Euroweek RMB report. RMB liberalization: the story so far

Euroweek, November 2013

The story of the offshore RMB market has unfolded at a heady pace. You wouldn’t quite call it a page-turner, but it certainly hasn’t wasted any time getting to the point.

A decade ago there simply wasn’t an offshore RMB market to write about. Renminbi stayed in China; you couldn’t use them anywhere else. The blueish 10-yuan notes with the Three Gorges on the back were souvenirs to take home, but couldn’t be converted when you got there even if you wanted to.

It is remarkable to think of that remoteness today when the currency has spawned a vibrant, increasingly liquid multi-jurisdictional bond market and become a key instrument in global trade. And this is just the start. In the last 10 years we have seen the formative steps taken in a journey from a fully restricted monetary instrument to one of the world’s key reserve currencies, which is surely, inevitably, where it will end.

“My opinion is the offshore RMB, especially the bond and interest rate market, started seven years ago, when Hong Kong first allowed individuals to purchase RMB on a daily basis, up to RMB20,000 a day,” says Philip Tsao, managing director, head of global finance and risk solutions, Greater China at Barclays. In fact, the very first step had taken place in January 2004 when retail depositors in Hong Kong were allowed to convert some of their savings into renminbi, but as Tsao says, it was when Hong Kongers were allowed to accumulate in reasonable size and frequency that the first inklings of a market came into being. “When RMB deposits accumulated to a certain level, they started looking for an investment target.”

That, in turn, led to a need for RMB bonds outside the mainland. The first of them came in 2007 from the China Development Bank, a RMB5 billion bond that was listed on the Hong Kong stock exchange, the first publicly listed bond to be traded and settled in RMB; issuance by mainland banks hit RMB20 billion by the end of that year. HSBC’s China arm became technically the first foreign offshore RMB issuer in September 2009. Then, in October 2009, China’s Ministry of Finance issued the first RMB-denominated offshore sovereign bond.

But what really prompted the market to take off were two steps in 2010. First, in February, the Hong Kong Monetary Authority said, with China’s support, that it would allow RMB bond business to be carried out in Hong Kong “in accordance with prevailing banking practices” – which, among other things, meant that anyone who was permitted to launch bonds in Hong Kong (that is, pretty much anyone) could do so in offshore RMB. This was followed in July with the agreement between the HKMA and the People’s Bank of China allowing banks in Hong Kong, and their clients, to conduct business in the Chinese currency.

In aggregate, these liberalizations engendered the birth of the dim sum bond market proper. And in its early days the market perhaps grew a little too fast and disjointedly for its own good.

Early landmark deals looked promising. In July 2010 came Hopewell Highway Infrastructure with a RMB1.38 billion two-year deal, the first corporate bond in the market. A month later came a RMB200 million deal from McDonald’s, the first truly multinational corporate issue. Citic Bank brought the first certificate of deposit deal, and then in October the Asian Development Bank brought the first 10-year deal. Sinotruk was another early corporate deal, and the first red chip; KEXIM showed appetite from Asian agency borrowers, Deutsche and UBS borrowed in their own names, and Caterpillar joined McDonald’s as a foreign corporate using the market for RMB funding. All of these were welcome developments.

But by the end of the year, there was a growing sense that the momentum was a little out of control. In consecutive days in December 2010, Galaxy Entertainment Group raised RMB1.38 billion in a Regulation S deal, and VTB Bank from Russia raised RMB1 billion, both in three-year deals. With Galaxy, the market had moved from Chinese policy banks to high yield casinos in just six months. Galaxy itself was not even rated – it had an affiliate, Galaxy Casinos, rated only single B – yet sold at just 4.625%, at a time when a similarly-rated credit was paying 13.5% for the same sort of funding in dollars. VTB, for its part, was a BBB-rated Russian bank with on presence in China, nor any stated intention to build one at that stage, and it paid just 2.95%.

Part of the early attraction of deals like this was that the steady improvement of the RMB’s value against the dollar was seen as a sure thing. The coupon on a deal was only part of the appeal to the investor. Instead, they were also assuming appreciation in the RMB, and they factored it in to any buying decision, making them much more comfortable with what would normally be seen as an unacceptable risk-return calculation.

