You win sum, you lose sum

Euromoney, June 2012

The dim sum bond market gets the headlines, as deal-driven capital markets always do. But while the emergence of the offshore renminbi bond market is a remarkable story, the truth is that many banks are likely to make a whole lot more money out of the less sexy work that flows out of the internationalization of China’s currency.

Let’s set the scene: the steady opening up of the RMB, from fastidious restriction as recently as five years ago towards full convertibility and a reserve currency probably five years in the future, is the most significant story in the world currency markets so far this century (assuming the euro hasn’t collapsed by the time you read this). China is the world’s largest exporter, a key trading partner to every country whose economy matters worldwide; and yet its currency is almost meaningless on a world scale in terms of its circulation outside its borders. The correction of this anomaly changes everything, and creates a host of work for banks along the way.

The early winners are the transaction and flow houses: the likes of HSBC, Citi, Standard Chartered and JP Morgan (through the old Chase business) on the international side, and the big commercial houses on the Chinese side – none more so than Bank of China, whose role as a clearing house in Hong Kong was instrumental in the very creation of offshore RMB. Banks with trade finance and cash management businesses in China are the most obvious early winners. “The renminbi accounts for just 0.3% of global payments, yet China accounts for 11% of world trade,” says John Laurens, head of HSBC’s global payments and cash management business in Asia Pacific. “That is out of kilter, and it’s evident which way the replumbing of commercial flows globally is going to go from here. The internationalization of the RMB has the potential to redefine the cash management industry globally.”

Trade numbers show just how much flow is waiting to be captured by banks. There was no cross-border trade settlement in RMB a few years ago; by March 2012 it had reached a cumulative RMB3.17 trillion, according to Standard Chartered, which expects to see China move from today’s 10% of world GNP to 24% by 2030. In the first quarter of 2012 cross-border trade settled in RMB was RMB580.4 billion; that’s a 61% year on year increase, and yet still only equates to 10.7% of China’s total trade. Banks have been positioning themselves for still greater flows, ever further afield. “The acid test is that trade is now being settled in RMB in 24 countries in the Asian region, as well as quite a bit of south-south trade – China-Brazil in particular,” says David Morton, regional head of corporate banking at HSBC. “We have already got capability in 59 markets: we have RMB trade capability in just about every country we operate in. That tells you we expect this to be a very strong theme running through the trade business.”

On the cash management side, the 20-page bound-out guide to cash management in China with this edition provides a comprehensive analysis of how the liberalizing currency is affecting business, but in essence, it affects everything: clearing and payments, liquidity management, deposits, access to the CNAPS national payment system, forex, advice on regulatory change, and integration of systems (try plugging a domestic Chinese ERP system into an international one built by SAP or Oracle and see how much fun you have). “RMB liberalization is the single most important development that is going to shape the global banking landscape going forward,” says Frank Wu, head of trade finance and cash management for corporates in Greater China at Deutsche Bank. “In a matter of months the RMB international clearing system infrastructure has started from zero to become widely available for a lot of the key trading partners of China. More and more customers have either started to convert their invoicing from dollars or euros to RMB, or made direct inquiries to do so. This is going to be a key theme in the next five to eight years.”

And it’s not just a matter of fashion that is driving corporates to embrace new possibilities in RMB. “Analysis shows that a client can save 2-3% in costs by switching their invoicing from foreign currency to RMB,” says Michael Vrontamitis, head of product management (East) in transaction banking at Standard Chartered.

Then there’s the increasing investment flows. The QFII (for qualified foreign institutional investors) scheme offers a mechanism for non-mainland institutions to invest RMB in mainland Chinese securities, and quota in the program has been carefully rationed. But in April the quota was increased from $30 billion to $80 billion. “In the last decade only $30 billion of QFII quota was allowed, cumulatively,” says Jun Ma, Greater China economist at Deutsche Bank. “An increase of $50 billion is a major step forward and that’s not the end of it. It’s the beginning.”

For banks, this matters more than just because of the statement of intent it represents. Immediately, it creates sub-custodial roles, as well as foreign exchange margins. “That business is continuing to grow as approvals start coming through,” says Vrontamitis. It goes two ways, too: the mechanism through which mainlanders can invest elsewhere in the world, QDII (qualified domestic institutional investors), also creates a need for regional custodian services. Vrontamitis also points to opportunities as a clearing institution. “Before, clearing business was done in dollars; now we are able to provide RMB clearing business to other banks,” he says. And, naturally, there’s new hedging business too. As Morton says: “People don’t like being unhedged, and that will drive currency product development.”

Still, it’s not just about making a mad dash for new business; in many cases international banks were already serving these transactions in dollars and now face a challenge to hang on to the business as it moves to a new currency. “Offshore business is anchored around providing working capital facilities, trade finance and foreign exchange services to our existing client base in China,” says Vrontamitis. “It’s as much about protecting our existing market share with these clients as it is being able to provide a new service to them.”

