The rise of the redback II

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1 Macro Qu Hongbin Co-Head of Asian Economic Research, Chief Economist The Hongkong and Shanghai Banking Corporation Limited Qu Hongbin is Managing Director, Co-Head of Asian Economics Research, and Chief Economist for Greater. He has been an economist in financial markets for 17 years, the past eight at HSBC. Hongbin is also a deputy director of research at the Banking Association. He previously worked as a senior manager at a leading Chinese bank and other Chinese institutions. Sun Junwei Economist The Hongkong and Shanghai Banking Corporation Limited junweisun@hsbc.com.cnv The rise of the redback II An updated guide to the internationalisation of the renminbi Sun Junwei is an economist for on the Asian Economics team. Prior to this, she worked as an economic analyst at a leading US bank and in the public sector.junwei holds an MSc in Economics from the London School of Economics and a BA in Economics from Peking University. Paul Mackel Head of Asian Currency Research The Hongkong and Shanghai Banking Corporation Limited paulmackel@hsbc.com.hk Paul Mackel leads HSBC's Asian Currency Research team and is based in Hong Kong. He joined HSBC in June 2006 and was previously based in London, covering G10 currencies while working alongside David Bloom. Prior to joining HSBC, Paul worked in similar roles for other financial institutions. He is a regular contributor to the FX strategy publications and appears regularly in the media. The rapid pace of the internationalisation of the redback has taken the world by surprise The renminbi is on track to become the third largest trade settlement currency by 2015 and is likely to become fully convertible within five years Wang Ju Senior Asian FX Strategist The Hongkong and Shanghai Banking Corporation Limited juwang@hsbc.com.hk Wang Ju joined HSBC in 2012 as a Senior FX strategist with primary focus on North Asia. Prior to HSBC, Ju worked as an Emerging Market strategist at two other major investment banks for six years, in both the US and Singapore. She holds Masters degrees from SAIS, Johns Hopkins University and Nanjing University. Ma Xiaoping Economist The Hongkong and Shanghai Banking Corporation Limited xiaopingma@hsbc.com.cn Ma Xiaoping is an economist for on the Asian Economics team. Prior to joining the team in 2005, she worked with a leading academic research institute in Beijing. Xiaoping holds an MA in Economics from Peking University. Donna Kwok Economist, Greater The Hongkong and Shanghai Banking Corporation Limited donnahjkwok@hsbc.com.hk Donna Kwok is a Greater Economist for HSBC Research, based in Hong Kong. Before joining HSBC in 2010, Donna worked as an economist for the Hong Kong- equities research arm of a global research provider. Prior to that, she was East Asia analyst at Strategic Forecasting (US) and a strategy consultant at Deloitte Consulting (London). Donna holds a Master of Arts in International Relations (Economics and Studies) from Johns Hopkins University School of Advanced International Studies, and a Bachelor of Arts (Hons) in Economics and Management from Oxford University. By Qu Hongbin, Sun Junwei, Paul Mackel and Wang Ju Disclosures and Disclaimer This report must be read with the disclosures and analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

2 Summary Less than two and a half years ago, as the US pursued quantitative easing and the world worried about the future of the dollar, we wrote that the internationalisation of s currency, the renminbi (RMB), was set to take off. It hasn t just taken off it has soared, becoming perhaps the fastest growing currency in the world. Already, s seemingly-relentless rise has completely transformed the world economy. Even as western nations have succumbed to debt-induced slumber, s continued expansion has dramatically improved economic prospects elsewhere in the world: some of its closest neighbours and many of the world s major commodity producers have been caught in s powerful slipstream. s gravitational pull is not, however, confined to purely economic developments. Thanks to the redback s rise, the world financial system is also beginning to be radically reshaped. This development will have a profound impact on both and the world. Today, more than 10,000 financial institutions are doing business in RMB, up from 900 in June The pool of offshore RMB, non-existent three years ago, now tops nearly RMB900bn (USD143bn). The proportion of s exports and imports settled in RMB has increased nearly six-fold in three years to nearly 12%. The growth can be seen everywhere from the FX and bond markets and new offshore centres like Singapore, Taiwan and London to licensed stock market investment schemes, foreign direct investment (FDI) and overseas direct investment (ODI) in RMB. These flows are going in both directions in and out of through an ever-increasing number of financial conduits being opened by Beijing. This report looks at the factors driving RMB usage internationally and how anticipated financial reforms will lead to full currency convertibility within five years, the benchmark for making the RMB a truly global and, eventually, a reserve currency that is an alternative to the US dollar. It is essential reading for all investors and particularly whose who conduct business in, trade with the country, manage RMB FX risk or use the currency to invest. From trade to investment Back in 2009, seeing an opportunity created by the changing world financial order after the global financial crisis, Beijing introduced a small pilot scheme to test the appetite for using RMB in cross-border trade. The private sector s response was immediate and dramatic, unleashing huge pent-up demand for settling invoices in RMB, especially in emerging markets (EM). Trade flows between the mainland and other EM countries now account for more than 60% of s total and will likely grow much faster than those between and the developed world. We stand by our projection that a third of s total trade will be settled in RMB by 2015, making it one of the top-three global trade settlement currencies by volume. Meanwhile, RMB cross-border capital flows have also taken off. RMB FDI almost tripled in 2012, while outward RMB investment surged 50%, implying that international acceptance of the currency has already started to extend from trade settlement to investment. 1