On top of that, in the early days, demand far outstripped supply, as RMB deposits grew dramatically in Hong Kong and the bond market struggled to keep up with new issues. Numbers from that time show truly extraordinary growth rates: RMB deposits in Hong Kong were RMB90 billion in June 2010, RMB 150 billion in September 2010, RMB217 billion in October 2010 and RMB314 billion by the end of that year. The deposit base trebled in six months. And as the fund manager base engaging in RMB bonds began to grow in order to create new products for their clients, they also became avid buyers of new issues to put into their funds. Additionally, the Chinese sovereign itself, through the Ministry of Finance, was borrowing at just 1% for three-year funds at the time, so investors were more inclined to look elsewhere for yield.

This environment allowed the launch of new, synthetic deals, like Shui On Land, which raised RMB3 billion in December 2010 with an order book of RMB32 billion that had been accumulated in just seven hours of bookbuilding. This deal was sold in RMB but with settlement in US dollars. This, clearly, was a currency play, since it got around the fact that the investor didn’t need to have any use for the RMB. Other synthetic issues followed swiftly: China SCE Property did the same thing the following month, this time including a Rule 144a element and allowing US investors in for the first time.

Another interesting deal, though it didn’t necessarily look it at the time, came from Export-Import Bank of China in December 2010, with a dual tranche RMB5 billion bond. Headlines at the time went to its absurd level of overheated oversubscription – its institutional tranche was covered 53 times over – but actually the more significant element was that for the first time, it wasn’t sold almost exclusively into Asia, with 12% going into Europe. This would prove to be a forerunner of much broader international participation. By the following May, 26% of a deal for Volkswagen would go into Europe.

Aside from the blatant overheating of the market – “some of these deals are restructurings waiting to happen,” one lawyer told the author at the time – there were other early headwinds, not all of which are fully resolved today. One was the issue of repatriation of capital to the mainland. Businesses raising funds in RMB because they actually needed RMB, rather than as an opportunistic way to raise cash, had a stressful time moving the funds from Hong Kong to where they were needed afterwards. The McDonald’s deal, for example, grappled for months with repatriation issues.

“I do remember in the beginning, when the first dim sum issuers came to market, there were so many different procedures to go through with the various different local authorities: the PBOC, SAFE, provincial or national levels of government,” recalls Candy Ho at HSBC. “There were not proper formalised procedures about how RMB raised offshore could be remitted into China.”

And for those who didn’t want RMB funds, there was an equally vexing problem: the absence of a liquid swap market. In the early days, it would cost 2 or 3% to swap funds to dollars, often wiping out the funding advantage from going to the market in the first place. Gradually, in subsequent years, this has improved, first with one year funding and then steadily to longer durations.

Finally, there was no secondary market. Having had to fight their way through 50-time oversubscriptions in order to get any paper, the last thing investors were going to do was sell it. This, too, has improved since, but you still wouldn’t call it a very liquid secondary market.

The vibrancy of new issuance continued into 2011. Between July 2007 and June 2010, the month before the HKMA’s new measures came into effect, just RMB34.3 billion of offshore RMB bonds were issued; in the 11 months afterwards, up to May 2011, the total volume outstanding rose to RMB103 billion: a trebling of the market in less than a year. The increase in Hong Kong deposits continued unabated, and was running at 10% a month by early 2011.

By the middle of 2011, just a year into the market’s development, a startling range of sectors was represented in the market: automotive by Sinotruk, utility and energy by China Resource Power and China Power International Development, alternative energy by China WindPower and LDK Solar, chemicals by Sinochem, retail by PCD Stores, real estate by half a dozen names, construction by Road King Infrastructure, technology by TPV, transportation by Singamas Container, forestry by Shandong Chenming Paper and electronics by BYD. Many of them were unrated, with coupons varying from 1% to 7%.

But there were the first inklings of a rebalancing taking place between investors and issuers. By the middle of 2011, covenant packages began to change on RMB deals. In fact, they had hardly existed at all in early deals, partly because they would have been almost impossible to enforce since most of the mainland issuers were holding companies without a direct or guaranteed link to the assets of the parent. But, whether enforceable or not, investors began to request them, and to differentiate between rated and unrated CNH deals. Also, by the middle of 2011, the synthetic sector already seemed to be flagging. Evergrande Real Estate, Kaisa Property and China SCE Property had all used the structure, but China SCE had seen its bonds slump considerably in the aftermarket. LDK Solar followed it and barely covered its books, and by the time Zhong An Real Estate approached the market in the spring of 2011, it ended up delaying the deal indefinitely.

