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 [email protected] 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 [email protected] 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 [email protected] 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 [email protected] 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 [email protected] 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 [email protected] Sun Junwei Economist The Hongkong and Shanghai Banking Corporation Limited [email protected] 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 [email protected] Ma Xiaoping Economist The Hongkong and Shanghai Banking Corporation Limited [email protected] 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

21 Long overdue If history is any guide, the internationalisation of the RMB is long overdue given s rising economic power and the relatively limited use of the RMB overseas. After overtaking Japan as the world s second-largest economy in 2010, s nominal GDP topped USD8.3trn at market exchange rates in From a trade perspective, is also one of the most globalised economies in the world, with the value of its foreign trade growing 21% per year over the last decade, more than double the average rate of global trade in the same period. overtook Germany as the world s second-largest trading country in 2009 and moved past the US to become No 1 in Chart 2. 4 RMB internationalisation is long overdue considering s rising economic power % GDP Trade FDI&ODI RMB trade settlement Source: World Bank, UNCTAD, SWIFT as % of w orld How things got started Making the RMB a global currency became a major priority during the global financial crisis when the value of the USD tumbled, putting at risk Chinese assets worth USD1.8trn (this figure had risen to USD3.3trn by the end of 2012). The US Federal Reserve s response, the introduction of quantitative easing, caused concerns in Beijing about inflationary risk weighing on the value of the greenback, creating a dollar trap. This had major implications for Chinese exporters and importers who used USD invoices. For more details see From People s banks to people s hands, 8 March 2006, and Recycling s trade dollars, 7 May 2007). The first step was to increase the level of acceptance of the RMB among neighbouring countries. This was and still is being encouraged through currency swaps between the PBoC and other emerging economies. For example, South Korea proposed a currency-swap agreement with in 2008 to bolster market liquidity and confidence amid massive capital outflows. At that time, a currency swap deal using USD was not feasible given the uncertainties created by the US sub-prime crisis. Instead, suggested a swap deal based on the RMB, a proposal South Korea accepted. Subsequently more countries entered RMB-based currency swap agreements with and many wanted to go a step further by using RMB for trade and investment settlement. Since then the pace of internationalisation of the RMB has surprised even the sceptics (see The rise of the redback, 9 November 2010). Strong policy initiatives How can achieve the ultimate goal of making the RMB an international currency? Beijing s strategy is best summarised as a double-layered, three-step process. Layer one is the geographical expansion of RMB use, first in neighbouring and regional economies, then in other emerging markets, and finally the rest of the world. The second layer has three stages RMB use in global cross-border trade, then global investment flows and ultimately reserve holdings: 20

22 Global trade settlement currency: The 2009 pilot programme to expand the RMB s role in trade settlement was a crucial milestone in the process of RMB internationalisation. We foresee 30% of s total trade flows (or around 50% of bilateral trade with emerging market countries) being settled in RMB within the next three years, from around 12% currently. If we are right, nearly USD2trn worth of cross-border trade flows could be settled in RMB by 2015, making it one of the top-three currencies used in global trade. International investment/debt currency: In January 2011 the PBoC announced a pilot scheme for overseas RMB ODI. Then, in October, it formalised guidelines with the Ministry of Commerce for RMB FDI. Together, these moves opened up an array of onshore and offshore RMB investments. The launch of a new RMB products platform in Hong Kong in July 2011 laid the groundwork for a wide range of future offshore RMB investment vehicles for foreign holders of s currency. An international reserve currency: Empirical research 4 has suggested that each 1ppt increase of GDP as a share of the world total (measured at actual exchange rate) leads to a 0.55ppt rise in central bank reserve holdings in the corresponding currency. Assuming the share of Chinese GDP to world GDP (at current prices and actual exchange rates) rises by 10ppt (taking into account the likely appreciation of the RMB) over the next 10 years, this would suggest at least a 5.5ppt increase in central banks RMB holdings. 4 Eichengreen, Barry and Jeffrey Frankel, 1996, The SDR, Reserve Currencies, and the Future of the International Monetary System in The Future of the SDR in Light of Changes in the International Financial System, edited by Michael Mussa, James Boughton and Peter Isard, International Monetary Fund, Therefore, as long as s GDP growth stays above global growth, central bank reserves should increase their share of RMB holdings, eventually making it an important reserve currency. That said, that day is still a long way off. Regulatory environment becoming more liberal Thanks to strong policy support, cross-border trade finance and cross-border current account transactions (e.g. dividends) can be made with limited restrictions. However, cross-border capital account transactions, RMB ODI and RMB FDI require government approval. In addition, RMB cross-border payments with one leg in mainland still face restrictions. Restrictions on interbank transfers, transfers between corporations or individuals and transfers between corporations and individuals with both legs of the transaction outside mainland have been eased in the last few years. Shanghai: An international financial centre of the future Shanghai s municipal government has ambitious plans for RMB business as part of its plan to become an international financial centre by As well as more cross-border trade settlement, Shanghai is encouraging trial RMB settlement in capital accounts, including the use of the currency for overseas project financing and direct overseas investment. RMB cross-border trade settlement in Shanghai already accounts for nearly 20% of the national total, as of The PBoC is allowing Chinese enterprises to use RMB in ODI on a trial basis. This opens another offshore channel and will encourage more investment of RMB offshore trade funds outside. 21

23 Shanghai is the first mainland city open for RMB-denominated FDI settlement. Inward RMB investment in the domestic bond market by foreign central banks and trade clearance banks is already allowed (see : PBoC starts trial for RMB direct investment overseas, 14 January 2011). Seven foreign reserve managers are starting to invest in RMB bonds and other assets, although the amount is still small (the amount disclosed is less than USD50bn). By the end of 2012, RMB ODI by Chinese companies totalled RMB29.2bn, up 45% y-o-y, and RMB FDI into the mainland reached RMB251bn, up 177% y-o-y. Combined, this represents over 30% of total cross-border investment for the same period. Private sector has a significant role to play region suggest that 42% of companies are using RMB for cross-border trade settlement, up from 21% in For companies using RMB as a settlement currency, 72% are hedging foreign exchange risk (up from 49%) and 44% find using RMB more convenient in daily business operations/accounting practices (up from 34%). Overall, 82% companies expressed confidence in HSBC s forecast that a third of s trade would be settled in RMB by 2015 (the current level is about 10%). Chart 2.4 Rising demand for RMB as a cross-border settlement currency Holding RMB in the v iew of appreciation ex pectation Conv eniece in daily business operation Beijing s efforts to internationalise the RMB have been warmly welcomed by the corporate sector and financial institutions, indicating enormous demand for the RMB as a trade settlement and investment currency. Hedging FX fluctuation risk Source: HSBC Corporate sector: Huge demand HSBC s Trade Confidence Index survey of more than 6,000 companies in 21 countries and markets in June 2012 showed that the RMB is expected to overtake sterling to become the No 3 trade settlement currency in the coming months. In mainland over a third of surveyed companies expect to use RMB as a settlement currency in the next six months, well ahead of the EUR (24%). When the same survey was conducted six months ago more businesses expected to use EUR than the RMB and the RMB was ranked the second most likely primary currency for trade settlement in the Asia-Pacific region, after the USD. The results of another HSBC survey conducted in 2012 for 700 corporate clients in the Greater Global financial institutions: Hungry for RMB business According to SWIFT, as of August 2012 more than 10,000 financial institutions were doing business in RMB, up from 900 in June This increase reflects the simple fact that they see RMB internationalisation as a growth opportunity. In addition to meeting their clients needs for RMB payment and investment demand, many financial institutions have developed their own RMB strategy and are busy educating customers as they seek to attract new business. s rapid integration with the international financial community is expected to further accelerate this process, helped by increased liberalisation of regulations covering RMB cross-border settlement. 22

