Euroweek: offshore RMB report

Euroweek offshore RMB report, July 2012

RMB as a trade finance currency

While the dim sum bond market gets the headlines, arguably the most significant impact of the steady liberalization of the RMB will not be on the debt markets, but trade finance.

Just like CNH bonds, the growth in cross-border trade settlement in RMB has been exponential. From almost nothing in early 2010, the cumulative total settled in RMB had reached RMB3.17 trillion by March in the space of barely two years, according to Standard Chartered. The volume for the first quarter of 2012 alone was RMB580.4 billion, according to the People’s Bank of China – a 61% hike in a year, and that after a fairly slow three quarters.

And it’s just the start. “In the first quarter of this year, that volume accounts for 10.7% of China’s total trade,” says Thomas Poon, head of strategy and planning in Hong Kong at HSBC. “I think there is a lot of headroom for this volume to go up.” The logic is inescapable: China is the world’s second largest economy, and the world’s largest exporter; its trade relationships are central to most major economies worldwide and are only going to grow. The fact that the RMB accounts for such a small proportion of global trade today is an anomaly, and one that will clearly and steadily be corrected.

There’s no longer any regulatory restriction on Chinese exporters receiving export proceeds in RMB. “Nowadays, it is absolutely, utterly and completely free for all Chinese traders on both the import and the export side to use RMB for trade settlement,” says Poon. And the banks are ready. “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 Poon’s colleague, 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.”

That said, that 61% increase number disguises a counter-current, because it all happened in the space of one quarter between the first and second quarters of 2011 – after that, settlement volumes actually went down, and only in early 2012 has it regained much of the lost ground (see chart)(NOTE TO LAYOUT: Standard Chartered chart here). When the second quarter 2012 number comes out, it is likely to show a different headline: more or less flat year on year growth.

Puay Yeong Goh, FX strategist at Credit Suisse, agrees RMB trade finance settlement “has slowed a fair bit this year. Part of it is because China’s trade numbers have not fared particularly well, so the incremental increase hasn’t really come through. We’ve seen a bit of a set-back in the near term.” But he expects it to be temporary. “We expect China’s exports to grow this year, and with China looking to continue liberalization of the currency that should encourage exporters to use RMB as a mode of trade settlement.”

The next question: RMB exporters can settle in RMB. But should they? Most bankers think they should. “Using the RMB reduces some transaction costs in terms of having to go to dollars and conduct RMB hedging of the position,” says Goh. “That’s one benefit. Secondly, it’s just cleaner to use the currency.” As demand for RMB grows, it is likely to become easier to negotiate contracts in RMB than in dollars, he says. It’s a benefit that extends into cash management too: Standard Chartered analysis has shown that a client can save 2-3% in costs by switching their invoicing from foreign currency to RMB.

Perhaps encouragingly, the motivation for people on the other side of the fence to settle in RMB has changed from a speculative approach to a pragmatic one. “In the past, one of the major incentives for a lot of exporters outside China to settle trade in RMB was that it was deemed to be an appreciating currency,” says Poon. “Now, with RMB more or less reaching equilibrium, the chance of significant appreciation isn’t there. More important now is the saving in potential hedging cost, to both sides of the trade.” For example, if a company in Singapore trades with China, they might have to hedge using both US$-S$ and US$-RMB cross rates. “If some of the trades can be settled in RMB, that should be immediately a 50% saving in hedging costs.”Moving to RMB also helps with transparency and price discovery, in terms of establishing what the real cost of a supplier is in its own functional and reporting currency, with all ancillary costs such as hedging stripped out. “Being able to quote in RMB in many cases helps the sourcing company to compare the actual price more accurately.”

Take-up is a little more nuanced than headline numbers would suggest. David Koh, head of treasury services for Greater China at JP Morgan, says that smaller and medium companies have embraced the opportunities of RMB settlement more readily than multinationals. “I suspect part of it is systems driven,” he says. “There are enough financial products available now that enable them to hedge if they need to.” And taking the step makes sense. “From an accounting perspective, it is natural to use the home currency as the base currency.”