3 The offshore market The offshore RMB market, introduced in 2010, has seen liquidity surge two and a half times between 2010 and 2012 and is still rising strongly. This, plus the introduction of a broad range of RMB products, has significant implications for market participants with hedging, financing and investment needs. For example, international companies such as BP, Tesco and Volkswagen now have ready access to the currency through Hong Kong s booming dim sum bond market. While Hong Kong has become the de facto centre for offshore RMB, new offshore centres are emerging RMB clearing banks were recently approved in Taiwan and Singapore and there are signs that the UK will soon follow. All these factors will reinforce further growth in RMB internationalisation, reflecting s economic power and the rise of the redback. Window of the opportunity for full convertibility Yet, despite all these rapid developments, given the country s enormous global clout s currency is still severely under-represented in global trade and capital markets. To become a global currency requires full convertibility. Although this will be done gradually, Beijing policy makers are now more confident than ever about speeding up the process. s trade imbalance has been corrected and the RMB s exchange rate is much closer to its equilibrium level. There is evidence that interest rate liberalisation and other financial reforms are gaining momentum. This will pave the way for the opening of the capital account through further expansion of the Qualified Foreign Institutional Investor (QFII) and the Qualified Domestic Institutional Investor (QDII) share schemes and the removal of restrictions on individual cross-border capital flows in the coming years. We think that, combined with s already free flows of both inward and outward direct investment, these moves will make the RMB fully convertible within five years. While some controls will remain, the full convertibility of the RMB will have a profound impact on both and the world. Putting s domestic financial house in order first needs to develop accessible, deep and broad domestic financial capital markets. This is a pre-condition for full convertibility. Although the country s domestic equity markets are the world s third largest by market capitalisation, there are problems and irregularities that need to be fixed. Guo Shuqing, the securities regulator, is driving a series of reforms which should make a big difference. The bond market is still very underdeveloped relative to the equity market and the country s rapid economic progress. However, the pressing need to fund local government infrastructure projects is likely to trigger an expansion of the bond market in the coming years. More importantly, Beijing must develop a stronger institutional and regulatory framework to improve the market efficiency and control financial risks. In short, must put its domestic financial house in order before fully opening up its capital account. 2

4 RMB facts and figures As of August 2012 more than 10,000 financial institutions were doing business in RMB, up from 900 in June The monthly average RMB trade volume has surged from just RMB18bn in 1Q10 to RMB173bn in 2011 and RMB245bn in RMB settlement now accounts for 12% of s total trade, up from 9% a year earlier and 3% in Hong Kong is responsible for 79.6% of all cross-border RMB trades. Total RMB deposits in Hong Kong stood at RMB603bn in December 2012, accounting for 9% of total deposits in the banking system. Since July 2012 London processed 4% of global offshore RMB payments, moving ahead of Singapore (3.9%). The CNH bond market has grown substantially: the size of outstanding CNH debt (including bonds and bank CDs) rose from RMB69bn two years ago to RMB405bn by the end of January FX spot and forwards markets in CNH in Hong Kong have grown spectacularly since they were launched and more than doubled to USD8bn in

5 Contents Full convertibility within five years 5 The third largest global trade currency by Offshore RMB: Two years old and growing up fast 26 Reforming domestic financial markets 36 Appendix: Timeline, RMB products and regulations 48 Glossary 54 Related research reports 55 Disclosure appendix 59 Disclaimer 60 4

6 Full convertibility within five years Conditions have never been more favourable for pushing ahead with the liberalisation of the capital account a goal of s 12 th Five-year Plan The capital account is already more open than many people think thanks to the reforms of the past few years The reform process is likely to be speeded up, making the RMB fully convertible within five years, with some conditions The ultimate goal already the world s second largest economy, having overtaken Japan in 2010 replaced the US as the top trading country in Its economy is highly integrated with global trade and investment thanks to three decades of increasing openness and 12 years of WTO membership. The numbers tell the story. represents around 11% of global GDP, over 10% of world trade and nearly 9% of total FDI. At the same time Chinese companies are increasingly making their mark overseas. is no longer just the world s biggest factory it is the biggest factor in many parts of the global economy. Made in is now being matched by Bought by as the country s tourists, consumers and companies purchase more products, services and properties in other parts of the world. Given this increased integration, needs to reduce capital controls and to make its currency convertible in order to sustain its economic growth. Beijing has made it clear that full RMB convertibility is the ultimate goal for the country s currency reforms. The goal first appeared in the 11th Five-year Plan ( ), was reiterated in the current plan ( ) and reinforced at the current National People s Congress (NPC) being held in Beijing where achieving RMB capital account convertibility tops the policy agenda (see NPC: Takeaways from government work report, 5 ). Indeed, senior officials rarely miss an opportunity to talk up the subject. Zhou Xiaochuan, Governor of the People s Bank of (PBoC), told Caijing magazine, a leading financial publication in, that is not far from the goal of a convertible renminbi. Back in 2010 PBoC Vice-Governor Yi Gang told Caijing that this remains the ultimate goal for the nation s currency exchange rate reform. But this will be a step-by-step process. The PBoC says it will reform s exchange rate regime Qu Hongbin Economist The Hongkong and Shanghai Banking Corporation Limited hongbinqu@hsbc.com.hk Sun Junwei Economist The Hongkong and Shanghai Banking Corporation Limited junweisun@hsbc.com.cn 5