24 Huge potential outside the G3 Demand for RMB as a trade settlement currency lies in emerging rather than developed markets. The G3 the EU, US and Japan have been s top trade partners for the past decade. But the emerging market share of s trade flows is rising steadily in line with changes in the global economic landscape (see The great rotation, 20 December 2012). is the main driver of intra-asian trade; its imports and exports with ASEAN countries expanded 10.2% y-o-y in 2012, outpacing the 6.2% y-o-y growth in s overall trade. As a result ASEAN overtook Japan to become s No 3 trade partner in We expect a further leap in RMB trade settlement as trade with emerging economies continues to increase. First, EMs represented about 67% of s total imports in 2012, up from 52% in the 1990s. s exports to these countries account for 56% of total exports, up from less than 50% in the 1990s. With growth likely to continue, we expect around half of s trade flows with emerging market countries to be settled in RMB in the next three years. Chart 2. 5 Strong potential for RMB trade settlement with emerging markets Second, as EMs supply with commodities and intermediate goods for assembly before final shipment to the developed world, this should further increase RMB trade settlement. Third, given EMs increasing contribution to global growth, rising consumption and investment demand in EMs could translate into a boost for s manufacturing exports. Infrastructure-led recovery is positive for commodities s economic growth accelerated for the first time in two years in 4Q12. GDP expanded 7.9% y-o-y, up from the three-year low of 7.4% in 3Q12. Much of this was led by infrastructure investment which looks set to generate huge demand for raw materials and commodities. Infrastructure investment accelerated to around 20% y-o-y in 4Q12 after falling into negative territory in January-February We expect the momentum to continue in 2013 as the new leadership takes office and local governments strive to hit ambitious growth targets (24 out of 31 provinces are aiming for low double-digit growth rates, compared to the national GDP target of 7.5%). More infrastructure projects should generate new investment demand, industrial orders and jobs, which in turn are critical for lifting domestic demand and sustaining the recovery. Construction growth implies great demand for capital goods and raw materials such as mineral products, petrochemical products and base metals, much of which has to be imported (see Chart 2.6). Non-G3 ex ports as % of total ex ports Non-G3 imports as % of total imports Source: CEIC, HSBC 23

25 Urbanisation implies huge demand for infrastructure-related commodities Over the past three decades some 250m migrant workers have moved from the traditional agricultural sector to the higher productivity manufacturing, construction and services sectors in the cities. At the end of 2012 s urbanisation ratio had reached 52% and it is set to rise further. As long as the productivity gap between the agricultural and industrial sectors remains significant (currently 5-6 times), we believe rural workers will keep moving to the cities which, in turn, will increase productivity growth. This productivity gap should be the main driver of urbanisation and gains in productivity in the next decade. With new Premier Li Keqiang determined to push forward urbanisation (see From the horse s mouth, 15 October 2012), we expect further reform of s household registration system (known as hukou) and more flexibility about relocating labour between rural and urban markets. It is estimated that every 1ppt increase in the urbanisation rate generates a rise of RMB670 in per-capita GDP at 2010 prices. As a result, urban disposable income of urban residents could reach RMB27,000 (USD4,350) per person by the end of 2015, the last year of s 12 th Five-year Plan. This implies an RMB2trn increase in consumption demand over the same period. At the same time, incremental investment in city infrastructure and public services could top RMB10trn. s imports from Latin America, the Middle East and Africa are mainly basic goods, with natural resources accounting for more than 60% of total imports from these regions. For example, Australia, Brazil and South Africa are the top-three iron ore suppliers (see Table 2.3), while Saudi Arabia, Angola and Russia are the top-three crude oil providers (see Table 2.4). Booming domestic investment related to public housing, transportation systems and hospitals involves huge quantities of commodities. Chart 2. 6 Investment expansion driving commodities imports Source: CEIC, HSBC Import index FAI monthly (RHS) Table 2. 3 s top iron ore providers, 2012 %yr % of total 1 Australia Brazil S. Africa India Canada Peru 1.3 Source: CEIC, HSBC Table 2. 4 s top crude oil providers, 2012 % of total 1 Saudi Arabia Angola Russia Iran Iraq Venezuela 5.6 Source: CEIC, HSBC Industrialisation: Manufacturing exports Beijing is developing seven new strategic industries in a bid to upgrade its industrial base: clean energy and alternative energy vehicles, energy conservation and environmental protection, IT, bio-technology, high-end equipment manufacturing and new materials. Beijing hopes these industries will account for around 8% of s GDP by 2015 and 15% by

26 Chart 2.7 s exports by region 2500 USD bn Asia Africa Europe LatAm North America Oceania Source: CEIC, HSBC They should also boost trade. Given that people in EMs are becoming wealthier, Chinese exporters are targeting new export markets in the Middle East, North Africa, Brazil and Russia, especially for machinery, electronics and cars. For example, exports of laptop computers to Brazil and Russia have grown more than 20% in the last two years. s EM auto exports have also risen strongly even though their value accounts for only 4% of total exports. Chinese cars are generally inexpensive and energy-saving and domestic automakers such as Chery and Geely exported more than 1m cars to 197 countries in The Middle East and Latin America are the key markets (see Table 2.5). Table 2.5 Top-10 importers of cars made in, 2012 Rank Destination,000 units 1 Algeria Iraq 90 3 Russia Iran Chile Peru Egypt Venezuela Columbia Ukraine 30.6 Source: CEIC, HSBC Rapid infrastructure growth in EMs is also important. More and more countries including commodity exporters in Latin America, the Middle East and Asia are now part of the RMB trade settlement scheme. This has significantly reinforced the trade cycle between and major commodity exporters, setting the stage for future changes in global trade patterns (see The southern silk road, 6 June 2011). 25