There are challenges, though, some practical and some behavioral. One is the requirement to revamp systems; local Chinese ERP systems look very different from the SAP and Oracle systems that have become the norm internationally, and integrating the two is not straightforward. On both sides of the fence, there is a need to add new currencies. Beyond that, it’s fine for an exporter in China to switch to RMB settlement, but what about the person on the other side of the trade? Can they even do so? “If a Brazilian trader wants to settle trade in RMB in Brazil, I doubt the local banks there are able to offer any basic account services to do so,” says Poon. “Without an RMB cash account, it is difficult to increase the usage of RMB beyond Asia. Banks need to think ahead in terms of embracing the rising use of the RMB, and thinking about what customers will require from the banking sector to support trade in RMB.”

Still, with each new company that makes the change, the process becomes a little easier. Morton says:  “Whenever a company does something for the first time there’s a learning process, so we do quite a lot of hand holding on the way, but the fact that so much volume has gone through means it is a well-trodden path.” And Goh reminds us just how quickly all this has happened. “The system is still pretty new: the market has only been around about a year and a half,” he says. “There is still an issue whether the market is deep enough to provide RMB trade finance, and since people have traditionally used dollars for so long there is a bit of inertia.”

China is also increasingly fertile ground for banks who can provide financial supply chain services. “China is the world’s biggest trading nation and exporter, so it is the supplier base for a vast number of global companies,” says George Nast, global head of product, transaction banking at Standard Chartered. Little surprise, then, that he says “supply chain finance is one of our strongest global propositions to MNC companies in China.”

And this has broader consequences that just China. With China being a lynchpin of supply to manufacturers all over the region and the world, anything that facilitates smooth and transparent trade has a lot of knock-on effects. “From a treasury services perspective, the most amazing thing over the last decade has been the development of the logistics industry,” says Koh. “In so many industries, from automotive to electronics to chemicals, there is so much more component manufacturing spread out throughout Greater China and beyond. The ability to transport components quickly and cost effectively to where these need to be as part of the manufacturing process has developed significantly.

“For example, for many high end electronics products assembled in China, many of the components come from Taiwan – such as the touch screen and the semiconductors. Through improved logistics capabilities, many manufacturers including large Taiwanese companies can move much further west into inland China to set up new facilities, and still know that once the product is finished, it can be delivered to the end consumer efficiently.”

Taiwan should be particularly interested in RMB openness, since it has the potential to become an offshore centre for the currency in its own right now that relations between Taiwan and the PRC have become more harmonious. Certainly, nowhere has had a greater recent transformation in the use of RMB in its trade: none of Taiwan’s Hong Kong/China trade was settled in RMB in February 2011, but by February 2012 the figure was 11.4% (compared with, for example, 6.5% for South Korea. Singapore, at 17.6%, is further ahead.)

SWIFT date, quoted by Standard Chartered, shows that in November 2011 1,085 financial institutions in 95 countries made financial transactions in RMB; growth in the currency’s usage could be seen from the UK to the UAE to South Africa. This is the future – the currency’s use for settlement not just in Greater China, and not just in Asia, but further afield. The City of London Corporation says that, by the end of February this year, there were deposits of CNH109 billion in London accounts. It is another liquidity pool outside of Hong Kong, and probably the second of many more to come.

There are few sure things in markets, but surely the volumes of cross-border trade being settled in RMB are only going to move in one direction. It is said that the RMB accounts for 0.3% of global payments and 11% of global trade; as the first number move closer to the second, a unique transformation will be taking place in world trade settlement.

