Euromoney: Renminbi moves to a sweeter spot

Euromoney magazine, October 2010

For a nation that takes its own sweet time to do anything progressive on foreign exchange, China has been in a mighty hurry this year. A series of liberalizations has, in the space of a few months, created a new offshore deliverable forex market, prompted a whole now bond market and transformed trade settlement for businesses active in China. Not a bad summer of effort.

International banks active in Hong Kong and China have been delighted with the moves – particularly those who had hoped for it and invested a lot in getting ready. “We’ve been predicting this for about four years and we’ve built a cash and trade system with RMB settlement capabilities which is now in every country in Asia,” says Mike Rees, group executive director and CEO of wholesale banking at Standard Chartered. “We’re very relieved something’s happened. We’d have looked a bit stupid otherwise.” Stanchart and others spent the money to get ready for these developments because of a deep belief at the highest level of these institutions that the changes, when they came, could be transformative. “The potential is going to be huge,” says Rees, arguably the second most senior person in his bank worldwide. “If you believe in economic power in the east, and the power of the Chinese, then ergo you believe the RMB as an offshore tradable currency is a very big thing – potentially one of the biggest things that will happen in this region over the next 10 years.”

So what’s changed? To answer that, it’s useful to take a step back to see where liberalization has come from.

The Hong Kong Monetary Authority (HKMA) first announced the launch of RMB business in Hong Kong on a trial basis in December 2003, to little immediate effect: all it really meant was that RMB could build up in low-yielding retail bank deposits, and that some personal RMB services could be offered, in restricted form. It was four years before anything else of much consequence happened. Then, in 2007, mainland financial institutions were permitted to issue RMB bonds in Hong Kong targeted at retail investors there in order to create more uses for RMB deposits. In subsequent years the scope of permitted issuers expanded, and several significant deals have been launched from issuers including Bank of China, Bank of East Asia, HSBC and the Chinese government itself.

Two important things then followed in 2009. In January the People’s Bank of China (PBOC) and the HKMA signed a currency swap agreement to provide RMB liquidity of up to RMB200 billion, with a renewable term of three years. (It’s never been used, but was still a significant move.) Then in June, the PBOC launched a pilot scheme for RMB settlement of cross-border trade, involving Shanghai, four cities in Guangdong, and Hong Kong. This was a big step, reducing the foreign exchange risk for importers and exporters, and was swiftly taken up (see chart). It was followed in February this year by new rules from the HKMA allowing participating banks to develop RMB business provided the funds didn’t flow back to the mainland; one effect of this was to open the RMB bond market to any issuers eligible to issue bonds in Hong Kong (see box).

That’s the foundation upon which the latest liberalizations have been built. The significance of what happened next is that, rather than just an occasional step every few years, major revamps have taken place very close together. “The pace of change is very interesting,” says Jens Scharff-Hansen, co-head of FX trading for Asia at Deutsche Bank. “It took four years from the first regulation in 2003 to the next in 2007, yet now you have had four relaxations in 18 months. It’s a hint that it is reasonable to expect further relaxations over a fairly short period of time.”

On July 19, the HKMA and PBOC signed the Supplementary Memorandum of Co-operation, increasing significantly the pool of RMB holders and the products that can be offered to them. Among other things, non-bank financial institutions such as brokerages and insurers, and also corporates, can now open RMB accounts and receive unrestricted RMB services on non-trade-related RMB conversion. Also, restrictions were removed on transfers between Hong Kong-based RMB deposits, meaning Hong Kong banks can net out their positions with their peers. “That,” says Scharff-Hansen, “is the birth of an offshore RMB trading facility within Hong Kong. If banks are able to start trading with each other, without documentation requirements, it leads to swaps, forwards and securities. Suddenly you can make markets, subject to the liquidity available in your system.”

Four weeks later on August 16, PBOC opened a new channel for offshore RMB to come into the onshore interbank bond market. So foreign central banks, RMB clearing banks in Hong Kong, and banks participating in cross-border RMB trade settlement – such as HSBC, Stanchart, Citi and Deutsche – can invest their RMB liquidity not just in the new offshore bond market, but onshore bonds as well. These investments will come under a quota, and go through a separate account, but have some big implications: they allow qualified institutions to hold higher-yielding RMB-denominated assets than the deposits they had previously been stuck in, and can also diversify their range of counterparties.