27 Offshore RMB: Two years old and growing up fast Introduced in 2010, the offshore RMB is one of the fastest growing currency markets in the world This has significant implications for market participants with hedging, financing and investing needs But the potential for further growth is great, underlined by s drive to have a convertible currency It s come a long way in a very short time The process of making the RMB an international currency is best observed through the birth of the offshore RMB (primarily referred to as the CNH 5 ) and its subsequent relationship with the onshore RMB (known as the CNY) market. Since its introduction in July 2010, the CNH has been one of the fastest growing currency markets in the world as well as one of the most discussed stories in FX circles. Some of the numbers are simply breathtaking. For example, combined daily turnover in the FX spot and forwards markets in CNH in Hong Kong has risen spectacularly since they were launched and more than doubled to USD8bn in 2012 (see Chart 3.1). 5 RMB accumulated in other offshore jurisdictions like Taiwan is fungible with and viewed as an expansion of the CNH market. Chart3.1. CNH daily turnover has exploded since initiation USDbn Market liquidity in Hong Kong Aug-10 Feb-11 Aug-11 Feb-12 Aug-12 Source: HSBC CNH spot CNH fwd This growth is being driven by s desire to internationalise its currency and, in the long term, create an alternative to the dollar as the world s reserve currency. Although is the world s second-largest economy and the biggest global exporter, the influence of its currency pales into insignificance when compared with the major liquid currencies. Paul Mackel Head of Asian FX Research The Hongkong and Shanghai Banking Corporation Limited [email protected] Wang Ju Senior Asian FX Strategist The Hongkong and Shanghai Banking Corporation Limited [email protected] 26

28 Our estimates suggest global RMB (onshore and offshore, including non-deliverable forward, or NDF) spot and forward turnover now exceed RMB60bn, but this is still substantially below the USD3trn turnover in the US dollar and other major currencies (see Chart 3.2). We see the FX market as an important stage for the continued integration of into the global financial system. Chart3.2. but the RMB market remains significantly underdeveloped from a global perspective USD EUR Av g daily turnov er against all currencies USDtrn JPY GBP AUD CHF CAD HKD SEK RMB DKK BRL HUF CZK Source: RMB from latest HSBC estimation; other FX from April 2010 BIS estimation; both spot and forwards For investors who want to participate in this process it is important to understand the history of the offshore RMB market and the difference between the offshore and onshore RMB markets. Here we provide a brief overview. One currency, two markets, three curves It is important to keep in mind that despite all the changes that are taking place there remains one single currency the RMB. However, in designing an offshore market for their currency, the Chinese have created two separate and distinct jurisdictions and market places. This means that while the offshore RMB (CNH) is the same currency as is traded onshore, it is not a perfect proxy to the onshore RMB (CNY). As a result of this onshore and offshore segregation, the RMB is traded in different markets with separate supply and demand conditions. There is also a synthetic RMB market the offshore CNY NDF market (NDF) which before the CNH came into being was the only way to trade RMB offshore. Therefore there are now three different FX forward curves for the RMB (see Chart 3.3). Chart3.3. Three different FX curves (as of 3 March 2012) USD-RMB USD-CNH USD-CNY onshore Source: Bloomberg, HSBC Tenor (y ears) USD-CNY NDF To distinguish between these markets, we use RMB to refer generically to the Chinese currency, the yuan, irrespective of jurisdiction and market. CNY refers to currency within mainland and traded in onshore market; CNH to offshore RMB traded primarily in Hong Kong 6. NDF refers to the offshore dollar settled non-deliverable forward market. Below is a description of the three different RMB spot and forward curves. 6 Offshore RMB in other centres may go by other names in those locations such as CNT in Taiwan 27

29 Chart3.4. PBoC has widened the daily trading limit to encourage a more market oriented RMB Dec-05 Dec-07 Dec-09 Dec-11 Source: Bloomberg, HSBC USDCNY premium to USDCNY fix Band 1. CNY: Onshore RMB and the capital account The RMB has traditionally been a non-deliverable currency, convertible on the current account but not fully convertible on the capital account. Cross-border capital account flows were mainly limited to FDI. In recent years, however, there has been a significant increase in capital flows on the back of capital account deregulation. Examples include expansion of the QFII and QDII programmes, the introduction of personal account currency conversion (both onshore and offshore, with quota limits), and strong ODI 7 growth. Despite being deliverable, to begin with there was little visibility on interest rate parity in the onshore curve due to: 1) regulated interest rates and underdeveloped money markets; 2) a largely closed capital account that resulted in a large deviation between onshore and offshore interest rates for both the dollar and RMB; and 3) an overwhelming balance of payments surplus accompanied by significant one-way FX appreciation expectations. All three factors have shifted in line with s unfolding financial reforms, helping to improve visibility on interest rate parity in the FX curve (see Asia FX Focus: Proof of evolution, 29 November 2012). We expect reforms to continue to drive the dynamics of onshore FX. In April 2012 the PBoC widened the daily trading band further to +/-1%, bringing the currency closer to a market oriented-exchange rate mechanism (see Chart 3.4). The decision reflects the policy makers view that the RMB is close to equilibrium level, as indicated by s more even balance of payments. Onshore currency reform is also helping to speed up the process of liberalising the capital account. For instance, since 2010 the currencies of four of s main trade partners the Malaysian ringgit (MYR), the Russian rouble (RUB), the Thai baht (THB) and the Japanese yen (JPY) have become part of a bilateral trading platform that facilitates the expansion of s cross-border settlement of RMB CNH: The offshore RMB market Hong Kong and Macau were the first jurisdictions where offshore RMB trading was officially sanctioned and regulated and where there were also RMB clearing banks. The RMB first became officially deliverable in Hong Kong on 19 July 2010, following a joint announcement between the PBoC and the HKMA. Combined with the fact that Hong Kong has been the traditional centre of offshore RMB deposits and liquidity, Hong Kong and the CNH market have become the de facto centres for offshore RMB. However, as we will discuss in detail later, new offshore RMB centres are emerging. Clearing banks were recently approved in Taiwan and Singapore and there are signs that similar arrangements will be made in the UK. As there is 7 Note RMB versions of QFII, FDI and ODIs R-QFII, RMB FDI and RMB ODI do not involve FX conversion and hence have no direct impact on onshore CNY exchange rates. 8 Ten currencies are trading directly with CNY in the onshore interbank market (CFETS): USD-CNY, HKD-CNY, JPY-CNY, EUR-CNY, GBP-CNY, AUD-CNY, CAD-CNY, CNY-MYR, CNY-RUB, CNY-THB (regional trading). 28