7 in a proactive, gradual and controllable way. The timing of these reforms will very much depend on economic and financial conditions in and overseas. Conditions have never been more favourable The window of opportunity has never been wider as many of the elements that favour capital account liberalisation are in place a balanced current account, a more flexible exchange rate that is close to its fair value or equilibrium level, and rapid expansion of RMB use outside. At the same time, the country s domestic financial reforms have been speeding up. Let s look at these issues in more detail. Trade balance: s trade surplus to GDP ratio stood at 2.8% in 2012, well below the peak of 10.7% in This ratio may moderate further should s trade surplus continue to shrink, given that its domestic demand growth is expected to outstrip that of most developed economies. At the same time s current account surplus to GDP ratio has dropped to below 3% over the past two years, less than half of the peak of nearly 8% in 2007 and also well below the 4% threshold the US proposed at the G20 summit in Seoul in All this means the risks from large, rapid capital inflows, as happened in , have been significantly reduced. Meanwhile, s solid economic growth and bright prospects suggest there is limited risk of large capital outflows. Exchange rate: The RMB is much closer to its equilibrium value than before (see : RMB Q&A: The top 10 questions investors are asking, 5 February 2013). The RMB has appreciated by around 30% against a basket of currencies since being de-pegged from the USD in July With a more balanced current account, the annual rate of appreciation of the RMB s REER (real effective exchange rate) has slowed to 1.8% over the past four years, less than a third of the pace (5.8% pa) over In April the RMB s daily trading band against USD was widened to 1% from 0.5%. Volatility in the RMB has thus increased despite its slower pace of appreciation (around 2% in 2012 vs. an average 7-8% before the global financial crisis). All these factors indicate that the RMB is getting closer to its equilibrium level. Cross-border trade settlement: This has really taken off and RMB internationalisation is likely to gain further momentum in the coming years (see Chapter 2 for details). Capital account liberalisation is all about two-way capital flows and as the RMB becomes more widely held, Chart 1.1 Trade and current account are broadly balanced Chart 1.2 RMB exchange rate is closer to equilibrium (%) f 14f Appreciation Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan Current account surplus as % GDP Trade surplus as % GDP USDCNY(Lhs) REER (Rhs) Source: CEIC, HSBC Source: CEIC, HSBC 6

8 circulated and accumulated outside the mainland, there will be a greater need to broaden the range of RMB investment instruments, in turn upping the pace of RMB capital account liberalisation. Recent developments include: The RMB is now freely available to the corporate world, with Hong Kong already an established offshore RMB centre (see Chapter 3 for details). Apart from accumulating the currency through trade, companies can also issue RMB bonds in Hong Kong (also known as dim sum bonds) and borrow RMB directly from banks in Hong Kong. The PBoC now has currency swap agreements with around 20 foreign central banks totalling about RMB2trn, a mechanism that has already proved useful. It has helped to stabilise offshore RMB liquidity conditions in Hong Kong via a swap agreement with the Hong Kong Monetary Authority (HKMA) and the Bank of Korea recently made RMB62m of loans to the Korea Exchange Bank to help Korean companies settle bills with their Chinese trading partners. This is just the start of an emerging trend. Offshore RMB centres are progressing nicely. In Hong Kong, the first and most comprehensive offshore centre, foreign companies and individuals can invest in RMB products ranging from bonds to derivatives. Effective from 1 August 2012, non-residents in Hong Kong can open RMB accounts and convert foreign currencies without any limit (there is a RMB20,000 daily cap for residents). This makes RMB investment more appealing to foreign investors. At the same time London, Singapore and Taiwan are now competing with Hong Kong for RMB business. Domestic financial markets: Strong domestic financial markets are a precondition for opening up the capital account. Financial reforms have made impressive progress, boosting the confidence of Beijing policy makers. The big state banks have all been listed, the number of institutional investors is on the rise and the market is becoming more diversified and liquid, paving the way for further participation by foreign investors. That said, before it can achieve full RMB convertibility still needs to address several problems through further financial reforms. For instance, the bond market needs to play catch-up with its counterparts in more developed economies, interest rates need to be liberalised and shadow banking requires stronger supervision (see Chapter 4 for details). Table 1.1 s capital account is more open than many think Not convertible Partially convertible Basically convertible Fully convertible Total Transactions in capital market and money market instruments Transactions in derivatives and other instruments Credit operations Direct investment Liquidation of direct investment 1 1 Real estate transactions Personal capital transactions Total Source: PBoC, HSBC. Here partially convertible means strict restrictions and quota controls on payment for capital account transactions, basically convertible means loose restrictions on payments for capital transactions, fully convertible means no restrictions on payment for capital transactions a status rarely achieved even in advanced economies 7