By now, another side-effect of the supply-demand imbalances in Hong Kong was emerging: the Chinese currency was behaving in two completely different ways depending on whether it was onshore or offshore. Offshore, interest rates for bonds were low and falling because of demand. Onshore, they were high, and rising. Additionally, there were now three separate foreign exchange markets for exactly the same cross-rate, RMB to dollars: an onshore deliverable forward curve, a non-deliverable forward market, and an offshore deliverable market for dollar/RMB spots and forwards.

By the end of 2011, there was a sense that the dim sum bond market had started to grow up. The scale was impressive – RMB160 billion of issuance in 2011, compared to RMB40 billion the year before – but there was also a sense of discernment in terms of who could issue and at what rate.

Perhaps the biggest reason for this was that expectations on the Chinese currency itself had now changed. While most strategists were still predicting an appreciation of the currency, it was no longer seen as a one-way bet, a sure-fire way to get a guaranteed 5% appreciation each year. Also, volatility had begun to appear in the RMB-US dollar exchange rate, partly because by now the US economy was flagging and its currency deteriorating with it. So, if the currency appreciation was no longer a given, an investor had to be very comfortable with the credit and outlook for the bond itself. This changed investor attitudes towards risk.

Alongside this, and part of the reason for it, came the European debt crisis and its impact on global markets. New issuance in the dim sum markets held up well considering, but there was no denying that events in Europe had had an impact on both issuers and investors, and in particular risk tolerance.

Finally, the supply-demand imbalance that had driven the market in its first year had started to level out. In October 2011, for the first time in years, RMB deposits in Hong Kong actually declined from one month to the next, albeit by just 0.6%. The apparently unstoppable growth in deposits had flagged.

Deals began to change subtly in favour of the buyer. In late 2011, Baosteel brought a landmark three-tranche RMB3.6 billion issue – a landmark because it was the first time a Chinese company had issued a bond directly rather than through an offshore subsidiary, which has relevance for investor protection in the event of a default. Unrated deals began to fade from the market. And the names in the market became more internationally familiar: BP, Tesco, Air Liquide, BSH Bosch und Siemens.

Still, there was scope for new names, and their home bases demonstrated just how international the currency was becoming. In December 2011 America Movil, the Mexican telco, began marketing a dim sum deal, eventually selling it in February 2012, and the Central Bank of Nigeria began looking at an issue. The Movil deal brought the highest non-Asian distribution yet, with 26% of the deal going into the US and almost 20% to Europe.

Another problem had eased by now: repatriation of funds. For Ho, a turning point came with the introduction of RMB FDI laws by the Chinese authorities in late 2011, “normalising the procedures for the RMB to be used in foreign direct investment for capital injections into China. That eased the whole process,” she says. “It used to take anywhere between six and nine months to get the approval to send money into China. The promulgation of the FDI rules significantly shortened the procedures to around three months. These days it is relatively easy for corporates who have raised debt in the offshore market to inject those RMB funds back into onshore entities.”

Structural innovation grew too – for the right names. ICBC, through its ICBC (Asia) subsidiary, launched a RMB1.5 billion issue of tier two subordinated bonds in November 2011, the first lower tier two bond from an Asian bank to be Basel III compliant in any currency. As a 10-year non-call five bond, it demonstrated the increasing range of tenor the market could support too.

These are the themes that have driven the market since. China Development Bank priced a 15-year deal in January 2012, then a 20-year in July. ”Tenor,” says Ho, “isn’t a big issue anymore.” This year the World Bank continued the theme of top-notch borrowers, including the biggest supranationals, accessing the market. There have been Islamic RMB transactions, including some from Khazanah, the Malaysian state investment entitiy.

New headaches have appeared – for bankers, the appearance of seven or eight bookrunners on a small deal has been particularly unwelcome – and the market has had to deal with periods of underperformance, with bonds widening considerably in the second half of 2011 in particular, and with investor favour diminishing once again with China’s slowing growth during 2012. Issuance even stopped for three months in mid-2013. And the soaring deposit liquidity of the early days has gone. “There is little need to worry about excessive growth in offshore RMB liquidity,” says Nathan Chow, analyst at DBS. “Stock of CNH deposits will likely grow only gradually.” But all that, in itself, is seen as a sign of market maturity.

