Euroweek offshore RMB report: the pipeline

Euroweek, July 2011

It can be easy to forget, in this strange era in which Macanese casino operators and Russian investment banks can tap cheap funding in offshore RMB,  that Chinese issuers remain the driving force of the dim sum bond market. And, while the proportion of foreign issuers is growing, it will be mainlanders and their Hong Kong subsidiaries who continue to drive this market for the foreseeable future.

In the beginning, of course, every issuer in this market was Chinese: between China Development Bank’s first deal in June 2007 and HSBC’s landmark first foreign issue almost two years to the day later, only Export-Import Bank of China, Bank of China, Bank of Communications and China Construction Bank issued. And for the next year, when foreigners like HSBC and Bank of East Asia started raising funds, they did so through Chinese incorporated businesses too.

The big bang that came with changed HKMA policies in 2010, effectively launching the dim sum bond market in the form we see it today, was characterised by foreign names taking the headlines: Hopewell, McDonald’s, UBS, Caterpillar. But the truth is that mainland institutions have continued to conduct not only the most issues but the biggest issues too.

This starts at a policy level. Most obviously, the Ministry of Finance has been an active and shrewd participant in this market, launching a series of bonds since October 2009 going from two to 10 years in duration. The ministry alone has launched seven issues totalling RMB14 billion, accounting for 11% of the whole market (a figure that was much higher until the recent glut of issuance; as recently as mid-March, its issues represented 19% of the entire market).

On top of that, Chinese financial institutions make up 29% of outstanding CNY bonds for a total of RMB36 billion, according to data compiled by RBS. This includes both policy banks and commercial banks. There’s every reason to imagine they will remain vital engines of issuance. China Development Bank and Eximbank were among the pioneers in the market and are active issuers; one would expect them to remain so, since the offshore markets provide them with cheap and diversified funding.

Mainland commercial banks do seem to have quietened as issuers since the early days of the market, which is understandable, since the banks face regulatory constraints and are being encouraged through Chinese macroeconomic policy to lend less than they have done in recent years. But they’re definitely still there, and still issuing. For example, during the week in May when the headlines were being hogged by Volkswagen’s RMB1.5 billion issue – understandably so, since it represented the debut of a key multinational and the longest-tenor deal from a western corporate – the Hong Kong branch of Bank of China was raising more than three times as much. Its RMB5.2 billion issue of five one-year dim sum CDs – two of them through JP Morgan and one each through Standard Chartered, BNP Paribas and RBS – was bigger than all the other RMB issues for the week put together.

Additionally, another category of issuer – the foreign financial institution, accounting for 33% of the amount outstanding as of May 23, or RMB41 billion – actually includes several overseas subsidiaries of Chinese banks. For example, Bank of China’s issues in September 2010 were from the Hong Kong subsidiary; likewise China Merchants in November.

Arguably the most interesting segment of the market is the corporate sector. For mainland Chinese issuers, it is not straightforward to get permission to launch bonds offshore. But for those with a Hong Kong subsidiary, and in particular a Hong Kong listing, there is no great challenge involved, and this is where much of the momentum has been.

One of the most widely noted deals in the market’s early development was for Sinotruk, which raised RMB2.7 billion in a three-year deal in October. This issue, led by CICC, CCB Asia and Bank of China (Hong Kong), was the first RMB-denominated bond from a Hong Kong-listed Chinese state-owned enterprise. More than that, it gave a very clear indication of just how much appetite was out there for a state-backed corporate name: it was upsized from RMB2 billion, was close to three times covered, and paid a yield of only 2.95%.

Seeing this, numerous others have followed. China Resources Power became the second red-chip in the market when it launched a RMB2 billion deal in November; with two tranches, its three-year chunk came even cheaper than Sinotruk (2.9%) and its five-year tranche, the first in the market by a non-sovereign, paid just 3.75%. Again, the appetite was considerable: a RMB10 billion order book from 50 accounts worldwide.