9 Table 1.2 Summary of s rules about major capital account transactions Stock market Bonds and other debt securities Money market Collective investment securities Foreign investors Domestic investors Foreign investors Domestic investors Foreign investors Domestic investors Foreign investors Domestic investors Derivatives and Foreign other instruments investors Domestic investors Direct investment Foreign investors Source: IMF, HSBC Domestic investors Inflows Can purchase B shares (USD/HKD) listed on the Chinese Securities Exchange (also available for domestic investors) Foreign investors may make strategic investments in domestic listed companies with some restrictions QFIIs can purchase A shares subject to certain limitations Domestic companies can issue shares abroad with CSRC approval QFIIs are permitted to purchase exchange-listed equities, bonds, securities investment funds and warrants and other financial instruments Domestic companies can issue bonds abroad with maturities in excess of one year with prior approval by the State Council QFIIs may purchase money market funds, but they are not permitted to participate directly in investment transactions on the interbank foreign exchange market Domestic companies can issue money market instruments (such as bonds and CP with maturities of less than one year) with SAFE approval QFIIs may invest in closed-end and open-end funds locally Issue collective investment securities with SAFE approval Not allowed Regulated financial institutions with the approval of the Chinese Banking Regulatory Commission (CBRC) may sell for the purposes of hedging, gaining profit, and providing transaction services for clients Derivative operations are subject to prior review by regulatory agencies and there are restrictions on open foreign exchange positions If approved by the Ministry of Commerce, non-residents are free to invest in Outflows Can sell A and B shares listed on the Chinese Securities Exchange There are no restrictions on the issuance of A or B shares by foreign institutions under current regulations, but no foreign institution has yet to issue any A or B shares in Domestic companies may repurchase shares issued by them abroad with SAFE approval QDIIs purchase shares and other investment instruments abroad subject to certain limitations International development agencies are permitted to issue RMB denominated bonds with the approval of the MOF, the PBoC, and the NDRC Foreign-funded enterprises are permitted to issue bonds with approval Insurance companies, securities firms, qualified banks and groups (QDIIs) are permitted to purchase foreign bonds that meet rating requirements, subject to the approval of the Insurance Regulatory Commission (CIRC) and SAFE Not allowed Insurance companies, securities firms, qualified banks and QDIIs are permitted to purchase money market instruments that meet rating requirements, subject to the approval of the CIRC and SAFE Not allowed Insurance companies, securities firms, qualified banks and groups are permitted to purchase collective investment securities that meet rating requirements, subject to the approval of the CIRC and SAFE Not allowed Regulated financial institutions with the approval of the CBRC may purchase for the purposes of hedging, gaining profit, and providing transaction services for clients Derivative operations are subject to prior review by regulatory agencies and there are restrictions on open foreign exchange positions Regulated financial institutions that meet risk management requirements may trade in gold futures on domestic market Permitted after an examination of the sources of foreign exchange funds and approval by the related authorities Domestic institutions are permitted to make outward investments using a variety of asset sources. Individuals cannot (apart from the Wenzhou pilot programme) 8

10 Already quite open The RMB is already more convertible than many think (see Table 1.1). Only four of 40 items under the capital account are non-convertible (institutional investor participation in domestic money markets, funds and trust markets and trading derivative instruments); 22 are partially convertible, including transactions in the bond market, stock market, real estate market and personal capital transactions; and the other 14 are basically convertible, including credit operations, direct investment and the liquidation of direct investment Based on the type of investment (see Table 1.2), the transactions which are not allowed involve derivatives and other instruments (both in and out), the outflow of money markets and collective investment securities. Reforms: Faster than expected FDI and ODI: Free flows Both outward and inward direct investment flows are fully liberalised in. FDI liberalisation started in the 1990s and investors have long been free to convert foreign currency into RMB. A 2003 circular issued by the State Administration of Foreign Exchange (SAFE) permitted foreigners to invest in foreign-invested companies with freely converted currency. This covers imported equipment, intangible assets as well other categories approved by the foreign exchange bureau. RMB profits are fully convertible. Just as it has become easier to move money into, the same applies in reverse, as ODI has been gradually liberalised. In 2009 Beijing allowed Chinese companies operating overseas to keep profits offshore and a subsequent trial programme let some Chinese businesses use RMB for ODI (see PBoC starts trial for RMB direct investment overseas, 14 January 2011). s FDI and ODI are both gaining global share. According to the United Nations Conference on Trade and Development (UNCTAD), has been the top FDI destination amongst developing markets since the middle of the 1990s. The country s FDI has increased 2.5 times over the last 10 years to USD113bn in Despite a modest decline in 2012, replaced the US as the world s largest FDI recipient. ODI is also rising as Chinese companies become increasingly global. Non-financial ODI expanded 12.6% y-o-y in 2012 to USD77bn, making the world s sixth largest exporter of capital. There are signs that this figure could double in the next 3-5 years as Chinese companies continue to expand overseas. Chart 1.3 s rising share of global FDI Chart 1.4 ODI is taking off (USD bn) (%) (USD bn) Chinese FDI (Lhs) FDI as % of the w orld (Rhs) Total Emerging markets Source: UNCTAD, HSBC Source: CEIC, HSBC. NB: chart denotes only non-financial ODI. 9

11 Not surprisingly the amount of RMB used in FDI and ODI has been accelerating (see Chart 1.5). In 2012 the currency was used for 35% of s FDI and 6% of its ODI, up 12% and 4.5% y-o-y, respectively. Three schemes: QFII, RQFII and QDII While portfolio investment remains highly restricted, there are now three schemes, all controlled by quotas, which allow capital to flow in different directions: The Qualified Foreign Institutional Investor (QFII) programme, launched in 2003, allows licensed foreign investors to buy and sell A-shares in mainland stock exchanges in Shanghai and Shenzhen. The Qualified Domestic Institutional Investor (QDII) programme, started in 2006, allows selected Chinese financial institutions to invest in offshore securities and bonds. The RMB QFII programme (R-QFII), launched in December 2011, permits qualified institutional investors to channel offshore RMB funds into mainland stock and bond markets. QFII gave foreign investors access to s capital market for the first time. Investment is now allowed in A-shares, treasury bonds (T-bonds), convertible bonds and corporate bonds listed on stock exchanges. By January 2013, some 213 foreign institutions had received QFII approval from the Securities Regulatory Commission (CSRC) with the total quota topping USD40bn (about 80% y-o-y growth). The QFII scheme is expanding rapidly on several fronts. First, the number of participants is rising more quickly than in previous years. Before November 2011, on average only two to three new QFIIs were approved per month but this jumped to eight over 2H12. Second, the total QFII quota has been expanded to USD80bn from USD30bn. The last time the quota was increased was back in May 2007, when it rose from USD10bn to USD30bn. Third, the CSRC is also considering relaxing the QFII approval rules. This could see institutions granted more than one licence and given greater flexibility governing the asset classes in which they can invest. The RMB version of QFII, known as R-QFII, was launched in December The initial quota was raised from RMB20bn to RMB70bn, before the latest expansion to RMB270bn. As of January 2013, R-QFII licences had been granted to 24 companies, with approved investment of RMB70bn (around USD11bn), with the amount invested doubling in about half year. Following the launch of RMB business in Taiwan, the CSRC is considering giving Taiwan investors an R-QFII quota of RMB100bn. Chart 1.5 RMB FDI and ODI on the rise (as % of total flows) Chart 1.6 QFII quotas are picking up pace 40 (%) (USD bn) (RMB bn) FDI ODI * QFII (Lhs) QDII (Lhs) RQFII (Rhs) 0 Source: CEIC, HSBC Source: CEIC, HSBC 10

