Hong Kong’s RMB market a forerunner for convertibility

Credit Magazine, December 2010

In September Hong Kong’s renminbi bond market took a major step forward. To that point, it had been a fascinating but fairly insubstantial new venture, attracting some interesting credits but lacking the scale or liquidity to have broader impact. But then China’s Ministry of Finance launched a RMB6 billion sale of government bonds to retail investors in Hong Kong – and by the time the offer closed on October 20 had attracted bids for three times that much.

The deal was significant on a number of grounds. The 13^th RMB bond issue in Hong Kong, it was the biggest, the first by a sovereign, the first to come in multiple maturities, and it increased the market’s curve from three to five years. Not only did it provide a government pricing benchmark to this new market, it also represented the first time the Chinese sovereign had issued an RMB bond anywhere outside the Chinese mainland. And, in so doing, it heightened the sense that what’s happening with this market in Hong Kong is a tentative but vital step towards convertibility of the Chinese currency.

“China obviously doesn’t need the money for fiscal purposes, so you have to ask why they are issuing,” says Tim Condon, chief economist for Asia at ING Financial Markets. “The answer is to prepare to give the renminbi a wider circulation outside of China – and so a small step towards internationalizing the renminbi. I see these small steps as being towards the end of full convertibility.”

Hong Kong’s RMB bond market started out with a RMB5 billion issue – still the second biggest to date – from China Development Bank in July 2007, and was followed by other Chinese state-linked agencies (Export-Import Bank of China in August that year) and major mainland banks (Bank of China in September 2007 and again a year later, and Bank of Communications and China Construction Bank in July and August 2008). The next milestone was allowing foreign banks with incorporation on the mainland to issue too through their Chinese subsidiaries: HSBC (China) was first, with a RMB1 billion institutional bond, the market’s first floating rate issue, in June 2009, followed by Bank of East Asia (China) with a RMB4 billion raising the following month. HSBC was back again in August with a RMB2 billion deal, this time chiefly for retail buyers.

With the Ministry of Finance deal, the total raised now stands at RMB38 billion from eight issuers, with tenors from two to five years and coupons between 2.45 and 3.4%.

Whatever China’s broader ambitions for the currency, the Hong Kong RMB bond market is underpinned by a pragmatic rationale: the steady accumulation of the Chinese currency outside of China. “Although as a percentage it’s small, it’s something that China has allowed and wanted to see,” says Anita Fung, treasurer and head of global markets for Asia Pacific at HSBC. “It started with the growth of renminbi deposits, and the RMB bond market in Hong Kong reflects the fact that it’s important to give investors a wider choice of investments than just those deposits.” Hong Kong resident retail investors can accumulate RMB20,000 a day, and by September 2009 RMB deposits in the city’s banks stood at RMB58.2 billion.

Aside from retail, selected specialist merchants can open RMB accounts with banks – those groups who naturally accumulate Chinese currency in the course of their business, such as international trading companies that accept RMB from their Chinese mainland counterparties. It’s a limited field: even these businesses must get approval from the Hong Kong Monetary Authority before being allowed to open an RMB deposit account with a Hong Kong commercial bank.

Between them, these two groups have created a modest institutional market too, made up of the banks in Hong Kong who offer the accounts that service those retail and merchant clients. “The RMB bond market in Hong Kong provides a means for the banks in Hong Kong to diversify their RMB assets from just placing them with the clearing bank,” says Fung. There is only one clearing bank licensed to handle RMB today – Bank of China (Hong Kong) – and it pays just under 1% interest, hopelessly unattractive for an institution. “If you have RMB deposits, you can invest them in RMB bonds at a more attractive yield without compromising the risk, if it’s a quality issuer.”

Consequently there is healthy appetite for any new issue. “Renmimbi retail deposits in Hong Kong receive a very low deposit rate, below 1%,” says John Sun, executive director of fixed income at Citic Securities International. “Anyone who has an RMB bank account in Hong Kong is going to receive that interest rate; compare that against 2.7% [the rate on the three-year tranche] for a bond from the Chinese government. That’s why the response is so good from retail.”

Between retail and the modest permitted institutional market described above, there’s already more demand than supply has yet been able to cater for. But if the net was broadened to a greater range of buyers, that demand would become truly insatiable. “When the MOF issued this bond I got a lot of calls to see if they could buy this bond – from Taiwan, the Middle East, Europe,” says Sun. “A three year bond offering 2.75% yield, and the potential appreciation of the renminibi – which on a two year trade is probably roughly 5% – means in US$ terms this bond offers more than 5% yield. It’s very attractive when US treasuries and yen offer so little. But unfortunately none of them can be involved in the deal.”