The widening of the CNY trading band and what that means for the capital markets

In April, the People’s Bank of China doubled the width of the US$-CNY daily trading band – the range within which the currency can move from a set fix within any given day. The shift, from 0.5% to 1% (meaning the currency can now go up or down 1% from the fix on any given day), was accompanied by statement saying the PBOC wished to “further improve the managed floating CNY exchange rate regime based on market supply and demand with reference to a basket of currencies.” Like all bland statements from policymakers and central banks, it was closely studied by the market to work out what it means – not just now but for the future.

In the short term, the effect is not likely to be significant. “We don’t think it will have a direct impact on the markets,” says Candy Ho, head of RMB business development at HSBC, who says the market was expecting it to happen. “What will happen is the widened band will introduce more intra-day volatility. It is part of the reform that the PBOC wanted to implement: there has been a lot of flak about valuations of the CNY in the last few years and this will allow more flexibility.”

And, so far, that volatility has been fairly modest. “We’ve definitely seen a gradual increase in intra-day volatility, but that doesn’t necessarily mean that the markets are fully utilizing the expanded range,” she says. In fact, even at 0.5%, markets rarely used the full range anyway.

Analysts point out that, even with a widened band, the currency is not really responding to market forces. That’s because the RMB isn’t moving up one or two per cent in a day against what the broader market thinks it’s worth; it’s moving relative to a fixed point established not by the markets but the PBOC. “Technically it [the widening of the band] can lead to higher intra-day volatility, but whether it can turn into a more market-determined currency depends on the fix itself,” says Puay Yeong Goh, FX strategist at Credit Suisse. “Fluctuations are against the fix, and if that is not determined by markets, volatility will die off because the market realises it is just going to be fixed at the same rate regardless. At the end of the day it all depends how much market pricing is going to transmit into the fix.”

So instead, the market has focused on what the shift symbolises for the long term. “It is effectively showing China gaining comfort with more volatility around the exchange rate,” says Michael Vrontamitis, head of product management (East) in transaction banking at Standard Chartered. “We see the widening of the band as positive. It is part of the market growing up.”

Goh adds: “I see two things from the widening of the band. One is a step further towards full convertibility in the onshore dollar CNY rate; the other is that it is a signal that the PBOC is more comfortable with the level of China’s currency, which is why it is letting the band open up a fair bit. But it remains to be seen if it is a symbolic move, given that the previous band wasn’t fully utilised before this shift anyway.”

It is a characteristic People’s Bank technique to do things through pilot programs in order to alert the broader market about what’s on its way so they can get ready. This widening of the band should perhaps be seen in the same context. Goh, for example, thinks the widening of the band is a message to China’s corporates to start getting their act together for greater volatility in the future. “Widening the band is a signalling tool to onshore players, exporters and investors, to start expecting volatility and to start learning to use more hedging tools.”

And Thomas Poon at HSBC adds: “Does it mean they are going to widen the bank from 1% to 2% to 5%? I don’t know, I hope they do. But I would expect in the next few years to see significant financial reform in the domestic market.”

One interesting knock-on effect of the decision may be that the divergence between the onshore and offshore forms of the renminbi – which has at times reached 3% – could narrow. Candy Ho is one who argues that the widening of the band ought to help bring about convergence between CNY and CNH – and if that happens, there are a host of consequences for the capital markets. For Ho, the band is part of a broader suite of changes, including changed expectations about RMB appreciation and increases in cross-border flows, “that have encouraged the onshore and offshore markets to converge. And as we see more convergence in the FX market, that should impact offshore borrowers. As currency appreciation pressures have lowered down, the incentive for borrowing in RMB is higher.”

This is a big issue for capital markets, on several grounds. First, the change of currency expectations has also changed the way investors approach these markets. “Now people will focus not so much on appreciation pressure, but more on underlying credit quality when they consider investing in the offshore capital markets,” says Ho. Indeed, it’s clearly already happening, as one can see from the generally improved credit quality of dim sum bond issuers over the last year. “It shifts the investor mindset from a pure FX play to a more traditional capital markets investment, focusing more on the credit side of the story. That is a healthy development of a mature market.”