12 More recently, the CSRC revised the rules for R-QFII, allowing eligible Hong Kong subsidiaries of Chinese mainland commercial banks and insurance companies or financial institutions which have major operations in Hong Kong to apply as well as relaxing investment restrictions. QDII started in April 2006, enabling local RMB assets to be pooled and converted into foreign currencies and then invested overseas through professional financial institutions. Although hit hard by the financial crisis the scheme has survived and prospered. As of January 2013, there were 109 QDIIs that can invest up to USD85.5bn, almost 65% more than before the crisis. What s next? The next step on the road to capital account liberalisation will be the expansion of these three schemes along with the opening up of individual cross-border investment. Following the recent acceleration of QFII, R-QFII, and QDII, we expect further growth in terms of scale and investment instruments as well as significant developments in s onshore financial markets. During a recent visit to Hong Kong CSRC Chairman Guo Shuqing said that QFII and QDII could be expanded 10-fold. Such a development would have a very positive effect on s domestic financial markets, taking them closer to international standards. At USD80bn, the current QFII quota is only around 2% of s A-share market capitalisation (as of January 2013). On a broader measure, the inward foreign portfolio investment in equities represented only around 3% of GDP in 2011, well below the average of around 20% in developed markets (see Chart 1.7). Likewise, QDII also has huge growth potential. After a quiet 2H11-1H12, QDII investment has resumed double-digit expansion and the 2012 return of QDII funds was higher than the average for domestic mutual funds. As global growth recovers and risk appetite returns the future for QDII investment looks bright. s outward portfolio investment in equities topped USD61.9bn in 2011, a mere 0.8% of GDP. Again, this is just a fraction of the scale of developed markets over 30% in the US, more than 10% in Japan and above 6% in South Korea (see Chart 1.8). This should change, especially as in the coming years we expect to see the relaxation of both the approval process for qualified institutional investors and the products in which they can invest. QDII2 At the PBoC s recent annual work conference it was suggested that the authorities were actively preparing to launch QDII2 a pilot scheme allowing individuals to make direct portfolio Chart 1.7 's foreign portfolio investment is tiny Chart 1.8 and so is the outward portfolio investment 40 Foreign portfolio inv estment (equity ) as % of GDP 40 Outw ard portfolio inv estment (equity ) as % of GDP CH KR JP US CH KR JP US Source: CEIC, BEA, HSBC Source: CEIC, BEA, HSBC 11

13 investments in overseas markets. Information is still scarce but we expect the scheme to be launched in the coming months (the domestic media has reported that the details are likely to be announced around May). This is important. Investors may remember that a pilot through-train scheme was first proposed in 2007, one that would allow mainland residents to directly invest in the Hong Kong market. Nothing happened but now it seems the programme is back on track. Similar to the abandoned through-train scheme, this time around we expect limits for individual investors and an overall quota (for reference, the initial quota for QDII was USD100bn). Pilot zones for financial reform such as Wenzhou on the east coast and Qianhai in Shenzhen, bordering Hong Kong, are keen to be among the first to participate in a QDII2 programme. If the pilot scheme runs smoothly, the potential to expand it is enormous. Chinese households, with over RMB41trn of savings, would almost certainly jump at the chance to diversify their investments, especially in Hong Kong. QFII2 and R-QFII2 Individual cross-border investment is likely to be liberated in two ways. While QDII2 (the individual version of qualified domestic investor scheme) looks to be on the way, the prospects for foreign individuals direct investment in s capital market likely to be named QFII2 and R-QFII2 also look good. Given the rapid development of offshore RMB centres and the need for more RMB investment instruments, we think R-QFII2 will start first. According to CSRC Chairman Guo, R-QFII2 will be assigned its own quota (separate from R-QFII s RMB270bn), although no timetable has been announced. Individual FX quota expansion The individual foreign exchange quota, raised from USD20,000 a year to USD50,000 in 2007, is likely to be increased again. As well as growing demand from the rising middle class, two other recent signals point to a higher quota: 1) the expected launch of QDII2; and 2) the pilot scheme in Wenzhou allowing residents to make ODI (non-financial) of up to USD200m per year (no more than USD3m per person, per project; a maximum of USD10m for multi-person investment in one project). Local media reports suggest that other cities such as Shanghai, Tianjin and Beijing are all preparing to launch similar pilot programmes that will open the door for residents to invest abroad. Direct financing Another important step that has been on the cards for some time is to allow foreign companies to raise RMB funding through IPOs and bond issuance. No schedule has been announced for the launch of an international board, which would allow foreign companies to list in Shanghai. This move is in line with the goal of establishing Shanghai as an international financial centre by 2020, so we think it is only a matter of time before policy makers press the button. Progress has also been made on foreign companies issuing bonds. While the dim sum bond market has expanded rapidly onshore activity has also increased. Examples include: 1) international agencies the Asian Development Bank and International Finance Corporation have issued panda bonds (RMB-denominated bonds issued by the foreign institutions in the domestic market); 2) locally incorporated foreign banks have issued financial bonds; and 3) the domestic interbank market has opened its doors to foreign investors; in August 2010 foreign central banks and all RMB clearing banks participating in the RMB trade settlement scheme were allowed to enter the onshore interbank bond market (see Completing the on/offshore RMB circle, 12