One consequence of this is a market that lacks liquidity. Deals fly out the door, but don’t then tend to trade. “Because of a lack of participants, the secondary market is not active,” says Sun. “Retail use these bonds as a replacement for their deposits, and so hold them. And commercial banks do the same thing – there’s no other way for them to invest their renminbi.”

More broadly, the market helps develop expertise, opportunity and familiarity. “By having an RMB bond market in Hong Kong it expands the range of RMB products and services outside China,” Fung says. “It’s part of integrating into international trade and financial markets, and it complements QFII, QDII and other initiatives to open up the financial sector.” QFII refers to qualified foreign institutional investors, a system whereby selected foreigners are permitted to invest in domestically-listed securities in China; QDII, or qualified domestic institutional investors, is the reverse process, where mainland asset managers can invest outside of China and launch mutual funds giving domestic investors exposure to world markets. Both have long been seen as early experiments in opening up China’s financial markets while improving the expertise of domestic participants.

In this context the Ministry of Finance bond was particularly important, since quite apart from soaking up available deposits in Hong Kong, it demonstrated the conviction in government towards this process of gradual openness. “It’s very significant,” says Fung. “It provides a sovereign bond curve, provides a wider range of investment tenors, and provides a pricing reference for future issuance. It also arguably provides a foundation for building an offshore interest rate swap market, or even a cross-currency swap market, as and when regulations permit.”

But she cautions against going too far. “People tend to mix up this market with the liberalization of the currency, saying it’s going to appreciate faster or means we have a faster timetable for capital account convertibility. I don’t think that’s the right way to look at it. It’s more a continuing process of gradual opening up of the financial market, becoming more internationalised, more market driven.”

From an issuer’s perspective, for the foreigners, RMB bonds in Hong Kong are not really about the money. “In terms of our funding needs we are well funded in RMB in China,” says Fung. “When we issued RMB in Hong Kong, it was not because we don’t have the RMB deposits to fulfil our local ratio of assets and liabilities. We issue because we think it very important to broaden the investor base and the types of investment products available in Hong Kong. We want to be the front runner in terms of the development of the RMB market for onshore and offshore.”

There are really only three major RMB deposit banks in Hong Kong: Bank of China (Hong Kong), HSBC and Standard Chartered. Bank of China (at the parent level) and HSBC have both tapped the market already, so all eyes are on Standard Chartered, which instead has more frequently been linked in the trade press with RMB issuance in China itself. Asked about Standard Chartered’s intentions, Sundeep Bandari, regional head of global markets, says: “As an active capital markets participant in Hong Kong, Standard Chartered is very keen to be involved in the development of the market.”

Whatever Stanchart decides, or is permitted to do, the trend appears to be towards a greater range of issuers. “We have seen good progress over the last two years,” says Bandari. “Initially only a few select Chinese banks were allowed to tap the market. Since this year, it has broadened to include the China subsidiaries of Hong Kong-based banks as well as the sovereign.” Bandari notes the China subsidiaries of Hong Kong’s banks, rather than the banks themselves, were permitted to launch RMB bonds in Hong Kong. “This is significant as it signals the Chinese regulators may be willing to consider non-Chinese issuers to tap the RMB market in Hong Kong, and may pave the way for possible future consideration of other foreign issuers.”

Fung’s perspective is also useful as an arranger, since HSBC has held a lead arranger role on nine of the 13 issues to date. “Issuing an RMB bond in many ways is no different to issuing a bond in other emerging currencies, but there’s a lot of work and coordination required in bringing these to market as it’s about transcending between the Hong Kong and mainland Chinese markets,” she says. “Coordination and setting the price discovery processes is critical to ensure it’s not a one off transaction, but benefits investors as well as setting a good benchmark for issuers, and this requires a lot of cross-border work, including with the regulators on both sides.” HSBC wasn’t a lead on the MOF deal, which instead was handled by Bank of China (Hong Kong) and Bank of Communications as bookrunners.

So what next? In launching the Ministry of Finance bond, vice finance minister Li Yong said that investor response to the issue would determine whether the Chinese sovereign issues more RMB sovereign debt in Hong Kong. Judging by the reception, they’ll be back.