From the issuer perspective, corporates will have an increased incentive to look at CNY (onshore) markets if there is convergence between onshore and offshore exchange rates. And there is another knock-on effect too: the largely ignored possibilities in offshore RMB loans. “Obviously dim sum bonds are the most active offshore capital market in RMB, but slowly loan markets are picking up,” says Ho. According to the HKMA, at the end of the first quarter there were RMB42 billion outstanding in offshore loans, compared to RMB30.8 billion at the end of last year. “They are up close to 40%. The base is obviously still small, but with the capital account opening and the formalising of the FDI rule [allowing FDI to be made into China in the form of RMB using loans], we are seeing quite strong demand for RMB loans, whether bilateral or syndicated.” There is still not a benchmark for these loans to be priced against, but already eight banks have published their RMB offshore loan rates on the Treasury Market Aassociation web page, which has brought about a convergence in rates.

Some go further still. Woo Khien Chia, emerging markets strategist at RBS, argues that the widening of the band helps to bring about a convergence not just in the two forms of China’s currency, but in Asian FX performance generally. “We see the PBOC’s move to widen the US$/CNY intra-day trading band enhancing this Asia FX convergence trend,” she wrote in April. While that is quite a big academic call, she also agrees with others about what the band widening signifies, arguing the move “has its longer-term significance in counting down to China’s full FX liberalization, which will pave the way for the CNY realizing its potential as a reserve currency.” In her view, the next step is for the CNY to enter the SDR basket – the special drawing rights, the supplementary foreign exchange reserve assets maintained by the IMF – which are next due for review in 2015. She is already telling clients to establish a long CNY forward position against the four SDR component currencies as they stand today: Us dollars, euros, sterling and yen.

She expects a next step to be a gradual reduction in the US dollar weight in the CNY’s benchmark. “Barring a repeat of a full-blown global financial crisis, China will stay on track to gradually shift the CNY into a diversified freely-floating currency,” she says. Today, the dollar has an 82% weight in the CNY; she feels that could be reduced in order to favour Asian currencies as they have grown in importance as major trading partners.

In the long run, the mechanisms through which CNY-CNH exchange rates are driven could change. “For the moment, CNY is most likely to be the determinant of the CNH exchange rate,” says Jun Ma, Greater China economist at Deutsche Bank. “In very unusual circumstances CNH can be driven by a major global shock, but in normal conditions, given that CNY has much larger liquidity, it has the price-setting power. But in the longer term, when CNH becomes much more liquid and the arbitrage channels are widened, more individuals and institutions will be able to trade in both markets. Then, the role of price setting may shift more to the CNH market.”

That’s all some way off. For the moment, the widening of the band is a directional statement which might have limited short-term impact on markets, but which fits within a broader package of gradual liberalization. It’s one of many milestones.

Looking at the regulators

“It’s perhaps not what you expect from a regulator.” Michael Vrontamitis, head of product management (East) in transaction banking at Standard Chartered, is talking about the People’s Bank of China and the Hong Kong Monetary Authority – and he means his remark as a compliment.

The essence of Vrontamitis’s observation is this: that unlike regulators throughout history, this pair are listening to the market and doing, largely, what it really wants to see. Naturally, bankers, fund managers and (in most cases) companies all want to see a further opening of the RMB, believing there is a lot of money to be made from the process, but it’s the sense of a market and regulator moving in tandem that is pleasantly unusual to market conditioners. “They [PBOC and HKMA] have been operating in a way that is very close to the market, listening to the market very carefully, identifying speed bumps along the way, and being responsive to challenges,” says Vrontamitis. “They are taking feedback regularly, not only from banks but also from corporates.”

