A half-open door

CFA Institute Magazine, November 2011

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

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

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

[Subhead] Slowly opening the door

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

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

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

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

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

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

[Subhead: The strange case of the RMB]

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

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

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

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

[Subhead]The dim sum boom

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

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

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

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

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

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

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

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

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

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

[Subhead] The future

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

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

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

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

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

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

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

ENDS