Outside of the steady flow business, other areas of banking are trying to get in on the act. One obvious example is wealth management, where advisors have already seen their clients’ attitudes change swiftly during the brief life of the RMB as an offshore currency.

Scott Wehl, head of banking products for Asia Pacific at UBS Wealth Management, calls the opening of the RMB “an evolving story”, which effectively begins with the 2010 step to allow corporates to hold RMB in Hong Kong without restriction. That move led to the rapid growth of deposits in Hong Kong, and from there to the launch of the dim sum market as those deposits chased yield. But already, investor expectations have developed. “The initial interest was around putting money into RMB for the currency appreciation story, and hence all the dim sum bonds issued at that time were at abnormally low yields,” Wehl says. “Now you see a maturing of that story.”

At UBS wealth management in Asia RMB has gone from zero to 3% of assets within three years. “What we tried to do was build an investment product shelf so clients could use RMB as an investable currency,” says Wehl. “There is still a lot of RMB in cash, although the proportion has got a lot lower as clients have put RMB to work in dim sum bonds and investment funds.”

Most obviously, client enthusiasm to invest their offshore RMB has been manifested in a host of dim sum bond funds, and already these have evolved into a segmented marketplace, from credit-hungry funds backed by local names like Haitong and Citic, to more sober, investment grade funds from the likes of Barclays, UBS and Schroders. Interestingly, the next step of evolution is RMB going into funds that have nothing to do with China. Wehl reports growing interest in RMB classes of international mutual funds – US high yield bond funds, regional equity funds, hedge funds. “Clients can stay in RMB, but invest as they normally would,” he says.

Structured products have also been an important area for UBS and its peers. “For example, given the limited RMB equity offshore, we offer RMB structured products with underylings such as Hong Kong shares.” Wehl says UBS “tried a fair few approaches” to structuring, and found that the most successful was one in which the customer can retain RMB. “So when you look at an RMB equity note against a HK$ underlying, if the strike is hit, they will be able to get all their money back in RMB and settle the trade in Hong Kong dollars. That way they’re not going to lose their RMB if they have to purchase the stock.”

Private banks were initially troubled by the dim sum market. They could clearly see that their clients needed a better return on their money than the near-zero available in Hong Kong deposits, and could sense that clients believed RMB would go inevitably and inexorably upwards without interruption. But it was also clear to any observer that some of the deals that were getting away were little short of preposterous: sub-investment grade or, more commonly, unrated, with little or no security for the bondholder over anything tangible, yet borrowing at rates that blue chips would look twice at. Last year, though, as expectations about the currency as a sure-fire one-way bet started to change, and as the previously exponential increases in RMB deposits began to tail off, some logical supply-and-demand good sense started to return to the market, helped by the development of institutional investors like mutual funds alongside retail punters. Correspondingly, the dynamics around dim sum bonds have changed.

“Now we have an investment theme out saying we think RMB bonds are good value,” says Wehl. “Some of the hot money has flowed out and yields are quite attractive.” Wehl says 50% of UBS clients’ RMB assets are in certificates of deposit, basically securitized deposits issued by a third party (and usually Chinese) bank; these might offer a yield of around 250 basis points compared to 100 for a dollar deposit. “The client is thinking: not only am I diversifying my risk away from the US dollar, I’m getting a higher yield and potentially currency appreciation.”

Another consequence of changed expectations around the currency could be that offshore RMB loans, which have so far been largely ignored, could take off. “A natural evolution is the development of the RMB financing market,” says Morton. “The bond market is only one aspect; there has not been similar growth in the RMB loans market. But a large part of that deposit base was put there because investors saw the RMB as a one-way bet on the exchange rate. As people have started to think the currency has reached fair value, and that there may be upwards and downward movements now, as a consequence you will see a significant lift in the RMB loan market.

“People weren’t prepared to borrow RMB loans before, because paying it back in the future would be more expensive if you were sure the currency was going to go up in value,” Morton says. “Now there’s a chance that it might even go down, people are prepared to use the currency for borrowing.”

One other thing we’ve learned in the last 12 months is that not everything turns to gold just because it has a link to the Chinese currency. The clearest example of this is in offshore RMB equity issues. So far there has been just one: Hui Xian REIT, which listed in April 2011, fared badly, and has yet to be followed by a second issue.

“The [offshore] equity market has not taken off as the authorities would have liked,” says Wehl. “There’s a question whether it’s necessary, because a lot of H share stocks are exposed to RMB in the underlying business anyway. What’s the differentiation in having an RMB share class? Equity is a missing piece at the moment.”

Some feel this is just a consequence of difficult global markets. “It’s probably a reflection of the IPO market in general,” says Morton. “The number of floats is well down on the boom years; people just aren’t prepared to put their company to market if they think they’re going to get a low price. We’ve got a number of mandates across a range of products, including RMB IPOs, that are basically in the drawer awaiting an improvement in market conditions.”