30 little control over the flows between the RMB in Hong Kong and other RMB centres, they should be seen as expansions of the CNH market rather than alternatives. Importantly, there is no official intervention in the CNH exchange rate. The supply of CNH is indirectly calibrated through the management of the cross-border channels through which the RMB is allowed to flow purchases by individuals in Hong Kong, trade settlement, central bank swaps as well as various cross-border RMB investment pilot schemes. The HKMA acts as a regulator over market and liquidity risk as well as a short-term RMB liquidity provider (via the one-week RMB lending facility) based on the bilateral swaps signed with the PBoC. There are very few restrictions on opening CNH accounts in Hong Kong, effectively exposing the market to factors that dictate offshore demand for RMB. As such, the CNH market has a separate set of participants and thus a different set of demand and supply conditions from the onshore CNY. However, it is important to stress that the onshore CNY and offshore CNH are trading increasingly closer as the channels between onshore and offshore widen and both curves better reflect interest rate dynamics (see Chart 3.5). Chart 3.5. Three RMB curves: increasing convergence m implied y ield % Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 USD-CNY DF USD-CNH CNH deposit Source: Bloomberg, HSBC 3. The NDF market Before the establishment of the CNH, the USD-settled NDF market was the traditional way of gaining RMB exposure offshore. With onshore players prevented from participating, this is truly an offshore market. The one link between this and the onshore CNY market is that the NDF fixes off the onshore CNY fix. This is what separates the CNY NDF and the CNH market. Historically, the NDF curve is little influenced by interest rate differentials and is largely priced by market expectations of RMB appreciation. However, since the introduction of the CNH market there has been increasing convergence between the NDF and the two deliverable curves, particular the longer tenor. In our view, this trend reflects investor belief that the NDF curve will eventually be replaced by the deliverable curves, and the USD-CNY USD-CNY fix will eventually be market-driven. Table 3.1: Summary of the different RMB markets Market What Regulator FX mechanism Participants Market liberalization Forward curve CNY Onshore RMB PBoC, SAFE CFETS, Daily CNY fix, PBoC intervention CNH NDF CNT* Offshore deliverable HKMA with the cooperation of PBoC RMB Offshore nondeliverable RMB Offshore deliverable CBC with the cooperation of RMB PBoC Onshore (residents), permitted investors (FDI, QFII, QDII) Heavily regulated OTC, market clearing None OTC, Daily CNY fix Offshore Unregulated, except the fix OTC, market clearing Source: HSBC, *CNT is fungible with CNH and can be viewed as an expansion of CNH in Taiwan Onshore interest rate Offshore Mostly liberalised Offshore interest rate Expectation, but influenced by deliverables Offshore Mostly liberalised Offshore interest rate 29

31 Taking the pulse of RMB internationalisation The litmus test for RMB internationalisation will be the pace of development of the offshore RMB market, as measured by size, liquidity and the variety of products. Let s look at these factors individually. 1. Market size The growing size of the market is a reflection of the increase in the number of offshore RMB centres and the broadening of liquidity in these centres. The recent launch of the new offshore RMB market in Taiwan (Asia FX: Offshore RMB: Introducing the CNT, 6 February 2013) sends a clear signal that internationalising the RMB is a policy priority in Beijing. This view is supported by the recent announcement about a CNH clearing bank in Singapore and the likelihood of a RMB swap line between the PBoC and the Bank of England (Asia FX: Offshore RMB: Next stop London? 22 February 2013). The fact that the Chinese policy makers are expanding the offshore RMB market beyond Hong Kong suggests they are comfortable with developments so far and that they intend to internationalise the RMB as quickly as possible. Expanding the number of offshore centres will help accelerate the process in terms of cross-border RMB trade settlement, the deposit base, market liquidity and range of products. As of the end of 2012 global RMB liquidity, as measured by total RMB deposits and CDs, was nearly RMB900bn (HSBC estimates), distributed between the different RMB centres (Hong Kong, Taiwan, Singapore, London, and Macau, see Chart 3.6) The global offshore RMB pool is rising through the introduction of more RMB centres Hong Kong Singapore Macau Taiw an London Source: HSBC, HKMA, CBC, City of London commissioned study, Xinhua News, AMCM *Hong Kong as of end of 2012, including CNY603bn deposits and RMB130bn CDs, Singapore as of June 2012, Macau as of November 2012, Taiwan: CNY24bn held by OBUs as of Dec 2012 and CNY10bn held by DBUs as of Feb 2012; London as of June In Hong Kong, RMB liquidity topped RMB733bn at end 2012, including RMB130bn CDs and RMB603bn deposits (up from RMB63bn at the beginning of 2010). Taiwan has also witnessed a rapid build-up in RMB deposits since the business was initiated. Trade settlement, the earliest and most developed cross-border channel, played a key role to begin with. Indeed, RMB liquidity in Hong Kong initially grew in step with the expansion of RMB trade settlement (see Chart 3.7). In 2012, s trade settled in RMB reached RMB2.94trn, up 41% on the previous year and now accounts for around 12% of total trade in, according to the PBoC. However, the double-digit monthly deposit growth seen in the early days of CNH has moderated over the past year. Rather than signalling a deceleration in activity and development, this reflects the fact that bilateral cross-border flows have become more balanced between importers and exporters. For instance, the ratio of RMB settlement in imports versus the exports has shifted from 1:5.5 at early 2010 to 1:1.2 at the end of

32 Chart 3.7. Hong Kong RMB deposits initially rose in line with trade settlement Chart 3.8. A rising amount of offshore RMB is flowing back onshore CNYbn Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Time deposits (bn, LHS) Demand and Sav ing Deposits (bn, LHS) RMB trade settlement in Hong Kong(bn, RHS) Jan 12 Feb 12 Mar 12 Apr 12 May 12 Jun 12 Jul 12 Aug 12 Sep 12 Oct 12 Nov 12 monthly increase in RQFII approv ed quota RMB FDI Dec 12 Source: HKMA Source: PBoC, CEIC, HSBC More channels are now available to accommodate RMB flows in and out of mainland and the authorities are working to widen them further. R-QFII and RMB FDI are the two most important conduits for offshore RMB to flow back to mainland (see Chart 3.8). Combined, they totalled CNY260bn in 2012, comparable in size to the liquidity accumulated from RMB trade settlement in offshore RMB markets. In late December 2012, the PBoC approved a cross-border RMB loan pilot programme in Qianhai, which adds an additional channel for RMB to flow back to (: RMB Q&A: The Top 10 questions investors are asking, 5 February 2013). Although the growth in circular cross-border RMB flows slows down the accumulation of liquidity in the offshore market, it does help to ensure the organic growth of offshore RMB activities by enhancing the returns for investors who are holding RMB assets. 2. Market efficiency The offshore RMB market has clearly deepened as indicated by the explosion in market volume and the fact that the CNH curve has overtaken its NDF equivalent so quickly. According to HSBC estimates, daily CNH spot and forward trading totals around CNY10bn. This is three times higher than current NDF trading volumes. The growing efficiency of the market can also be seen from the convergence between the onshore and offshore RMB curves, particularly the spot and the long-end forward, as well as the fungibility of the RMB deliverable curves in different RMB centres (Hong Kong and Taiwan). When it was first launched, the CNH market was volatile and there were large gaps between the CNH spot and onshore spot rates during periods of extraordinary market sentiment (see Chart 3.9). Chart 3.9. The gap between onshore and offshore USD-RMB spot is getting smaller Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Source: Bloomberg, HSBC CNH-CNY spread, pt But the gap has shrunk significantly in the last 12 months, thanks partly to the increasing openness of the capital account. The HKMA s gradual deregulation of financial institutions net open positions (NOPs) and liquidity risk controls was another important driver. The introduction of the RMB liquidity facility by HKMA, based on its 31