They have, after all, achieved an exceptional amount in a short space of time. One can argue that the internationalization of the RMB took its first step in 2003 when the HKMA began CNY business on a trial basis in Hong Kong, or in 2007 when the PBOC and the National Development and Reform Commission (NDRC) allowed a small handful of Chinese incorporated financial entities to issue CNY bonds in Hong Kong. China’s first bilateral currency swap arrangement (with South Korea, in 2008, followed by the HKMA); the pilot scheme for CNY settlement of cross-border trade between Shanghai, four Guangdong provinces, Hong Kong and Macau in June 2009; and the first CNY issues from China’s Ministry of Finance in September 2009 were all landmarks too. But the truth is that in almost every significant respect, CNH was really only born in 2010.

It is remarkable now to think that in early 2010, barely over two years ago, there was no dim sum bond market of any consequence (and certainly no commonly used ‘dim sum bond’ terminology); there had been no corporate issuers, whether Hong Kong, Chinese or international; there was still scarcely any RMB trade settlement, which was still limited to the Shanghai/Guandong pilot; exporters generally did not and could not settle their invoices in their own currency; and inbound quota under the QFII system was still considered scarce to the point of rarity.

Since then, a market that took decades to take the first step towards internationalization and then several years to do anything else has instead unleashed reform after reform on a monthly basis. On the trade side, that modest pilot grew to 20 mainland provinces and all overseas countries in June 2010; then to 67,000 mainland companies; then to every company in China; and by April 2012 – less than three years after that first tentative pilot – the PBOC was talking about establishing the China International Payment System, a new system to settle cross-border trade and investment in RMB. On the debt side, it was only in August 2010 that McDonald’s launched a RMB200 million bond, the first by an overseas non-financial corporation, signifying the start of this new funding channel for international companies; in less than two years that market has gone through several stages of evolution, first with a flurry of often unrated high yield issues before gaining some maturity, and along the way has attracted issuers from as far afield as Latin America, Russia and (in the pipeline) Nigeria. Then there’s QFII. “In the last decade only $30 billion of QFII quota was allowed, cumulatively,” says Jun Ma, Greater China economist at Deutsche Bank. Then it went up to $80 billion in a single hit. “An increase of $50 billion is a major step forward and that’s not the end of it. It’s the beginning.”

This has only been able to happen because of a clear level of trust between PBOC and HKMA. “It is terribly important from the Chinese regulator’s point of view to be able to find some degree of comfort and confidence in the counterparties they are doing business with,” says Thomas Poon, head of strategy and planning in Hong Kong at HSBC. “In the HKMA obviously the working relationship is very close, and that helps.”

It has worked because the roles of the two institutions are quite different, and the HKMA has clearly understood its place: that the PBOC will drive all of this and that the HKMA, which has only upside in being the testing ground for currency liberalization, has to make it happen as easily as possible. “PBOC and the State Council decide on the direction and pace of liberalization,” says Puay Yeong Goh, FX strategist at Credit Suisse. “The HKMA is more of an implementer.”

The HKMA is hardly likely to stand in China’s way, after all. Markets are what the city is about. “The HKMA has been quite business driven in delivering all these new initiatives,” says Candy Ho, head of RMB business development at HSBC. “They are aware of the business opportunities that are lying in the hands of the banks in Hong Kong, and the HKMA has very good relationships in working with those banks.” Ho, like Vrontamitis, feels consulted and assisted. “We are getting very timely updates as to what the local authorities want to do in terms of liberalising the RMB, and the HKMA has done a lot of work in terms of the regulatory updates and policy reform to make it happen and make it user-friendly for banks here.” She points to the relaxations of documentation requirements for RMB cross-border trade settlement as an example. “They wanted to make trade settlement procedures as user-friendly as possible for banks while keeping the integrity of the whole program.”

So with this spirit of mutual benefit clearly entrenched, what should we expect these regulators to do next?