And so the procession has continued: China Power International Development; Sinochem; PCD Stores; Beijing Capital Land; Road King Infrastructure; Shandong Chenming Paper Holdings; Zhongsheng Group; Overseas Chinese Town Enterprises; China Chengtong Development Group. There are real estate companies, resources companies, automotive, forestry and computer companies. At the time of writing Far East Horizon, a mainland financial leasing company, had just appointed CICC, HSBC and Standard Chartered just two months after a Hong Kong IPO and appeared to be next in the queue.

So what’s next? There’s little reason to expect Chinese issuers to become any less active, because the same fundamentals that are driving international issuers to offshore RMB are equally compelling for mainlanders. “The most important consideration for them is the interest rate,” says Freda Wong, executive director, corporate finance at Citic Securities International. “The interest rate in the PRC is going up and up, but in Hong Kong’s offshore RMB market the interest rate is very low. So there is a difference between the two markets, and if you are a Chinese corporate in Hong Kong, you will get a lower cost there.”

One wonders whether China is particularly happy about this arbitrage – not just in terms of funding cost, but the opportunities that arise for traders when one currency behaves in two wildly different ways according to whether it is in onshore or offshore form. But many feel China accepts it as an unavoidable consequence of the way it has chosen to liberalise the currency. “You have to look at this from the end-game: they want this currency to be international,” says Chia Woon Khien, managing director and head of local markets strategy for emerging Asia at RBS.  “It’s not just an experiment to see how it looks if one day they open the capital account. The final objective is to make the RMB the international reserve currency for the world. And they know there will be some sacrifices along the way.”

“There will be an initial one to two years in which they continue to deepen the offshore market and there will still be this one-way physical flow of money out,” Chia adds. “At some point there have to be two-way flows, otherwise it becomes a stagnant pool of money, but not yet.” This interpretation suggests that China is unlikely to stop giving approvals to mainland entities to raise funds in offshore RMB just because of the cost differential; indeed, it’s logical for it to want its financial institutions to get cheap and diversified funding, all the more so if it helps deepen a vital market to the greater national good.

Chia says China is “still approving banks.” It makes sense for it to do so if the concerns that many analysts raise about solvency issues in Chinese lenders are accurate, particularly in relation to the property market. “That raises questions about the potential need for Chinese banks to be recapitalized at some stage,” she says. “And the Chinese authorities are thinking it would help to have an alternative, cheaper source for them to get capital.” By that logic there would be no sense in inhibiting mainland bank access to offshore RMB, no matter what the arbitrage consequences.

Other bankers agree there is still a strong pipeline of mainland lenders – policy and commercial – seeking to launch RMB bonds. “I know there are a few state-owned banks and financial institutions intending to issue RMB bonds in Hong Kong, because they need to enhance their capital base and they want to enjoy the cost advantages,” says Wong at Citic. And it is likely that the next evolution of the market will come through different types of bank capital being raised through offshore RMB. “Some banks are also talking with the PBOC [People’s Bank of China] to issue RMB sub debt in Hong Kong to boost their capital base in a cost efficient way,” says Xiang Hong, deputy head of global rates, Greater China at Deutsche Bank. “That’s in the pipeline. But whether approvals will be granted, I’m not certain.”

But Xiang points out that approval on subsequent bank raisings will also be dependent on what has been achieved in the development of the market for investors, and in this respect, the deepening of the market means it’s less vital for China to send its banks to issue offshore. “An important reason for onshore banks to issue offshore when the market started was that assets needed to be made available to investors, on top of deposits with banks in Hong Kong, which was the only other option,” he says. “There is less urgency to do so now however, because the bond market is becoming so popular with many issuers. When regulators approve onshore banks to issue offshore, they have to take into consideration that these banks are getting a huge benefit from cross border rate differential.” In that reading, the arbitrage question may prove to be more of an issue after all.