14 18 August 2010). The next step will likely be to simplify the approval procedures and encourage foreign companies to issue bonds. Experimental zones Financial deregulation will continue to be tested in some pilot cities/zones. Qianhai, a special economic zone in Shenzhen is at the forefront of an experiment to test freer use of the RMB and its capital account convertibility. The first batch of RMB cross-border loans for enterprises registered in Qianhai were made in January In addition, Beijing plans to allow Qianhai companies to directly issue dim sum bonds in Hong Kong and to allow foreign companies to set up private equity funds there. If successful, large coastal cities such as Shenzhen, Shanghai and Tianjin could follow suit. Rules to limit risks There is some ambiguity about exactly what capital account convertibility means. There is no clear internationally-accepted definition, unlike current account convertibility which the IMF covers in article VIII ( achieved this status in 1996, see s Big Bang, 5 November 2012). However, the IMF does provide a checklist covering seven categories and 40 items. If a country ticks most of these boxes it can claim to have a convertible capital account, but no economy meets all the criteria. We think s capital account convertibility will follow the Korean or Taiwanese model, so there will still be rules to limit risks; capital account convertibility will not mean an absence of regulation. Full convertibility does not equate to completely free capital flows, as it implies that regulators will continue to monitor transactions in order to safeguard domestic financial stability. While these controls involve some inefficiency and cost to the economy, they are likely to stay in place during the period of transition 1. First, from the point of view of international standards, the IMF does not oblige member countries to achieve convertibility under the capital account, although according to Article VIII there is an obligation to avoid imposing restrictions on transactions under the current account. In fact, Article VI (3) allows members to exercise such (capital) controls as are necessary to regulate international capital movements, but not so as to restrict payments for current transactions or which would unduly delay transfers of funds in settlement of commitments. 2 Second, capital controls still co-exist with capital account convertibility in certain economies (for example, South Korea and Taiwan and some Latin American countries). According to the IMF, over 70% of its member countries still impose restrictions on direct investment, real estate transactions and capital market transactions. The level of cautiousness about capital account management has increased since the Asian financial crisis in During the global financial crisis many countries strengthened capital controls to ensure domestic financial stability. Based on the experience of other economies risk management, controls on short-term capital flows are also important. For instance, the process of liberalising the capital account in India went rather smoothly but the authorities still have the power to impose restrictions that minimise risks associated with big swings in capital flows which can affect financial stability. For instance, the central bank s adjustable quota for foreign 1 Stanley Fischer (1997), Capital Account Liberalization and the Role of the IMF, Conference on Development of Securities Market in Emerging markets, Inter-American Development Bank, Washington DC

15 institutional investors in government and corporate securities has been raised in recent years. Meanwhile, short-term capital gains on the sale of securities are subject to tax of 30%. We believe can achieve full RMB convertibility while at the same time retaining appropriate capital controls to minimise risks. Prudent controls are likely to be kept in place, possibly in the form of restrictions on speculative money inflows and short-term foreign debt. 14

16 The Qianhai experiment Not so long ago Qianhai used to be a piece of muddy reclaimed land. Today it is brimming with potential and buzzing with investor interest as the 15 square-kilometre area of Shenzhen is transformed into what is officially labelled the Qianhai-Shenzhen-Hong Kong modern service industry co-operation zone. The media are calling it the Manhattan of South. While the zone will officially focus on the development of finance, logistics and IT, all eyes will be on its role in the fast-moving RMB story. In June 2012 the National Development and Reform Commission (NDRC), s economic planning body, confirmed that the zone would be a testing ground for the introduction of freer RMB movement and capital account convertibility. Qianhai s mission is to: 1 Widen the channels for returning offshore RMB, support the development of offshore RMB business in Hong Kong and create a test area for cross-border RMB business innovation. 2 Allow banking institutions that set up business in Qianhai to issue offshore project RMB loans. 3 Help qualified enterprises and financial institutions to issue RMB bonds in Hong Kong to support construction in Qianhai. 4 Establish fund of funds investment in the zone. 5 Develop foreign equity investment funds, including from Hong Kong. 6 Help give Hong Kong financial institutions access to Qianhai under the Closer Economic Partnership Arrangement (CEPA), a trade agreement between and Hong Kong. 7 Support the establishment of innovative financial institutions and trading platforms. 8 Help financial institutions in Hong Kong and other domestic or foreign financial institutions set up operational headquarters in Qianhai. The HKMA has welcomed the plans to facilitate cross-border use of the RMB and flows between the mainland and Hong Kong (source: Daily, 30 June 2012). It said that the measures would also provide support for RMB bank loans and RMB bond market business as it develops its own offshore RMB business platform. 15

