Asiamoney: trade finance the big story of an open RMB

Asiamoney  Trade Finance Report, May 2011

The internationalization of the RMB in Hong Kong has largely been depicted as a debt capital markets development so far. That’s natural: the dim sum bond market lends itself to league tables, headlines about volumes, and deals. But increasingly, the story of global RMB is going to be about trade finance.

Developments here have their roots in a pilot program from July 2009, which allowed direct settlement of RMB transactions for cross-border trade between Shanghai and four cities in Guangdong on one side, and Hong Kong, Macau and Asean nations as counterparties. In the subsequent year, as the offshore RMB bond market was permitted and launched in Hong Kong, this pilot program on trade expanded to 20 mainland provinces and all foreign countries as counterparties. Then, in December 2010, the Chinese government expanded its cross-border RMB trade settlement program to over 67,000 exporters.

Even before that expansion – when the number of mainland exporters covered by the scheme numbered just 365 – cross-border RMB trade settlement had been growing rapidly. Between June and November, cross-border trade transactions settled in RMB came to RMB340 billion, which was more than seven times the total volume from January to May. December itself, the month the scheme came through, saw RMB100 billion of volumes.

But even 2010’s volumes represented only around 2% of China’s total trade, suggesting enormous potential for growth with this dramatic widening of the pool of exporters. And there is certainly more to come. Neil Daswani, regional head of transaction banking for North Asia at Standard Chartered, argues that the 67,000 figure should, for now, “be taken with a pinch of salt. The number of eligible exporters under the scheme has grown exponentially, but the volume hasn’t seen the full benefit because various exporters are still at different stages of approval.” Some have established themselves as Mainland Designated Enterprises (MDEs, the official parlance under the expanded scheme) and are putting transactions through, but others are still getting their various clearances. “There are as many as six windows to deal with before they can be set up as MDEs,” says Daswani. When they get there, the floodgates will really open.

In the meantime, banks are swiftly working out who on the list of 67,000 they can reach. “The list is readily available to participating banks [Stanchart among them] and everyone is drilling down to see how many of their clients are on that existing list, and if they’re not, banks are trying to build bridges to them,” Daswani says. And it’s clear that with the expansion of these schemes, the opportunity for local and international banks is getting steadily bigger. “Clearly all the raft of regulatory change, which has meant a greater scope for the scheme, has had a beneficial impact,” he says. “The widening from five pilot cities to 20 provinces means 90% of the geographic footprint, as far as imports into China go, is available, and that’s a massive canvas.”

That’s the background. What does it all mean in practice for customers and their bankers? So far it’s largely a story of great promise and some progress.

“Even though trade has grown significantly, particularly if you use Hong Kong’s total deposits as a barometer, we are still at the beginning stages,” says Lisa Robins, head of treasury and securities services for China at JP Morgan. “A phrase I hear often is that the story is still to be written, but the first chapter is there, and we are seeing more and more of our clients using RMB.”

Already, there are differing views on where the opportunities lie. “We are seeing its use more on the Chinese importer side than overseas exporters at this stage,” says Robins. “Part of the issue is that if you accumulate RMB offshore, you do need to be able to have alternatives for placing it. So I think we will continue to see the Chinese have a competitive advantage in terms of price and want to use that while products develop.”

But Philippe Jaccard, head of liquidity and investment in Global Transaction Services Asia Pacific at Citi, has another perspective. “So much money has flowed into Hong Kong, because China is primarily a net exporter, particularly of manufactured goods and services,” he says. “When China imports, it is primarily commodities, traded in US dollars. So what you see is that generally the greater interest is for Chinese manufacturers to export overseas and get paid in RMB. As a result, RMB tends to find itself offshore.” This makes sense: Jing Ulrich at JP Morgan notes that in 2010, 73.4% of bilateral trade between China and the US came from US imports.

In any event, there is plenty of scope for trade finance business arising from these trends. Jaccard says Citi has seen sufficient interest in clearing to start running webinars on the subject – the three it has run in the last six months have attracted 750 people from all over the world. Citi has had RMB transactions all over Asia, has developed RMB capability in London and Dubai and is now extending it into Africa, Russia, Eastern Europe and Latin America. “Recently we got an order from Ecuador,” says Jaccard. “They all have clients interested in clearing goods imported in the Chinese currency.”

Standard Chartered reports active interest from Singapore, Switzerland and Dubai, among other places, while Deutsche sees plenty of emerging letter of credit business in RMB. “We have a lot of clients, companies in China, who have opened LCs in RMB and who used to do that in US dollars before,” says Venkatesh Somanthan, trade finance head at Deutsche Bank, who notes that doing so avoids using up scarce foreign currency quota. “The other leg is that we’ve been seeing a lot of LC confirmations and negotiations that were happening in any case, but historically in US dollars, which are increasingly getting denominated in RMB.”

One universal comment is that there aren’t enough assets for the flood of RMB to go into. The growth in RMB deposits in Hong Kong has been remarkable: up 378% in 2010 to around RMB 300 billion. RMB41.1 billion in bonds were issued in 2010, up from RMB16 billion in 2009, and RMB deposits became 4 to 5% of Hong Kong’s total deposit base (JP Morgan estimates it will reach 15% by the end of 2011). “I firmly believe more liquidity could come into Hong Kong if only there were more assets, and banks are struggling to keep supply and demand in line,” says Jaccard. “The opportunity in trade finance is clearly to offer term funding in any way to facilitate that process.”

Developing these assets would be easier were it not for the fact that many investors think the best thing to do with RMB deposits is sit on them. “What is hampering the process is today there is a bit of a speculative bubble, where a lot of companies love to hold RMB deposits but are not keen on having RMB liabilities,” says Jaccard. “That phenomenon is exaggerated by the long term view of the currency.”