33 HKD-CNY swap agreement with the PBoC, has also helped to alleviate CNH volatility in extreme market conditions (see Table 3.3). However, with further policy deregulation expected, the offshore RMB is likely to show more two-way movement in the medium term. This implies that over time the RMB will become more volatile. This makes sense given that s capital account is opening. The future of the RMB will be less about appreciation and more about internationalisation as it becomes more like currencies with flexible exchange rates. 3. Range of products The variety of asset classes and range of products available are useful measures of the maturity of any financial market. Unsurprisingly, developments on this front have been just as vigorous (see Table 3.2). FX: Besides the sharp increase in spot and forwards mentioned previously, there have also been significant developments in the options market. Since the first over-the-counter (OTC) CNH option traded in November 2010, HSBC estimates that turnover has reached USD3bn per day. This is three times the volume of the NDF options market in Hong Kong. Other CNH FX linked structured products and derivatives have also been introduced. Fixed income: The CNH bond market has grown substantially in line with a more diversified investor and issuer base. The size of outstanding CNH debt (including bonds and bank CDs) rose from RMB69bn two years ago to RMB405bn by the end of January believe more investors will participate in the CNH bond market (see Offshore RMB bonds: Dim Sum Tracker, 4 February 2013). Chart3.10. The CNH bond market has grown substantially 500 CNYbn Bonds CDs Q Q Q Q Q Q Q Q Q Q Q Q Q 2013* Source: Bloomberg, HSBC; *1Q13 only includes January data Other products: The CNH market offers a broad range of other products, which include investment funds, equities and equity related products, and other structured products (see Table 3.2). Table 3.2: Products offered in the CNH market Type Sub-type Date of first deal Certificates of deposits Jul-10 Bonds FIs incorporated in Mainland Jul-07 Non-FIs incorporated in Mainland Nov-11 Corporate-incorporated outside mainland Jul-10 Supranational, Sovereign and Agency Oct-09 Structured deposits/notes Jul-10 Insurance products Late 09 Investment RMB funds Aug-10 funds R-QFII funds Jan-12 Equity Real estate investment funds Apr-11 products Dual currency listed stocks Oct-12 Exchangetraded RMB Gold ETFs Feb-12 funds R-QFII A-share ETF Jul-12 Derivative Currency future Sep-12 Source: HSBC Secondary trading on CNH credits has also picked up thanks to the steady growth in new issues. More international issuers have raised funds in this market due to strong investment interest from regional investors. With Taiwan becoming the latest offshore RMB hub, we 32

34 The impact so far The emergence of the CNH market affects almost everyone who interacts with, manages RMB FX risk or uses the RMB more generally. The implications can be summarised according to needs of the participants, be it FX hedging, financing/borrowing or investing. 1. FX hedging For offshore corporations with limited access to onshore markets the CNH curve is emerging as a great FX hedging tool: Direct participation in RMB trade settlement: The clearest opportunity for offshore companies appears to be via RMB trade settlement. This reduces hedging costs for those who have direct trade and investment relationship with. And the increasing breadth and depth of CNH products and services available in the offshore market gives more option for them to manage their RMB exposure. A more efficient FX curve: The CNH curve, being deliverable, also reflects the RMB s true funding costs much more accurately than the NDF curve. And the interest rate component of CNH forwards is rising on the back of: 1) the increasing accessibility to the onshore market, which narrows the gap between offshore and onshore interest rates; 2) ongoing interest rate liberalisation and foreign exchange reforms, which make the onshore RMB curve more interest-rate driven. All three RMB curves have priced in persistent depreciation in recent years to reflect interest rate parity (see Chart 3.11). This has reduced FX hedging costs for corporates. Chart FX forward curves no longer pricing in appreciation 10% 8% 6% 4% 2% 0% -2% -4% Jan-06 Jan-08 Jan-10 Jan-12 12m NDF 'priced' 12m CNH DF 'priced' Source: Bloomberg, HSBC Appreciation in the nex t 12 mths Consensus fcst The diminishing NDF market: Investors with existing risk in the non-deliverable forward curve (NDF and the offshore RMB market) have also been affected. As we explained in the One currency, two markets, three curves section, the dynamics behind NDF pricing have shifted because of the emergence of the CNH market. Also, as more participants migrate to the CNH curve, declining NDF liquidity (see Chart 3.12) will become more noticeable and will eventually be an important consideration for investors. We believe that the NDF market will continue but the greater convergence between the onshore and offshore RMB curves will slowly undermine the rationale for investors to trade the NDF. Chart As the CNH becomes the dominant offshore market, so will the influence of its forward curve % share of total offshore RMB FX spot + fw d turnov er in Hong Kong Aug-10 Feb-11 Aug-11 Feb-12 Aug-12 NDF CNH Source: HSBC 33

35 Large Chinese companies with onshore and offshore entities now have the option of trading on all three FX forward markets. Onshore they can trade the spot and the forward deliverable curve, while offshore they have the NDFs (as well as the CNH). This gives companies more options on how to hedge and more potential to make economic gains, especially where they have matching flows of USD and RMB in different markets. As active players in the CNH market they have played a significant role in bringing onshore and offshore RMB prices closer together. 2. RMB borrowing or financing As discussed in the section on the CNH fixed income market, a deep debt market has been developed in Hong Kong to help meet financing needs. Besides the RMB trade financing facilities, other types of loans in RMB are also available. Significant cost savings can be achieved in the CNH market for both onshore and offshore borrowers, particularly when RMB appreciation expectations rise. For onshore borrowers, as CNH interest rates have mostly been lower than onshore rates, the cost saving can be significant when they choose the CNH market for financing RMB investing The broad range of products (see Table 3.2) in Hong Kong, as discussed in the previous section, has enhanced offshore investors investment options. Beyond giving direct access to RMB denominated assets offshore, the CNH will increasingly be an indirect vehicle to access RMB denominated assets onshore as the authorities gradually open up cross-border capital channels such as the R-QFII scheme. The quota has been increased to RMB270bn, from the initial RMB20bn. Future steps We expect the authorities to continue their drive to ultimately make the RMB a fully convertible, deliverable and internationalised currency over the coming years. The most important indicator remains the size of the CNH deposit base. The growth of other key measures such as the asset base and trading turnover will depend on the size of the deposits. HSBC estimates that the total will reach just over RMB1trn this year, over RMB 1.5trn by the end of 2014 and more than RMB2.5trn by the end of 2015 (see A very special relationship Hong Kong will benefit from s rapidly changing economy, 14 December 2012). Chart3.13. Global RMB liquidity to continue to grow 3000 RMBbn f 2015f Source: HKMA, CBC, HSBC Policy is important too. For example, Hong Kong s offshore RMB market has received policy support from both the and Hong Kong authorities (see Table 3.3). These measures have greatly helped the CNH market by increasing the breadth and number of participants and the range and sophistication of products. 9 Note that RMB proceeds obtained from non-trade financing related facilities, including loans and bonds, can only be remitted back to with approval from the relevant authorities, including SAFE and PBoC. 34