Today, swap markets are much less of an issue. “With the opening of up cross-currency swap markets and the increasing daily turnovers and volumes seen in those markets, we now have a lot more foreign companies and financial institutions who would use the dim sum market as a funding vehicle,” says Ho. “They don’t necessarily need RMB funding, but they look at the cost of funds versus the home currency and, if the swaps make sense, will do the deal.” She says that interbank cross-currency swaps now go out to 10 years. “Seven to 10 is the extension of maturities we have seen happen this year,” she says.

Meanwhile, momentum has moved to other centres. In April 2012, HSBC announced plans for the first RMB bond in London, and raised RMB2 billion, 60% of it placed into Europe. Issues in London have followed from international names like Banco de Brasil and ANZ, and also from several Chinese entities. China Construction Bank raised RMB1 billion here in November 2012 through its London subsidiary, and in October 2013 UK Chancellor of the Exchequer George Osborne announced that ICBC would become the first mainland bank to issue an RMB bond in London, which appeared to suggest it would do so in its own name as a mainland parent rather than through some distant subsidiary.

This reflects an internationalization of the market that has many elements to it. “We’ve seen bank issuance from Russia, from Brazil, from Europe, and we also have RMB transactions that are targeted in a specific market,” says Ho. “Taiwan’s Formosa bonds, Singapore’s lion city bonds; we ourselves [ie HSBC] have issued both in Singapore and in London. The infrastructure is now in place with clearing banks set up.”

Today, there is a sense of a market that has found its feet and a certain maturity – an adolescence, perhaps. “It’s a lot more professional now,” says Tsao at Barclays. “A lot of banks, pension funds, sovereign wealth funds and central banks are all participating in this market. Hong Kong, Singapore, London and now Taiwan are involved. The real question is how this market should develop further.”

So where next? Standard Chartered says it expects the offshore RMB debt market to grow by 30% a year and reach RMB3 trillion by 2020, alongside various other developments for the broader currency (such as it accounting for 28% of China’s international trade, or $3 trillion, by 2020). “We expect the offshore renminbi market to grow to become bigger than many Asian local-currency bond markets today, including the Philippines, Indonesia, Hong Kong, Singapore, Thailand and Malaysia,” Stanchart says.

But to get there, the market does still need a few things.

One is a regular benchmark issuer – a widespread request. “As a participant, what is needed is a regular issuer who can help to set up a benchmark for offshore RMB future pricing reference,” says Tsao: “Benchmark securities that can be held long and short by market makers. It should be the Chinese Ministry of Finance, just as the main issuer in US dollars is the US Treasury.”

The problem is, the Ministry of Finance has so far not worked in that way. “We need issuance quarterly, not annually. China MOF issued this year in June, and before that, more than a year ago, in May 2012. At the same time, the way they manage their transactions isn’t really a bookbuild process it leads to a pre-paid type of situation where the paper tends to go to accounts that are buy and hold, meaning there is not much secondary trading. So neither the frequency nor the trading are high enough for people to take it as a true benchmark.”

If the MOF won’t take that benchmark role, “then the next in line will be the policy banks like China Development Bank, but their quota process is even worse,” says Tsao. “The last quota they got was at the end of 2011.” They then issued in January and July, but have now not been back to the market for 15 months. “So that’s not the way to set up a benchmark security.”

That’s a problem. One banker, asking not to be named, says: “How do we price a Chinese deal? There is no benchmark. Why are we selling it at 6%, why not 8% or 10%? As an underwriter, I don’t have a good answer except that the issuer wants 6%, take it or leave it. That’s not a healthy market conversation at all.”

Tsao adds: “The problem is, what is the floating rate benchmark?” But he does see some progress here. “People have started to use Hibor, which is a great start. We think the floating rate benchmark is being established.”

A proper benchmark issue would then lead to other helpful developments for the market, he says: easier quoting of cross-currency swaps, and, with all the proper risk management tools then in place, greater participation by US and European pension funds and insurers. That, in turn, would drive secondary trading volume, “when people are confident they can get out when they want to get out, and that they can hedge underlying risk.”

Ho would also like to see the offshore RMB loan market develop in tandem with the bond market. “We haven’t seen that take off yet. With the help of the establishment of CNH Hibor in June, we are hoping to see more syndicated loan market demand.” She also calls for an interest rate derivative market to help the development of the product.

At some point the currency will become convertible and we will see some convergence of the onshore and offshore markets, but that doesn’t necessarily mean the end of the dim sum bond. “If you look at the dollar, 60% of Treasuries are traded offshore,” Tsao says. “The dollar would be a very good example for CNH to follow.”