the HKMA’s new measures came into effect, was just RMB34.3 billion (US$5.29 billion). Yet as of May 20 2011, just one year on, the total outstanding is RMB103 billion: a trebling of market size in less than 12 months.

RBS is predicting a total of RMB180 billion of outstanding bonds by the end of 2011; Vishal Goenka at Deutsche says RMB200 billion across a range of issuer types. “We’ve seen issuance all the way from 1% coupons up to high yield at 7%,” he says. “It gives investors a whole credit portfolio to choose from.”

It is an unprecedented rate of growth, and it is driven by a mismatch. For all that the bond market has grown, it has not nearly kept pace with supply: RMB deposits in Hong Kong. These stood at RMB90 billion in June 2010 before growing two and a half times over by the end of the year to RMB315 billion. And by the end of March, the most recent data published by the HKMA, they stood at RMB451.4 billion. Deposits are growing at a rate of more than 10% per month; RBS expects them to reach RMB700-800 billion by the end of 2011. “Even if new issuance of CNH bonds in 2011 triples from the 2010 level,” bringing the total to RBS’s predicted RMB180 billion, “it will reach only 24% of the CNY deposit base,” says Woon Khien Chia, managing director and head of local markets strategy for emerging Asia at RBS.

This supply-demand mismatch, which isn’t going to fade away any time soon, is causing some curious things to happen. For a start, issuers are able to get vastly better rates in offshore RMB than they are in many other currencies, or indeed in onshore RMB. The swap curve from RMB into other currencies, even dollars, is expensive, but the rates of borrowing are so cheap that it still makes sense for some issuers to borrow in RMB even if they have absolutely no need for the currency.

Early issuers after the July big bang were natural borrowers. Hopewell Highway Infrastructure was an early mover, followed by McDonald’s – which needs RMB to expand on the mainland – and Caterpillar, alongside Chinese-backed corporate names like Sinotruk and China Resources Power. But as it became clear just how cheaply issuers could borrow – the Ministry of Finance paid just 1% for a three-year deal in November, in a four-tranche raising that included RMB50 billion of demand for a RMB5 billion institutional tranche – then many less likely names started to take a closer look too.

In December, Galaxy Entertainment Group raised RMB1.38 billion in a Regulation S deal, followed by the next day by VTB Bank which raised RMB1 billion, both of them in three-year deals. Galaxy is a Macau casino developer – and is unrated, although it is affiliated with Galaxy Casinos, rated single B by Standard & Poor’s. And VTB is a BBB-rated Russian bank with absolutely no presence in China nor any known intention to build one. Yet Galaxy – widely seen as the first of many high yield names in offshore RMB – got its funds at just 4.625%. By contrast, the same week, Yuzhou Properties, rated single B like Galaxy Casinos and probably a similar credit, went to the dollar markets and paid 13.5% (although for a slightly longer deal). VTB, surely an unknown name to Hong Kong investors, paid just 2.95% for its funds. And these deals weren’t scraping the barrel of demand: Galaxy received RMB13.5 billion of orders including more than 80 institutional investors in the completed deal.

And so the flood continues, with investors desperate to get some yield on their RMB deposits but lacking any other instruments to invest in, and issuers seeing a great opportunity for cheap cash. Investors are also enthused because they see it as inevitable that the RMB will appreciate, so they add that onto the yield as part of their expected return. Some issuers, like Shui On Land, have built synthetic structures in which the capital raising is conducted in RMB but settlement takes place in US dollars. They pay a bigger yield to do so (6.875% on a RMB3 billion deal in December) but don’t have to fight their way through illiquid swap markets or find a use for the Chinese currency.

Some are becoming alarmed by the ease with which names – onshore Chinese borrowers in particular – can access eager funding with what appears an absolute minimum of due diligence (although some bookrunners say this is beginning to change). One lawyer describes says that “some of the deals coming out of China right now are restructurings waiting to happen”, and there is growing concern about what rights offshore investors have when they buy bonds issued by a holding company that has no guarantees linked to underlying assets on the Chinese mainland. But with this sort of fervour for investment, those who stand back and wait for better investor-friendly covenants are going to miss out completely.

That aside, the growth of this market, and of offshore settlement in RMB generally, is also having some perplexing side-effects. The most obvious is that RMB, despite being just one currency, is behaving in two completely different ways depending on whether it is onshore or offshore. Offshore, interest rates are low and falling, because of this demand. Onshore, they’re higher and rising. It spells a classic opportunity for arbitrage.

Most feel that this isn’t what China wants, but that it accepts it as an unavoidable consequence of the way it has chosen to liberalise the currency. “You have to look at this from the end-game: they want this currency to be international,” says Chia. “It’s not just an experiment to see how it looks if one day they open the capital account. The final objective is to make the RMB the international reserve currency for the world. And they know there will be some sacrifices along the way.”Among these is the fact that, with an open current account but a still-closed capital account, money is tending to move in just one way – outwards – and that these arbitrage possibilities will exist. “There will be an initial one to two years in which they continue to deepen the offshore market and there will still be this one-way physical flow of money out. At some point there have to be two-way flows, otherwise it becomes a stagnant pool of money, but not yet.”

Another example of this oddity is the fact that there are now three separate foreign exchange markets for exactly the same cross-trade, RMB to US dollars. There is an onshore deliverable forward curve, a non-deliverable forward market, and now an offshore deliverable market for dollar/RMB spots and forwards. All of this is great news for product innovation, from offshore RMB money markets to structured investment products and mutual funds. But there are, inevitably, concerns about the imbalances that are coming with these flows.

So what comes next? The so-called mini-QFII scheme will allow Chinese securities and fund management companies to raise funds in Hong Kong and then invest them into China’s asset markets. Guidelines and a timeline are long-awaited, but this seems likely to be the next initiative, followed by a further broadening of Chinese companies permitted to conduct trade settlement in offshore RMB (not that there are all that money companies still restricted).

In Hong Kong, discussion centres around RMB IPOs. One can argue that the first has already happened: at the end of April Hui Xian REIT raised RMB10.48 billion for its parent, Cheung Kong. But this was a real estate investment trust, which is considered something of a middle ground between a bond and an IPO, with a more pure equity listing still some time away. “The features of a REIT are a mixture of bonds and equity,” says Freda Wong, executive director, corporate finance at CITIC Securities International. “They pay interest, so the regulators in Hong Kong and the PRC were more comfortable to launch it to test the market. We expect some more of these RMB REITs will follow, but a pure equity RMB product will take time.” It is hard to say when. “If it was just micro factors involved, like a deal, that is easy to handle. But there are many macro factors that need to be considered before an innovative product like this is launched. They need to see if liquidity is ready, trade settlement, brokers, intermediaries… there is a lot to do.” Hui Xian performed disappointingly, opening down 7.82% on its first day of trading and closing 9.36% down, and this underpins the sense that it will be a while before this market develops.

In Singapore, all the talk is about whether that country could become the next offshore centre for RMB. Hong Kong is clearly going to remain the main centre, but there is a strong argument for others too, including in the long term London or New York. “Singapore has to get themselves a central clearing line, otherwise they will just be a sub-centre to Hong Kong,” says Chia. “They are in the process of getting that. Once they’ve announced it, our interbank market can start making a price on CNH.” She believes China will be happy to support further centres. “If China wants to make the RMB an international currency, they have to spread it geographically. Then there are more potential users.”

Then, the longer term game is fully convertibility. That’s a long way off. But everything that has happened in the last 12 months suggests it’s only a matter of time.