36 Table 3.3: Major policy deregulation to support offshore RMB business 2009 RMB trade settlement pilot scheme kicks off in five mainland cities 2010 Offshore RMB products platform launched in Hong Kong 2010 RMB trade settlement rolled out globally 2011 RMB ODI and FDI started 2011 Official launch of R-QFII scheme 2012 PBoC widened the daily USD-CNY band from +/-0.5% to +/-1% 2012 HKMA loosens NOP & liquidity risk management rule; RMB lending facility introduced 2012 R-QFII, QFII schemes expanded significantly 2012 PBoC approved cross-border RMB loan business 2013 RMB business started in Taiwan 2013 ICBC nominated as the RMB clearance bank for Singapore 2013 BoE and PBoC agreed to sign bilateral FX swap Source: HSBC Table 3.4: PBoC bilateral swaps with other countries/regions Expiry Date entered Country / Region Period Amount (RMBbn) 10-Mar Mar-09 Belarus 3 years Mar Mar-09 Indonesia 3 years Apr-12 2-Apr-09 Argentina 3 years 70 9-Jun Jun-10 Iceland 3 years Apr Apr-11 New Zealand 3 years Apr Apr-11 Uzbekistan 3 years Jun Jun-11 Kazakhstan 3 years 7 22-Jun Jun-11 Russia 3 years Oct Oct-11 South Korea 3 years Nov Nov-11 Hong Kong 3 years Dec Dec-11 Thailand 3 years Dec Dec-11 Pakistan 3 years Jan Jan-12 UAE 3 years 35 7-Feb-15 8-Feb-12 Malaysia 3 years Feb Feb-12 Turkey 3 years Mar Mar-12 Mongolia 3 years Mar Mar-12 Australia 3 years Jun Jun-12 Ukraine 3 years Jun Jun-12 Brazil 3 years Mar-15 7-Mar-13 Singapore 3 years 300 Source: PBoC, HSBC The road map HSBC expects the RMB to be fully convertible within five years (see s Big Bang, 5 November 2012). But what specifically can we expect in the coming year? At its annual work conference on January 2013, the PBoC summarised its 2012 achievements and laid out priorities for The central bank is set to carry out further interest rate liberalisation, improve the exchange rate mechanism, steadily increase capital account convertibility, and expand the use of RMB in cross-border activities. In line with these policy guidelines, we expect the authorities to do the following: Encourage the use of RMB in trade settlement and direct investment, push for more currency swap agreements with other countries, and encourage the development of offshore RMB centres. London is likely to join Taiwan, Singapore and Hong Kong in having a clearing bank. Over the medium term, we could see other RMB centres emerging in places with strong trade and investment relationships with e.g. countries that have signed bilateral FX swap agreements with (see Table 3.4). While Hong Kong will likely remain the dominant offshore RMB centre for some time, given its head start and the concentration of offshore entities of mainland companies and institutions, other centres will help form a globally connected RMB market. Further deepen capital account convertibility through the deregulation of existing channels such as QFII, R-QFII, QDII and RMB cross border loans. One example would be allowing individual investors to invest overseas via QDII2. Continue onshore exchange rate mechanism reforms, with a potential further widening of the onshore FX trading band and changes in the USD-CNY fixing mechanism. We expect these changes to take place during a period when RMB appreciation/depreciation is more muted. We also expect to see further introduction of other currencies into the bilateral FX trading platform in the onshore market. 35

37 Reforming domestic financial markets A deep and liquid domestic financial market is a precondition for full RMB convertibility; it s also important to get the sequence of reforms right s bond market needs to develop; allowing the issuance of municipal bonds will help it expand Interest rate liberalisation needs to be speeded up, banks have to be prepared for challenges and financial risks need to be addressed While rapid growth in the offshore market has promoted the RMB s role in global trade and investment, for the RMB to reach the status of a global and reserve currency it is essential for to have accessible, deep and liquid domestic financial markets. This is also a precondition for full RMB convertibility and includes: Breadth: the availability of a broad range of financial instruments and products; the market must provide the instruments for importers/exporters and investors to hedge the exchange risks in an open capital account. Depth: a large volume of financial instruments in specific markets. The full convertibility of the RMB requires a deep and liquid market to accommodate the flows, both onshore and offshore. Liquidity: liquidity and investor confidence are essential if a currency is to be used in international transactions which require a large capital market (especially for bonds). History suggests that domestic financial reforms are needed to set the stage for capital account liberalisation, often in tandem with giving foreigners greater access to onshore investment opportunities. For example, before fully opening its domestic capital market in 1996, Korea had introduced a range of reforms that started way back in The development of the country s domestic money, securities and foreign exchange markets paved the way for the opening up of the capital account for portfolio capital flows in the 1990s. Qu Hongbin Economist The Hongkong and Shanghai Banking Corporation Limited [email protected] Sun Junwei Economist The Hongkong and Shanghai Banking Corporation Limited [email protected] 36

38 Reforms: The order matters It is very important to introduce reforms in the right order. Before making the RMB convertible needs to strengthen its domestic banking system, liberalise interest rates and develop a fully-functioning bond market. Some of this has already happened. s financial markets have undergone massive changes over the past 10 years. For example, the big state banks have all been overhauled and turned into listed companies, domestic institutional investors have grown in terms of asset size and numbers, the equity market has undergone shareholding reforms, and the bond market has also made impressive progress. However, we think a number of issues need to be resolved in the next three to five years before can fully liberalise its capital markets. The bond market needs to be further developed, interest rates have to be liberalised, the banking system requires more reforms and risks associated with shadow banking must be addressed. We think two factors have created favourable conditions for Beijing to speed up financial reform: 1) financial markets appear to be stabilising as global economies start to recover; and 2) s new leaders are more confident about making changes. A snapshot of mainland financial markets Banks dominance in decline s banks are no longer the masters of the country s credit universe. Based on total social financing (TSF) a measure of all the financing available to the real economy the share of RMB bank loans has fallen from 90% in 2002 to 52% in Beijing wants more diversified capital markets with a larger share of direct financing. But it is easy to understand why the banks dominated lending for so long. Over the last three decades has maintained spectacular growth, averaging 10% a year. Half of this was driven by investment roads, rail, factories and skyscrapers which runs at around 20% y-o-y in nominal terms. Lending by banks represented the majority of investment financing and their hand was strengthened by the huge stimulus package that Beijing rolled out in 2009 to fight the financial crisis. The solution is to encourage growth in direct financing through the equity and bond markets. According to the 12th Five-year Plan ( ), Beijing wants to significantly lift the share of direct financing and actively promote the development of the bond market. More specifically, in the financial sector s 12th Five-year Plan announced in September 2012, the aim is for direct financing to total at least 15% by 2015, up from 14% in Chart 4.1 The banks dominance is decreasing RMB loans as % of TSF Source: CEIC, HSBC Equity market: Big but problematic There are two main stock exchange markets in : Shanghai and Shenzhen, both founded in As of January 2013 there were 914 companies listed in Shanghai and 1,540 (mainly smaller cap) in Shenzhen. Bonds, derivatives and funds are also traded on the two exchanges. 37