It’s no longer really disputed by anyone that the end game is full liberalization and a standing as a reserve currency; for doubters, the announcements about China’s intentions for Shanghai as an international financial centre turned even their expectations around, since clearly no international financial centre can operate with a restricted currency. “We think it’s inevitable that the RMB will become a global trade currency, then a global investment currency, and finally the next global reserve currency,” says David Morton at HSBC. “We have a view that the RMB will be a top three global trade currency within five years, and that by 2016, one third of China’s $6 trillion trade could be settled in RMB.”

Questions revolve instead around how soon full liberalization will take place, and what the process of getting there will be.

“We are three to four years away from basic liberalization of the capital account,” says Ma at Deutsche Bank. “By then we are likely to see individuals and corporates allowed to convert RMB into hard currencies with a much bigger quota than they are subject to right now; it’s even possible the quota will be abolished after five years.” Even if they are not, he expects QFII quota “could double or triple in coming years,” alongside greater openness in the interbank bond market and greater facility for individual and corporate FX conversion.

Ho thinks the next steps will involve embedding projects that have already begun. “The PBOC will first look at expanding its existing pilot programs,” she says. “That would include RQFII and the China interbank market [which at the moment is accessible only to clearing banks, settlement banks and the central bank].” Like Ma, she expects the interbank market to be expanded to supranationals and Chinese insurers in offshore markets. “The ultimate goal is for the RMB to become a major reserve currency, and some of that is already happening: some emerging market central banks have already indicated they want to increase their reserves in RMB.”

Ho also expects to see more direct lending opportunities for Chinese onshore corporates. She has heard reports that some companies in Guangdong province will be permitted to borrow from Hong Kong banks directly under a new pilot program. “This will ultimately happen, but it will be subject to final regulatory approval. It is another way of opening up the capital account.”

It’s already clear that another part of the liberalization process will be the establishment of other centres for offshore RMB beyond Hong Kong. It used to be that people expected Singapore to take this mantle, but the truth is Singapore doesn’t add anything notably different to Hong Kong, except for greater liquidity and perhaps the private banking community; London, on the other hand, offers a whole new time zone. “Part of internationalizing a currency means that it needs to be traded 24 hours a day, and so therefore you must be able to move it around the globe as the centres open,” says Morton. Goh at Credit Suisse agrees. “London makes a lot of sense, because of the geographic importance of that time zone. China wants the currency to be truly international, it needs to be traded 24 hours with deeper liquidity.”

Standard Chartered research talks about the H in CNH taking on a different meaning: where once it meant Hong Kong, since that’s where all settlement was taking place, now it means Hai wai, meaning overseas in Mandarin. And again, the PBOC appears consultative and responsive in its efforts to move to this next, global phase. “They are very keen to understand what’s going on outside the Greater China region in terms of what challenges people are facing in terms of redenominating their trade flows into RMB, and how that fits with policies in China,” says Vrontamitis.

What might stop the momentum? “Concerns are largely related to capital flows,” says Ma at Deutsche. “If you lift the FX conversion cap too quickly it could lead to a massive net inflow of capital pushing up the exchange rate and damaging export competitiveness, in an environment of RMB appreciation. Or it could also lead to a major outflow and depreciation pressure on the currency. It is hard to balance the macro risks with the need to open the capital account.” Ma believes that now is a good time to open; NDFs, predicting roughly no change in the RMB exchange rate on a one year basis, show that the balance is about right.

Further afield, liberalization will have other consequences for Hong Kong – chiefly that, for the first time, an abandonment of the dollar peg will become more practical. “Once the yuan becomes fully convertible, the HKMA can start thinking about another currency as an anchor rather than the dollar,” says Goh. For his part, he thinks the PBOC “look like they are keeping to a 2015 pledge for full convertibility.”

It is a remarkable era to witness, the opening up of a currency that logically ought to support as much trade as the dollar. One senses it has not been easy but has so far been achieved without obvious mis-steps. “Obviously at times there are things they haven’t anticipated, but they come in rapidly to fix the issues,” says Goh. “I think they’ve done all the right things so far. It’s been gradual, but a liberalization of a currency like this hasn’t been done for a long time.”