What offshore RMB means for private banks

Asiamoney, March 2011

Private banking clients are always the first individuals to get into new asset classes. Whether it’s commodities, emerging market debt or wine, private clients will always get exposure to it well before retail ever do: they expect. And right now, they’re asking their bankers how to get involved in the burgeoning offshore RMB market.

The announcement in July of the memorandum of co-operation between the Hong Kong Monetary Authority and the People’s Bank of China, opening up the options for what can be done with renminbi circulated outside of China, had a host of knock-on effects. It triggered the launch of a vibrant new bond market, for dim sum bonds; it created a new structure for offshore trading of RMB, including an inter-bank market; it created a whole new US$/RMB foreign exchange market; and it revolutionised trade finance for those dealing with the mainland. Along the way, it led to a vast increase in RMB deposits outside China, which now stands at RMB314 billion. And that, inevitably, means an investment industry will have to grow to accommodate it.

“Many wealth management firms in Hong Kong have enjoyed seeing their share of the RMB deposit base increase, and are now sitting on considerable volumes of those deposits,” says Scott Wehl, head of banking products for Asia Pacific at UBS Wealth Management. “The issue these banks now face is what to do with the deposits. On the one hand, there is almost a land grab mentality going on, whereby some banks are offering very attractive rates simply to attract new money and claim as much CNH market share as possible.” CNH refers to offshore RMB. “On the other, there are limited avenues – in terms of availability of investment products – to further deploy these funds.”

While the deposit base in Hong Kong is partly a retail development, private clients are believed to be a disproportionately large part of it. “Private clients are among the major contributors to the rapid growth of offshore RMB deposits in Hong Kong,” says Rocky Cheung, head of the investment team for private banking at DBS Bank in Hong Kong. Part of the reason for this is that individuals are subject to a RMB20,000 daily limit for transfers, which inhibits investment; “many private banking clients had the ability to open BVI companies in order to accumulate RMB” and thus get around the restriction, Cheung says.

For some, deposits represent a perfectly good solution. “We are recommending our clients take exposure to deposits,” says John Woods, chief Asia strategist for Citi Private Bank. “The reason being, RMB deposits have a higher yield than Hong Kong dollar deposits, so not only do you get a higher yield than you would with your cash in a Hong Kong dollar account, but for those investors who believe the RMB is subject to appreciation you have a capital appreciation upside.” Woods’s own view is that the RMB will appreciate 3% in the first half of the year and 5% overall in 2011 – not a bad outcome from cash. “So Citi absolutely recommends its private clients take their exposure to the RMB through deposits – I think it is by far the most attractive way.”

But deposits are not for everyone: many clients want more. “We have a lot of investors who want access to real assets in China,” says Woods. For them, the obvious answer is the dim sum bond market.

It’s hard to think of a parallel for a market that has grown so quickly, not just in volume terms but in range and sophistication. From a more or less standing start in the middle of last year, the market already had RMB66 billion outstanding by the end of 2010, with more than RMB6 billion more in bonds and CDs having followed in 2011 at the time of writing. From the finance ministry and Chinese state lenders, the issuer base has broadened steadily: first foreign multinationals like McDonald’s and Caterpillar; then unrated, high yield names like casino operator Galaxy; distant emerging markets institutions with no link to China, such as VTB Capital; and most recently a host of names issuing bonds synthetically with settlement in US dollars. “There are very few products for clients to choose from, and dim sum bonds are the only possible candidates right now,” says Edward Chan, global head of fixed income within HSBC Private Bank. “So they are a hot ticket for investors. Every new deal is several times oversubscribed and investors have to chase in the secondary market to get their intended holdings” – not that there is much of a secondary market, since few people who have bought the bonds want to sell them without something else to invest in first.

Issuers like these can tap the market because of the huge demand for paper: some transactions are being oversubscribed as much as 50 times over. And this is giving some bankers pause about whether putting clients into these bonds is necessarily giving them such a great deal. “Yields offered on the CNH bonds, when compared with the onshore bonds, are generally lower and this is primarily a function of the huge demand for the bonds from offshore investors,” says Wehl. The yields are higher than the deposit rates offered by the banks – which is why they are so popular – but are they sufficiently higher to make it a sensible risk-return tradeoff?

“We find dim sum bonds to be, on average, expensive,” says Anurag Mahesh, managing director and head of global investment solutions for Asia Pacific in Deutsche’s private wealth management division. He says this obviously varies from issue to issue, but “in any market where there is such a huge wall of money waiting, that will always happen: credits will get away with smarter coupons than they would otherwise need to pay.” Investing in dim sum bonds is, he says, “a valuation discussion.”

For Mahesh, the fervour about these bonds, and offshore RMB generally, has masked a fundamental point that investors are tending to miss. “Offshore RMB or onshore RMB are essentially just the RMB story. You’ve got to figure out the best way to play that.” And that, he says, should be “two separate decision points”, one for the currency and one for the product. “There is no reason the two should be co-mingled. We tell our clients to have a credit decision, or an equity or a commodity investment decision, completely divorced from the RMB. Then overlay a foreign exchange position on top of that.” Moreover, he’s reticent to recommend longer-dated RMB bonds in what is likely to be an inflationary environment in China. “When rates go higher, you don’t want long-dated bonds in our portfolio,” he says. “Three years is as long as we would look to go – that’s another reason you want to be cautious.”

Enthusiasm for the RMB had been creating some odd pricing behaviour even before the offshore market got going. Prior to that, the way to get exposure was through non-deliverable forwards. “Every client wanted so much to get into NDFs that they were at a negative discount – meaning that the effective interest rate for one year was minus 2 per cent,” Mahesh says. When something is as heavily in demand as this, it can cease being a sensible thing to be exposed to.