In addition to new assets, there are also other parts of the market that need to take shape. “In order for the RMB to evolve into a more widely utilized trade currency, we need to see a broader market for FX and hedging for the RMB, both onshore and offshore, and we need more investment opportunities both in Hong Kong and other markets around the world,” says Robins.

Related to this is the growing disparity between onshore and offshore interest rates: an anomaly where one currency has a high interest rate and is therefore trading at a premium to the other currency, despite both, in theory, being the same currency. This will have knock-on effects. “The supply and demand of RMB offshore is off-balance, and the rate differential between the offshore and onshore markets getting wider,” says Jaccard. “With rates on deposits so low – the PBOC is lowering the rate offshore while increasing it onshore – at some point it could push companies to say: we have to do something with the RMB, we might as well fund our supply chain. Eventually much of that money is going to be flowing back through the current account, and that is where trade finance could see a huge upside.”

This relates to another common question: how, and when, money will start to flow back into the mainland. Repatriation is not straightforward, approved on a case-by-case basis by the regulator, and is considered a big issue. “We do see a gradual expansion of the RMB globally, but I think there are a few things that are really critical,” says Robins. “One, the ability to convert the currency; two, the ability to have more products; and three, to repatriate the currency. Finally, that all supports one of the objectives of the five year plan – the further relaxation of capital controls.” In the meantime, with the capital account closed, one of the only ways RMB can move back into the mainland is on the back of trade and services.

That said, a new announcement in January gave a sense of direction. The PBOC said Chinese firms could transfer RMB offshore to invest in new ventures, including through M&A, while China’s onshore banks will be able to extend RMB loans for those investments, with profits permitted to be repatriated back into China. This announcement “adds another flavour,” says Frankie Au, director of product management for North Asia at Standard Chartered, “because it means it makes sense for banks to have a closer conversation with MDEs, not just on a piecemeal basis but in a more holistic way about investment opportunities outside China.” Daswani calls it “another important way for RMB to move cross-border into the wider world.”

Bankers generally don’t think China is against cross-border flows back onto the mainland per se – except as an unwelcome spur for inflation – but is instead just trying to stay on top of what is happening. “We understand there are quota constraints for FX conversions for cross-border RMB,” says Somanthan. “That is a strict concern for market participants in China, and we have learned to factor it into our business planning and the roll out of our products. But these quotas, by themselves, are not meant to be show-stoppers – that’s the feedback we get. It’s much more in terms of wanting to have some mechanisms to monitor, and see how it works in the real world.”

Bankers say their clients want to get involved but are naturally taking their time in doing so. “Clients are looking to do more with China,” says Robins. “It’s one of the biggest growth markets in the world now, so having the opportunity to take advantage of inbound and outbound investment, as well as a thriving and appreciating currency, is clearly in their interest.”

But it’s not straightforward. “The client view is that, like many things, it is both an opportunity and a risk,” says Robins. “The opportunity being that it’s another currency in the toolkit: an opportunity to develop a broader relationship with their counterparts in-country, or outside as the case may be. It’s an opportunity to work with a currency that clearly will be one of the key world currencies both now and down the road.

“Where’s the risk? Until those financial products are broadly established and accepted, you’re still holding onto a currency that is not fully convertible.”

Jaccard describes “a huge level of interest but not enough action yet,” because customers don’t restructure their supply chains overnight “but as part of an overall structure that will run day by day. That’s not so easy to do. Changing your terms of trade takes time and you need to be patient.” Daswani agrees. “The first time you encounter an RMB invoice from an exporter, or are asked to invoice in RMB, you’ve got to set up the RMB as a new currency on your own system,” he says. “And it’s not just yet another currency: It’s also making sure you are dealing with a mainland designated enterprise. Early on we came across multiple instances where the licence had still not been fully approved for an entity in mainland China, and companies on the other side would be wondering why the transaction wasn’t going through. Once that’s set up, it settles like any other currency.”

Au at Standard Chartered describes a gradual evolution in client familiarity. “In the beginning, companies started with just understanding the rules,” he says. “Then they tried cross-border transactions in RMB. And now you’re starting to see some companies settle their cross-border trade in RMB in a recurring manner, and not just in Hong Kong. You will be seeing more and more of this kind of activity from corporates once they adopt and establish confidence in trade settlement.”

There are other practical challenges that will surely be addressed in time: Somanthan gives the example of currency coding on SWIFT, where both onshore and offshore RMB carry the code CNY despite the fact that most market participants value their exposure in two different ways.

And another popular discussion is the evolution of further centres for RMB settlement outside of Hong Kong, with attention today focused on Singapore as the next offshore market. “That’s something we look forward to,” Somanthan says. “It will enable banks like us to come up with a wide array of risk mitigation and FX products. We will get to see greater liquidity, local liquidity and local clearing mechanisms for RMB.” Any increase in the number of centres helps market participants, he says, “so any events in specific markets do not cause dislocation. Having more than one location to go to deepens the market, and the price discovery is that much greater.” Daswani sees another benefit: that Singapore has far more double tax arrangements than Hong Kong, which can be useful for a regional treasurer wanting to set up a procuring or invoicing centre with RMB among a portfolio of other currencies.

So what next for full convertibility? RMB is now leaving China, and will do so more since January’s permission to let Chinese companies take funds out of China for M&A; it is also circulating increasingly offshore, and will do so the more so as more investment opportunities are created for it. The bottleneck today is return of capital to the mainland, but once that is resolved, and global RMB circulation increased, the natural next step is the opening of the capital account – the last stage of currency internationalization. “If you look at the 12^th five year plan, the goals are very clearly set. China will be developing the tools necessary to encourage the adoption of the RMB more broadly as a settlement currency and an international currency,” says Robins. “The process is already underway.”