39 After two decades of rapid development, the equity market is now big enough to accommodate the capital flows should further open up its capital account. As of January 2013 the combined market capitalisation of Shanghai and Shenzhen topped USD3.9trn, making it the third largest in the world after US NYSE Euronext and NASDAQ, and some way ahead of Hong Kong s USD2.7trn (see Chart 4.2). Its share of global equity market capitalisation was 6.7% in January, almost three times higher than 10 years ago (2.3%). The market is also liquid. The stock turnover ratio has averaged nearly 200% since the financial crisis, close to the level of Korea and much higher than the world average of 150%. Chart 4.2 Shanghai and Shenzhen have the third biggest market cap in the world NYSE Euronex t (US) NASDAQ OMX Shanghai & Shenzhen London SE Group Japan (Toky o) NYSE Euronex t (Europe) Hong Kong Ex changes Source: WFE,HSBC However, there are problems that need to be fixed. One of the most important tasks is to crack down on the irregularities in the mainland market, which is far less mature than those in developed economies. Issues such as insider trading, stock manipulation, false financial data, the spreading of misleading market information and opaque reporting practices hinder the market s development and erode investor confidence. Investors need to be properly protected; otherwise they could opt to take their money elsewhere, especially as more investment opportunities become available. Meanwhile, its poor performance relative to the country s economic growth and peer markets reflects the fact that listed companies have raised too much equity capital from the market and paid out too little in dividends. Guo Shuqing, the reformist Chairman of the CSRC, has put market supervision and investor protection at the top of his agenda. As a result HSBC s equity strategists expect the pace of reform to accelerate (see Strategy: Reforms to drive slow-paced A-share market rerating, 13 March 2012). Bond market still lagging Despite the impressive progress that has been made in the last few years, the bond market is still lagging far behind the equity market and economic development (see s Big Bang, 5 November 2012). Bond market capitalisation stood at RMB24.3trn as of end January 2013, or around 46% of GDP. While this ratio has doubled from 23% in 2002, the size of s bond market doesn t match the country s economic strength. This raises four points: 1) Punching below its weight: The world s second-largest economy represents over 10% of global GDP, but outstanding bonds represent 5.1% of the world total (3.5% if policy bank bonds are excluded). The gap between s bond market and GDP is huge compared with other large economies (see Chart 4.3). This explains why the banks have been the traditional lending channel for so long. 38

40 Chart 4.3 s bond market needs to catch up Chart 4.5. s bond market lags Asian peers (As % of w orld total) (As % of GDP) US JP FR CH GE BR UK VN ID PH CH EEA HK TH SG MA KR JP Bonds outstanding GDP Gov ernment Corporate Source: ADB, World Bank, HSBC Source: ADB, HSBC. EEA stands for emerging East Asia. Data as of 2Q12 2) Trailing its peers: In developed countries the bond market to GDP ratio is normally higher than 100% (see Chart 4.4). But even compared with its Asian peers, s bond market is still a laggard. According to the Asian Development Bank, the country s bonds outstanding to GDP ratio (44.8% in 2Q12) was 8.2ppts lower than the average for emerging East Asia and more than 30ppts below Singapore, Malaysia and South Korea. Chart 4.4. Bond market cap dwarfed by bank lending As of % of GDP) US Japan Korea Loans Bond market cap Source: CEIC, SIFMA, HSBC estimates 3) The market is dominated by governmentbacked bonds: Government-backed credits represent nearly 75% of s outstanding bonds. As of January 2012, 33% of outstanding bonds were financial bonds (mainly issued by policy banks and state-owned banks), followed by treasury bonds (30%), mid-term notes (10.6%) and corporate bonds (10%) (see Table 4.1). Local government and corporate bonds need to be a much larger part of the funding picture. 4) The bond market remains segmented: s bond market has three segments: the national interbank market, the exchange market and the bank counters market. The interbank market handles over 90% of total daily business. It has a centralised trust and clearance system provided by Government Securities Depository Trust and Clearing Company, while the exchange market is open to various (basically non-bank) investors but has thin trading volume due to the lack of participation by banks. This could change as, according to a joint circular by regulators, commercial banks are to be allowed to participate on a trial basis. The profile of the interbank bond market is likely to be raised further. It has opened its door to foreign banks on a trial basis, a key step towards internationalising the RMB (see : Onshore RMB bond markets open up a crack, 17 August 2010). Some 100 foreign institutions can now 39

41 invest in s interbank bond market (as of end 2012), including central banks, international financial institutions, sovereign funds, clearing banks in Hong Kong and Macau, participation banks, insurance companies and R-QFII. For example, the Bank of Korea has a quota of USD3.2bn and the Bank of Japan USD10bn. In addition, Shanghai aims to become a global centre for RMB trading, clearing and pricing by the end of the 12th Five-year Plan. This means that the expansion of the interbank market is likely to be faster than expected. Bonds need to catch up The development of the bond market is a high priority for Beijing policy makers, given that: 1 A strong bond market is essential for to build a deep and liquid financial market in preparation for further opening up of the capital account. 2 A properly-functioning bond market improves the efficiency of capital allocation and broadens the channels for financing the ongoing urbanization / infrastructure boom. 3 The bond market provides long-term investment instruments with fixed returns, in sharp contrast to the more volatile and riskier equity market. Further development of the bond market will provide the middle class with greater choices about where to put their money so they can earn a higher return and therefore spend more. This, in turn, will help make the economy more consumer-driven, another policy priority. Demand for bonds is not a problem. Insurance, pension and mutual funds as well as the large pool of household savings are all looking for long-term investment instruments. s households and companies generally have high savings rates, which require effective investment channels. 40

42 Table 4.1 s bond market Type of bond Issuing entities Regulator Trade Main institutional investors Outstanding (RMBbn / as % of total) Treasury bonds Policy bank financial bonds Ministry of Finance Policy banks, i.e., Development Bank, Agriculture Development Bank, EXIM Bank PBoC, Ministry of Finance, CSRC Interbank market, exchange bond market Commercial banks, securities companies, fund management companies, insurance companies, enterprises PBoC Interbank market Commercial banks, securities companies, fund management companies, insurance companies, enterprises /29.6% /33.0% PBoC bills PBoC PBoC Interbank market Commercial banks /5.6% Local government PBoC, Ministry of Interbank market, exchange Enterprises, individuals /2.7% bonds Finance, CSRC bond market Enterprise bonds Ministry of Finance on behalf of local governments Unlisted enterprises (but mostly SOEs) NDRC Interbank market, exchange bond market Corporate bonds Listed companies CSRC Interbank market, exchange bond market Insurance companies, commercial banks and mutual funds Mutual funds, insurance companies, enterprise annuity funds and commercial banks Commercial paper and mid-term note Non-financial firms NAFMII Interbank market Commercial banks and mutual funds Convertible Listed companies CSRC Exchange bond market Securities companies, fund bonds, bonds with (convertible bonds); Interbank management companies, warrants market, exchange bond market (bonds with warrants) Source: HSBC /1.5% /9.9% /10.6% 7.6 /0.03% Municipal bonds to trigger the expansion of bond market One way to develop the market is through municipal bonds. They currently play a very small role in s debt market, unlike in the US where they represent 10% of total bonds outstanding. We expect to see rapid growth in municipal bond issuance because: Allowing local governments to issue bonds is the most feasible near-term solution to the local government debt problem. Latest estimates put local government debt at around RMB12-14bn, or around 23% of GDP. But, unlike in Europe, 70% of the loans have been invested in infrastructure assets, most of them useful, so local government balance sheets are not in as bad shape as many think, although the duration mismatch between repaying the loans and generating returns needs to be addressed (see Inside Out: Structural problems, practical solutions, 30 January 2013). They are the best way to meet the demand for infrastructure being generated by the continued urbanisation process. At 51%, s urbanisation ratio is still low compared with Korea (c70%) and the US (over 80%). It will take another two to three decades to catch up with developed economies (see Inside Out: Slowdown more cyclical than structural, 28 August 2012). Municipal bonds would open a channel for local governments to raise funds needed for infrastructure investment in a more transparent and market-based fashion. As Governor Zhou said on the sidelines of the NPC in March, will consider financing its massive urbanisation over the next decades through asset securitisation and municipal 41