On top of that, it’s not all that easy to get exposure anyway. Lee Boon Keng is deputy chief investment officer at Julius Baer in Singapore. In theory, he prefers bonds to deposits. “You can always do the deposits, but the returns are simply not something I think are going to outperform you having access to the bond market.” But can he get direct access to these bonds from the underwriters? That’s another story. “It comes to us once in a while. But the amount you get is sometimes negligible, as it is usually so many times oversubscribed. The fund managers with volume usually get it first and you’re left with nothing. Sometimes it’s not even worth it and you’re better off just going with the fund managers.”

UBS came up with an innovative solution to this, though not one that’s going to be easy for everyone to replicate, by issuing a dim sum bond of its own: a RMB200 million, two-year issue in November. That’s one way to guarantee your clients exposure.

But for everyone else, Lee believes funds are the best way to play the RMB story. “There is limited supply and you really need to have someone who is able to get that supply,” he says. “And the people who can get access are usually professional managers.” But who is that? ICBC and Hang Seng have launched dim sum bond mutual funds, and for quality of access private bankers mention Schroders and BNP, for example, but it’s not a long list.

Julius Baer’s solution was to set up its own investment fund alongside DBS Asset Management. The private bank was given exclusive rights to engage its clients with the fund for 14 days, and in that time raised almost S$100 million. “We chose to work with DBS Asset Management: they are fairly deep rooted in the bond market, they have good connections and they can tap supply.”

The fund itself, called the DBSAM RMB bond fund, was launched in October; DBS says it adopts an absolute return strategy and invests primarily in a portfolio of RMB denominated certificates of deposit, fixed and floating rate bonds, convertibles, notes and money market funds issued outside of China. But despite the fund’s clear success in attracting capital, DBS has since opted not to go any further down that route. “We looked at developing an[other] offshore RMB bond fund but eventually dropped the offer,” Cheung says. “The current market situation is not the right moment: the market is not mature enough to offer this fund. There are too many deposits chasing too few high quality bonds.” Cheung has reached the same conclusion about weak available returns as others. “Last year the Ministry of Finance offered a bond, and within the first day of subscription people were willing to take 0.8%. This defeats the purpose. If you can put RMB deposits in the bank at 0.7%, why would you purchase that bond?” DBS has instead focused its efforts on QFII funds – using the allocations for domestic investment that China periodically allocates to foreign institutions – and has so far launched two. “There is a lot of demand for this.”

The fund world also gives access to the A-share market, another way of playing the China story without going through offshore RMB. According to Morningstar Research, there are seven funds authorised by the Hong Kong SFC that have more than 10% of their portfolio invested in A-shares: at the top of the pile is a product from Allianz, which is 89.42% in A-shares, then several from Hang Seng, one from Bank of China and the JF China Pioneer A-share fund launched by JP Morgan.

Private clients will also want to be well-positioned in RMB IPOs in Hong Kong as they come along. The first, a spin-off of Cheung Kong Holdings’ rental properties in China, is expected to raise around RMB10 billion in the first quarter through an RMB-denominated real estate investment trust issue led by BOC International, Citic Securities and HSBC. Many more are expected to follow. “I see that exploding,” says Woods, of RMB IPOs in Hong Kong generally. He wonders how shareholders’ rights will be addressed, with Hong Kong investors holding RMB equity in China. But he adds: “The underlying demand for these IPOs will be extraordinary.”

Various other structures are being put together. UBS, for example, offers not only fixed term deposits but foreign exchange, RMB-denominated investment funds and structured products, and RMB lending capabilities. DBS’s treasury department has developed a range of instruments including principle protected products which involve the purchase of digital options, with various underlyings such as foreign exchange rates, equity or interest rates, using the funding cost to buy the options. These pay out 2 to 2.5% and can also be structured as equity-linked notes, QFII notes or credit-linked instruments. All are available denominated in RMB, or synthetic products can be built using the RMB forward market to replicate higher yield notes or deposits. Elsewhere, HSBC made a significant step in February by starting to offer RMB deposits in Singapore; UBS says it is looking at options outside Hong Kong.

But it is a common refrain of bankers in this area that clients must remember what they’re really looking for. “We are telling our clients to believe in the Chinese story, and not just focus on the RMB alone,” says Lee at Julius Baer. “The Chinese story is a megatrend.”

Thinking like this leads to some interesting strategies. “An alternative is to buy H-shares, but that’s Hong Kong dollars,” he says. “But is that a bad thing? In our opinion that could be the best thing to do. We believe the RMB will become a reserve currency, and that the Hong Kong dollar will no longer be pegged to the US dollar but the RMB – and sooner rather than later. That allows investors who are holding Hong Kong dollars and investing in H shares not just to benefit from the China megatrend, but allows that one-off appreciation when the Hong Kong dollar is fixed to the RMB.” Clearly, he says, this requires “a long term outlook and the patience to ride out volatility and reap benefits when it ultimately happens.”

Another strategy is to look at CNY – that is, renminbi in its onshore form – rather than CNH. “There is a focus on getting assets to the onshore CNY bond market,” says Chan at HSBC. “This is a very interesting market, particularly because the yields onshore are higher than CNH bond yields. This will be a major area we will be focusing on.”

Bankers, clients, issuers and traders are all still positioning themselves in this new market, and it will take years for the various imbalances between supply and demand to iron themselves out. “We would expect to see the product suite diversify and increase,” says Woods. “This is just the start.”