Among other things, these measures have created a third market for US dollar/RMB forex. Alongside the onshore deliverable forward curve and the non-deliverable forward market, there is now an offshore deliverable market for dollar/RMB spots and forwards. And a host of markets ought to grow from this: an offshore RMB money market, bonds, structured investment products and mutual funds.  Also, since the HKMA appears supportive to the development of RMB-denominated financial instruments, with no general prohibitions, “this raises the prospect that the Hong Kong offshore market could become substantially more sophisticated than the mainland onshore financial markets,” says Standard Chartered in a report. The HKMA has already given in-principle approval for principal-protected structured investments and deliverable forwards, for example. The table shows what’s on offer so far and what is not.

From the corporate trade perspective, the new measures make it much more appealing to accept payment in RMB. Until now, that’s been a miserable way for a company outside China to be paid, because what can you do with the funds bar stick them in the bank to earn less than 1% interest and just hope you make a gain on currency appreciation? Now, there are investment products for those funds, and ordinary companies are permitted to invest in them. “We see trade volumes growing much faster this year than last, because of the general acceptance to settle trade in RMB, as well as China’s expansion of companies that are eligible to participate in the scheme,” says Justin Chan, deputy head of global markets, Asia Pacific, and head of Hong Kong trading at HSBC. Trade settlement numbers are already transformed: according to the PBOC, half-yearly offshore trade settlement volumes have grown from RMB3.6 billion in the second half of 2009, when the pilot scheme kicked off, to RMB70.6 billion in the first half of 2010. “And that’s still a very small percentage,” says Scharff-Hansen. “China is the biggest trading country in the world – in excess of US$2 trillion per year. It’s reasonable to expect more and more volume being remitted in RMB as opposed to dollars.” In particular, he notes that many transactions between Asian currencies are settled in dollars even when there’s no US component to the trade. “If the RMB really starts to open up for that purpose, we are going to see huge volumes coming to our markets.”

Thinking like this recently prompted Julia Leung, Hong Kong’s undersecretary for financial services, to predict a “dramatic expansion” in RMB circulating outside China. Momentum has been very rapid since the most recent cluster of liberalization measures, although clearly compared to the onshore industry it’s a drop in the ocean. In a variety of metrics offshore volumes come to about 01-0.2% of the onshore equivalent, according to Standard Chartered research published in late August: US$12.5 billion equivalent in RMB deposits in the Hong Kong banking system compared to US$10 trillion in China’s onshore deposits; US$30-50 million of offshore spot FX transactions in RMB per day compared to US$20 billion onshore; and US$4 billion in offshore RMB bonds compared to US$2.9 trillion onshore. (Even in the month since that report, numbers have started to increase: Justin Chan at HSBC says volumes in the offshore markets, combining general FX, spot and forwards, have already hit US$200-300 million per day, and notes that since many banks are probably matching trades internally rather than going to the interbank market, they are probably really much higher.)

This gulf between the onshore and offshore market tells us two things: that China will be confident the market can be allowed to develop further without having a big impact on the onshore system; and that there is huge potential for development in the offshore market.

This has very big implications for Hong Kong. For example if offshore RMB deposits grew to 4% of China’s onshore base, this would double Hong Kong’s total local currency deposits. “In the early 1960s, when the Eurodollar market started to emerge, the ratio of offshore to onshore US dollar deposit bases grew by about one percentage point per year,” says Standard Chartered. “If the same speed were to be repeated in the CNH market [the standard abbreviation for offshore RMB], Hong Kong’s bank deposit base could double within five to 10 years.” Similarly, Scharff-Hansen says if 10% of China’s trade were to be settled in RMB in Hong Kong, that would equate to up to US$2 billion of daily turnover. “I think that’s going to happen pretty quickly,” he says. “All the knowledge is there; all the professionals in the interbank community have that knowledge in Hong Kong in the offshore market. It’s just a question of applying that.”