17 The third largest global trade currency by 2015 The pace of RMB internationalisation has been much faster than expected There is rising demand for RMB as a trade settlement currency and inbound/outbound direct investment We expect 50% of -emerging market trade, or over 30% of s total trade, to be settled in RMB by 2015 As the RMB makes strides towards becoming a global currency, one of the most important areas of growth is trade settlement which has accelerated much faster than expected since the first pilot scheme was introduced in The monthly average RMB trade volume has surged from just RMB18bn in 1Q10 to RMB173bn in 2011 and RMB245bn in On an annual basis, trade and services settled in the currency totalled RMB2.94trn in 2012, up 41% y-o-y. RMB settlement now accounts for 12% of s total trade, up from 9% a year earlier and 3% in It is clear that more and more foreign enterprises that import goods from choose to pay in RMB, especially those in EMs. Another part of this equation is capital account settlement in RMB, which has also jumped. In January 2011 a pilot scheme was launched to encourage ODI in RMB. By the end of 2011, ODI had reached RMB20.2bn, rising a further 45% in 2012 to RMB29.2bn. A scheme for RMB FDI was introduced in October 2011 and by the end of the year inflows denominated in RMB totalled RMB90.7bn. In 2012, RMB FDI almost tripled to RMB253.6bn. Qu Hongbin Economist The Hongkong and Shanghai Banking Corporation Limited hongbinqu@hsbc.com.hk Ma Xiaoping Economist The Hongkong and Shanghai Banking Corporation Limited xiaopingma@hsbc.com.cn 16

18 Chart 2.1 RMB trade settlement is growing rapidly RMB bn Source: CEIC, HSBC Value of renminbi trade settlement Encouragingly, import and export payments in RMB are becoming more balanced. According to a report by the PBoC, the ratio between exports and import RMB payments has narrowed from 1:5.5 in 2010 to 1:1.7 in 2011 and 1:1.2 in Offshore market expansion The number of offshore RMB centres has risen recently. Four clearing banks have been appointed so far Bank of (Hong Kong) and BOC (Macau) were joined by BOC (Taipei) in January and ICBC (Singapore) in February. Hong Kong: Biggest offshore RMB centre Hong Kong continues to play a leading role in the RMB story. The city was responsible for 79.6% of all cross-border RMB trades, according to the latest report by SWIFT, an electronic financial messaging service provider (Chart 2.2). As of December 2012, total RMB deposits in Hong Kong stood at RMB603bn, up from RMB571bn in November, accounting for 9% of total deposits in the banking system. By the end of 2012, Hong Kong s RMB bond market was valued at RMB373bn, still only a fraction of around RMB2trn that foreign central banks can theoretically tap into through outstanding FX swap contracts. Despite the narrowing of offshore/onshore yield gap from a peak of 195bp in March to 30bp in mid-october (3-year Treasury bond) 2012, Hong Kong bond issuance in RMB remained steady. Chart 2.2 Hong Kong responsible for 80% of all cross-border RMB trade settlement Jul- 09 Jan- 10 Jul- 10 Jan- 11 Jul- 11 Jan- 12 Jul- 12 Jan- 11 Apr- 11 Jul- 11 Oct- 11 Jan- 12 Apr- 12 Jul- 12 Oct- 12 Hong Kong Other Countries Source: SWIFT. Customer initiated and institutional payments, sent and received 80% In an effort to broaden the offshore Hong Kong RMB bond market, new rules were introduced in May 2012 that standardised the process for offshore RMB bond issuance by onshore non-financial entities. The minimum requirements are lower than those for onshore bond issuance, so the new rules greatly expand the number of eligible offshore issuers and pave the way for a material increase in Chinese corporate bond supply over the medium term. The main beneficiaries are Chinese companies that do not already have substantial offshore exposure. Gross issuance of bonds and certificates of deposit (CDs) totalled RMB275bn as of the end of Of this, RMB192bn (70%) was bonds, with 20% issued by Chinese companies. To complete the on/offshore RMB circle, foreign holders of RMB need to be able to retain and invest RMB both inside and outside the mainland. Hong Kong s comparative strength as an offshore RMB centre lies in its ability to develop a wide range of RMB-related products and services, rather than simply creating depth in one product (e.g. RMB bonds). Hong Kong Exchanges and Clearing (HKEx), the city s securities and futures exchange, launched a USD-RMB contract on 17 September 2012 to 17