None of these considerations matter much to corporate issuers with Hong Kong subsidiaries, since there’s no regulatory headache to consider in issuing. For them, it’s a straightforward market decision. “For a pure PRC company, established and listed in the PRC, they will face a bigger hurdle to issue RMB bonds in Hong Kong because they need to get approval in the PRC before they can issue,” says Wong at Citic. “But if Chinese companies are listed in Hong Kong and want to remit the money back to the PRC then they will need an approval from SAFE only, and if they are using the RMB proceeds in Hong Kong then there’s no need for any approvals at all.” Chia at RBS adds: “Anyone can issue except onshore-incorporated non-banks. So if they want to look at cheaper funding, they have to do so through an affiliated company or subsidiary. McDonald’s China cannot issue CNH; McDonald’s can.” Hence the increasing appearance of red chip companies: Chinese assets, but Hong Kong domiciled companies.

The bookrunners who have specialised in mainland issuers remain optimistic. “My feeling is that the CNH bond market will be busy this year, and the whole market will keep its momentum for several more years,” says Tony Wong at Bank of China (Hong Kong), highlighting the more established legal framework and market infrastructure. He expects corporate issues in the RMB500 million to RMB 2 billion range, “and some larger deals in cases where the issuer has a solid external credit rating.”

Low rated issuers themselves are likely to continue to issue so long as they perceive there’s a willing buyer base waiting for them. “I think you are going to be seeing more of these [high yield] names, especially the smaller companies where they do not need as much liquidity as they could get in the G3 markets,” says Terence Chia at Citi. “Dim sum bonds provide a decently priced transaction for a relatively small-sized offering.”

Assessing the pipeline for onshore issuance in offshore RMB also requires us to look at what’s happened in synthetic deals, which started out with Shui On Land’s RMB3 billion deal in December. This transaction was denominated in RMB but settled in US dollars, giving global investors exposure to appreciation in the RMB – a key appeal of investment in these securities – but without them having to navigate the swap markets to use the proceeds.

Shui On was a blow-out success, bringing in RMB32 billion of demand in just seven hours of bookbuilding for the Shanghai-based property group. This swiftly became the fastest-growing part of the market: within five weeks total synthetic RMB issuance in Hong Kong had reached RMB18.75 billion, partly through a second issue from Shui On, which raised another RMB3.5 billion in January. “Between the two issues it raised close to US$1 billion,” says Paul Au at UBS, who was on the Shui On deals. “They were the first to open up this synthetic RMB market in high yield. It was a ground breaking deal and it has added another risk class for investors.” In being both high yield (though unrated) and synthetic, it is illustrative of the rapid evolution the market has made. “The emergence of the unrated high yield CNH market came of alive in the first quarter of this year,” says Au. “That market really is an extension of the synthetic market, and shows that the offshore RMB market is poised for further growth.”

But as 2011 has unfolded, doubts have arisen about the synthetic sector. Shui On Land, Evergrande Real Estate, Kaisa Property and China SCE Property all raised significant funds at cheap rates through the synthetic structure, but China SCE in particular saw its bonds slump considerably in the aftermarket after its January issue. When LDK Solar launched its own synthetic high yield bond, a RMB1.2 billion three year issue, in late February, it also swiftly fell (though it has since traded up). Around this time, sensing changing sentiment, Zhong An Real Estate delayed a three-year synthetic RMB bond of its own. LDK was the highest yielding offshore RMB bond to date, at 10%, but the fact that it barely covered its books suggests investors may be having a rethink about this arm of the market.

The arrival of the synthetic market was largely a function of circumstance. “The China market was going down a two-pronged road,” says Henrik Raber, global head of debt capital markets at Standard Chartered. “Firstly the dim sum bonds, which started off as all local currencies do, being more oriented to high grade issuers, and as a mechanism to soak up some of the deposits building up in Hong Kong. Then, as the market started to develop, some of the dynamics around the market started to change: the US dollar market for Chinese high yield issuers started to get a bit weaker, and we started to see those issuers in the synthetic format.”

The point we seem to have reached now is investor uncertainty about that sector, but from the issuer perspective if people will buy they paper, they are likely to keep issuing it. “It’s a case of the issuers looking for the best market opportunity to issue into and choosing that,” Raber says. “Chinese issuers have the option of a dollar transaction or a synthetic CNH deal, and will choose the one with the best pricing and dynamics.”