But when Wehl asks if an offshore RMB equity issue is necessary, he is echoing the concerns of issuers. A potential issuer in Hong Kong can launch an H-share issue, denominated in Hong Kong dollars, in a market with proven liquidity; or a CNH issue – where only one issue exists. “The problem is potential issuers are concerned about a lack of liquidity,” says Ma. “There is less than RMB600 billion available in Hong Kong, which may or may not be able to support the liquidity of a particular stock in CNH after listing. If there is not enough liquidity, it could lead to an undervaluation of the shares.” It is something of a chicken and egg situation. “Issuers need to be convinced that liquidity is good. But because nobody has listed, nobody can be convinced.”

Still, it’s not insurmountable; new issues are likely to come from companies that have never been listed in any market. “There will be demand for that, because you cannot get those shares anywhere else,” says Ma. But for those already listed in the A-share market domestically, “they probably don’t have as much incentive to do it.”

Another area which, while not a failure, didn’t really shoot the lights out is R-QFII. This is a branch of the broader QFII program but is specific to Chinese financial institutions in Hong Kong, allowing them to put money back to work in mainland securities. Two rounds of quota have been issued and it is rumoured that much of the second set has not been used, as investors have been lukewarm about products linked to it. “R-QFII was a great idea, because it’s obvious that there is a huge mismatch between interest rates onshore and offshore,” says Wehl. “Initially, it was seen as a sure winner by the fund management community, but I think they got a little bit ahead of themselves and put management fees too high. They’ve sold, but not as well as you would have expected.” Also, yields have risen in Hong Kong, which didn’t help. “The net yield to the client wasn’t hugely different, so therefore we didn’t see clients scrambling for them. We hear of fund managers with unused quotas.”

At Standard Chartered, Evan Goldstein, head of product management (East) in transaction banking Banking at Standard Chartered, adds: “I think what we learned from R-QFII is that investors are savvy, and don’t want to see the same old product.” Still, he believes that they could become more popular as quota is used to create equity ETFs in Hong Kong; this is also Ma’s view, who says that the first round of R-QFII quota was fully used in the domestic bond market and that the second, which is not yet fully used, will probably be deployed in China’s A-share markets or new Hong Kong ETFs.

Perhaps, as with anything new, it’s a question of time while people become comfortable with new possibilities. Medium to long term, this [R-QFII] is very exciting and a step in the right direction,” says David Koh, head of treasury services for Greater China at JP Morgan. “This is something that is needed if you want to continue the development of the RMB offshore, and to incentivize people to hold it. But the key here is at what pace developments will take place.”

The other big trend that is clearly underway is the shift from offshore RMB being a Hong Kong phenomenon to a global one. Standard Chartered has a nice take on this: it argues that whereas the H in CNH once stood for Hong Kong, now it stands for hai wai, meaning overseas. Earlier this year HSBC launched the first dim sum bond in London. Koh at JP Morgan points to the Indian government allowing issuance of dim sum bonds as a sign of future direction. On the private banking side, UBS has allowed clients to book offshore RMB in Singapore, Japan, Taiwan and Europe – principally Zurich – as well as Hong Kong. “If you look at Japan as an example, clients who are not necessarily personally involved in business with China are putting funds into RMB as a diversification and a viable investment currency,” says Wehl. “We’ve been looking to expand that around the world, to European and other Asian clients, to broaden the investor base.”

From the dim sum bond perspective, more offshore RMB centres are needed in order to ensure decent liquidity 24 hours a day; London clearly helps with that, although there’s no obvious enthusiasm in the Americas yet (it was only this year that the first SEC-registered dim sum deal was launched, and even then not for a North American but a Latin American enterprise, America Movil). “This is an important part of the overall internationalization process,” says Vrontamitis.

And the growing internationalization is helped by the fact that – and this hasn’t always been true of the PRC – there is the sense of a clear willingness to learn and to help. Speaking of cross-border trade settlement, for example, Vrontamitis notes: “Any issues about it are being addressed one by one. One was documentation, but that’s being resolved; another was around the number of companies in China that could access the scheme,” which was gradually expanded from a pilot of 365 companies to, in 2010, more than 67,000, and subsequently every company in China. “The market has increasing confidence about the availability of quota, so you’re unlikely to see the quota issues you saw in September last year where FX rates offshore varied by more than 3% from onshore rates.” The sense of accommodation, of schemes moving from pilot to mainstream and learning along the way, is helpful. “These measures are helping to increase the confidence of multinationals.”

And what of China’s growth story, and the fretting about hard or soft landings in this crucial engine of the world economy?

It’s true that there are concerns about PRC growth flagging. But those who work within the region are not concerned in the long term. “I’m very optimistic,” says Koh. “There’s not going to be a hard landing. We are already experiencing a soft landing.” Local consumption is steadily increasing, reducing reliance on FDI. “China being the second largest economy in the world, 8% growth is not a bad deal at all.”