One impediment to development is liquidity relative to demand, although again, the volumes are increasing dramatically and quickly. Scharff-Hansen calculates a total of RMB103 billion within the offshore market in Hong Kong today, and notes that will have to grow substantially to be sufficient to support demand. But Deutsche reckons that through a combination of trade finance and tourism, the total liquidity base will reach RMB500 billion by the end of 2011, and RMB1 trillion a year later.

It is irresistible to see these latest measures as part of a trend towards full convertibility of the currency. Every move like this is a step closer, and increasingly it just seems a question of time.

But Rees argues the issues involved for China doing that are big, far bigger than just forex or even export considerations. He points to growing cost and wage pressure in China, and suggests these will make China particularly cautious about allowing the RMB to rise. “The impacts on margins have already been significant,” he says. “If they let the RMB appreciate, wage pressure will quickly turn into unemployment, and that’s a very different scenario. This market will develop based on how China reads the sustainability of its domestic economy.”

BOX: A new bond market

Among the many developments triggered by liberalization is the creation of a new bond market. Although an offshore RMB bond market targeted at Hong Kong retail investors has existed since 2007, this new creation is more of a RMB Eurobond market.

Bragging rights have gone to three deals: an RMB200 million bond for McDonald’s, the first corporate deal for a multinational; RMB1.4 billion from Hopewell; and a certificate of deposit deal worth RMB500 million from Citic Bank.

These deals followed a decision in February by the HKMA, with China’s support, to allow RMB bond business to be carried out in Hong Kong in accordance with prevailing banking practices, so long as it did not entail any flow of RMB funds back to the mainland. “This essentially opened up the RMB bond market to any issuers that are eligible to issue bonds in Hong Kong,” says Tee Choon Hong, regional head of capital markets for North Asia at Standard Chartered, which led the McDonald’s bond. “There’s no more restrictions as long as the credits are acceptable by investors in Hong Kong. That changed the rules, the game plan, entirely, and it opens up that market to the whole world.”

While Hopewell was the first and the biggest deal, it was still seen as something of a local name; it’s McDonald’s that captured the headlines. It was issued by the parent, out of Chicago, not by some local subsidiary; it came off an existing MTN program; and it is one of the most famous multinationals in the world. It made sense for the company because it needs RMB funds, and the RMB/US dollar swap market is not yet liquid or efficient. “You need the right combination of the right name, recognition, with a need for RMB in China, and prepared to take the initiative to do new bonds,” explains Tee.

The Citic transaction – the first in a CD form – was significant because it opens the door for a financial institution without a retail deposit base to participate in the market. “A lot of banks who don’t have a retail base still want to support their customers doing trade finance, but they don’t have the money in RMB and there are limits to what they can borrow,” says Justin Chan at HSBC. “The Citic Bank deal is a landmark because it tells banks outside Hong Kong that in case they want to participate in the RMB bond market, they can do so in a CD format. Foreign banks, Japanese banks, Singapore banks who don’t have operations in Hong Kong but have customers with investments in China, they can now channel the necessary funding so they can make RMB trade finance part of their business.”

One challenge with this new bond market has been the remittance of funds back into China. Shortly after the McDonald’s bond priced and distributed successfully – to a range of banks, companies, insurers, funds and bank deposits – the praise for the deal gave way to rumours that McDonald’s had not been able to remit its money back into China. Tee stresses that “the bonds and the remittance into China are two separate issues”, with the bond in Hong Kong under the jurisdiction of Hong Kong regulation and the remittance into China under Chinese regulators; he says McDonald’s has its money as originally planned. But it will be an impediment to the development of this nascent market if issuers foresee they will have a problem accessing their funds having raised them.

“In the past, when China does a relaxation, it always comes along with guidelines or rules on how you can do it: what department you need to go through,” says Justin Chan at HSBC. “This time the guidelines just said you need approval – it didn’t say which department was coordinating arrangements. It’s a bit blurred at the moment and is causing a lot of confusion for people who want to raise money in Hong Kong and remit it to China.” That’s going to need to be resolved for this market to build on its promising foundations.