19 meet investors hedging needs. This is the first futures contract denominated in RMB. To broaden the range of products, it also plans to launch RMB commodities derivatives to meet the demand for risk management in mainland. A lot of progress has been made in the past few months. We have seen wider remittance channels (e.g. RMB foreign direct investment, R-QFII), RMB cross-border trade settlement expanded to the whole nation and banks given greater flexibility to conduct offshore RMB business through two refinements made by the HKMA released in January and February London, Singapore and Taiwan According to the latest data available from SWIFT, since July 2012 London processed 4% of global offshore RMB payments, moving ahead of Singapore (3.9%). In terms of market share of RMB payments outside of mainland and Hong Kong, London had a market share of 27.8%, while Singapore accounted for 26.4%. After BOC (Taipei) was granted clearing bank status in January, Taiwan s central bank (CBC) announced an individual RMB daily conversion limit of RMB20,000 with Taiwan ID card holders able to remit RMB80,000 a day to the mainland for current account transactions, the same as in Hong Kong (except remittances from the latter have to be to a same name account). We expect to see RMB deposits in Taiwan increase rapidly in the coming years. Table 2.1 Policy initiatives to internationalise the RMB Date Policy December 28, 2012 PBoC Shenzhen issued guidelines on RMB cross-border lending in Qianhai, effective 28 Dec The new guidelines allow corporations registered in Qianhai to borrow RMB from Hong Kong banks for the purposes of developing Qianhai, with a reported aggregate lending quota of RMB50bn (USD8bn). November 1, 2012 CSRC announced the total RQFII quota will be expanded by RMB200bn, from RMB70bn to RMB270bn. August 8, 2012 PBoC and Taiwan central bank signed MOU for cross-strait currency clearing. June 1, 2012 and Japan launched direct trading between RMB and yen on the interbank foreign exchange markets in Shanghai and Tokyo. May 1, 2012 NDRC formalised the rules for RMB bond issuance in Hong Kong by Mainland non-financial firms. April 14, 2012 PBoC expanded RMB daily trading band from 0.5% to 1%. June 21, 2011 A PBoC circular on cross-border RMB transactions stated that FDI in RMB settlement business is at a pilot stage. June 22, 2010 Pilot scheme for RMB trade settlement expanded to 20 provinces and municipalities. Overseas trade settlement rolled out to rest of the world. July, 2009 Six government departments jointly launched pilot programme for cross-border trade transactions. April 2, 2009 PBoC signed bilateral currency swap agreement with Argentina. March 23, 2009 PBoC signed bilateral currency swap agreement with Indonesia. March 11, 2009 PBoC signed bilateral currency swap agreement with Belarus. March 9, 2009 PBoC confirmed that the State Council has approved a pilot scheme making Hong Kong the offshore centre for RMB trade settlement. February 8, 2009 December 25, 2008 December 4, 2008 July 10, 2008 June, 2007 July 21, 2005 Source: PBoC, HSBC PBoC signed bilateral currency swap agreement with Malaysia. The State Council allowed cross-border trade between Guangdong, Yangtze Delta, Guangxi and Yunnan with Asian countries to be settled in RMB. signed bilateral currency settlement agreement with neighbouring countries, including Mongolia, Vietnam, and Myanmar. This is considered a big step towards speeding up the regionalisation of the RMB. Trade settlement between and Russia to switch to their domestic currencies. The PBoC signed bilateral currency swap agreement with the Bank of Korea, providing each other with RMB180bn in short-term liquidity. PBoC set up a new department responsible for exchange rate policy. One of its key functions was to "develop the offshore RMB market in accordance with the evolution of internationalization of RMB". First RMB-denominated bond issued by the Development Bank, worth RMB5bn, debuts on the Hong Kong Stock Exchange, making it the first publicly-listed bond to be traded and settled in RMB. RMB bond issuance by mainland banks totalled RMB20bn by the end of moved to a managed floating exchange rate regime based on market demand and supply with reference to a basket of currencies. The revaluation put the RMB at 8.11 to the USD, an appreciation of 2.1%. 18

20 From trade to investment Apart from trade, the market also needs a broad range of offshore RMB products and investment channels to encourage foreign investors to hold, trade and invest RMB. This is happening in a number of different ways: purposes of developing Qianhai, with the aggregate lending quota reported to be RMB50bn (source: Wen Wei Po, 29 January 2013 ). Ten Hong Kong banks have signed loan agreements totalling RMB2bn. Chart 2.3 RMB FDI inflows picking up RMB bond issuance in the Hong Kong 60 RMB bn offshore RMB market (known as dim sum bonds) is expanding rapidly Beijing started an R-QFII (RMB qualified foreign institutional investor) scheme at the end of 2011, allowing offshore RMB to be recycled back into domestic capital markets av g. Feb- 12 Apr- 12 Jun- 12 Aug- 12 Oct- 12 Dec- 12 The R-QFII quota was increased from RMB20bn to RMB70bn in April 2012, and further expanded to RMB270bn in November The domestic RMB market was further liberalised this year, giving wider access to foreign investors to the interbank bond and equity markets. Qualified fund management companies and Hong Kong branches of Chinese securities firms can sell R-QFII products to individual and institutional investors in Hong Kong and use the RMB to invest in s bond and equity markets; 24 financial institutions were granted R-QFII licences by January On 17 December 2012, SAFE relaxed a set of FDI regulatory controls, making it easier to open foreign currency capital accounts and simplifying the FX registration process for foreign invested entities. PBoC Shenzhen has issued guidelines on RMB cross-border lending in Qianhai, a testing ground for financial innovation in Shenzhen, effective 28 December The guidelines allow corporations registered in Qianhai to borrow RMB from Hong Kong banks for the Source: PBoC, HSBC FDI outflows FDI inflow s Matching s rising economic power What are the key factors that turn a currency into an international one? A number of empirical studies 3 conclude that the international acceptance of a currency goes hand in hand with the rise and fall of a country s economic power. In the 19 th century, between 60% and 90% of international trade was priced in British pounds. Then, as the US economy expanded, the dollar overtook sterling as the international reserve currency after World War II. The euro achieved its prominent position in the international financial system by inheriting the Deutschemark s status and the yen was internationalised only after the Japanese economy became the world s second-largest in the 1970s. 3 Bergsten, C. Fred., 1975, The Dilemmas of the Dollar: the Economics and Politics of United States International Monetary Policy, published for the Council on Foreign Relations by New York University Press, and Eichengreen, Barry, 1994, History and Reform of the International Monetary System, Center for International and Development Economics Research (CIDER) Working Papers C94-041, University of California at Berkeley. 19