43 bonds, in addition to bank loans (source: Xinhua, 6 ). A pilot municipal bond scheme in four jurisdictions (Shanghai, Zhejiang, Guangdong and Shenzhen) allows them to issue bonds directly. At the same time, the Ministry of Finance has increased the quota of municipal bonds it issues on behalf of the local governments to RMB350bn for 2013, up from RMB250bn in 2012 and RMB200bn for Corporate bond issuance by local government financing vehicles (LGFVs, also known as Chengtou bonds or 城 投 债 in Chinese) increased 148% y-o-y to RMB636.8bn in 2012 and its share of total interbank market bond issuance rose to 11% in 2012 (vs. 4% in 2011). The problem is that this type of debt is only thinly traded in comparison with mainstream products such as government bonds, central bank bills and debt issued by large corporations. They also tend to trade at high yields, given the concerns over the risk of default all the more reason to expect rapid growth in municipal bond issuance. Chart 4.6 LGFV bonds have seen explosive growth (RMB bn) Source: Wind, HSBC Corporate bonds need a boost The corporate bond market is very underdeveloped in both the primary and secondary markets. Unlike developed markets, corporate bonds represent around 20% of total bonds outstanding, much less than in developed markets and also well behind Brazil s 35% (see Chart 4.7). Chart 4.7. s corporate bonds need a boost Corporate bonds as % of total bond outstanding KR UK US FR GE IT BR JP CH Source: BIS, HSBC. Here corporate bonds include bonds issued by financial and nonfinancial corporations. We believe corporate bonds should play a larger role in direct financing. They provide long-term capital at a lower cost than bank loans and, unlike equities, bonds do not dilute the shareholders interests. And, more importantly, they will help broaden the financing channels for small and medium-sized enterprises (SMEs), which are important growth drivers. Today corporate (and enterprise) bonds account for only 9% of outstanding bonds, excluding midterm notes and commercial paper. The market is still dominated by state-owned enterprises (SOEs) and large companies. However, two recent policy initiatives suggest the pace of development is speeding up. In April Beijing set up a consolidation scheme led by the PBoC, working with the CSRC and NDRC. Few details are available but this move is expected to eventually lead to the consolidation of s bond market, 42

44 which should boost liquidity and issuance. There are three types of corporate bonds, which are regulated by different authorities and trade in different markets (see Table 4.1). The Shenzhen Stock Exchange launched private placement SME bonds in June 2012, which should help ease financing difficulties that small businesses face. Interest rate liberalisation The time is ripe Interest rate liberalisation lies at the heart of s financial market reform and is crucial for the development of a fully-functioning bond market. It one of the goals set out in the government s 12th Five-year Plan, following previous efforts to liberalise the money market and bond market rates (see Table 4.2). Under the current arrangement, money market and interbank rates are determined by supply and demand, with the PBoC setting a ceiling for bank deposit rates and a floor for lending rates (creating a high spread that generates fat bank profits). This creates distortions and inefficiencies in that: 1) The banks have an incentive to lend as much as possible to generate higher profits; 2) interest rates cannot fully price the risks and financial institutions need to improve their pricing ability; and 3) the returns savers earn on their deposits are below the level of inflation (average 1-year deposit rate at 4.4% over the past two decades vs. 4.7% inflation for the same period), so they are effectively losing money. This, in turn, works against the government s policy of making consumption a bigger driver of economic growth. Now comes the hard part the liberalisation of lending and deposits rates and establishing a benchmark interest rate system. But we think the time is ripe for change and favourable factors include: The banks are ready. They should now be able to stand on their own feet after being restructured and listed. Their pricing capability and risk management has significantly improved, especially at the bigger lenders. The financial markets are now more sophisticated and the Shanghai Interbank Offered Rate (SHIBOR) is an established benchmark for pricing financial products. The central bank has sharpened its macro-control skills and become more proficient at adjusting market interest rates through open market operations (buying and selling government securities to expand or contract the amount of money in the banking system). Policy makers want to make it happen. Zhou Xiaochuan, who is reported to be delaying his retirement to stay on as Governor of the PBoC (source: Reuters, 20 February 2013), has made it clear that the right conditions exist to liberalise domestic interest rates (source: Caijing). He is not a lone voice. The three bodies that regulate banks, equities and insurance are all led by former PBoC Vice-Governors who are proven reform-minded problem solvers and protégés of former premier and economic reformer Zhu Rongji: Shang Fulin at the Banking Regulatory Commission (CBRC), Guo Shuqing at the CSRC and Xiang Junbo at the Insurance Regulatory Commission (CIRC). For more details see Investment Atlas, Issue 37, The market s driving forces in 2012, 18 November 2011). 43

45 Table 4.2. Interest rate liberalisation milestones in Category Money market interest rate and bond market interest rates Lending rates Deposit rates Year Event 1996 PBoC abolished upper limit on inter-bank lending rates MoF adopted interest rate and yield bidding in treasury bond issuance (exchange platform) Liberalised repo rates in interbank markets MoF issued treasury bonds in the interbank market for the first time Upside floating limit for SMEs expanded from 10% to 20%; lending rate upper limit for rural credit units increased from 40% to 50%, while limit for bid enterprises unchanged at 10% Pilot scheme for reforming credit unit launched. Upper limit of lending rates for rural credit units included in the scheme expanded to 200% Removed ceiling for all lending rates, except interest rates for housing mortgage loans, and credit units for urban and rural areas (upper limits were increased to 230%) Lending rate floor lowered from 90% to 70% of benchmark PBoC allowed negotiated wholesale deposits for insurance company clients FX lending rates fully liberalised; deposit rates freed for USD3m deposits 2003 PBoC expanded number of institutions that can apply to negotiate wholesale deposits Floor for all deposit rates removed All FX deposit rates with maturity above 1-year liberalised 2012 Deposit rate ceiling was expanded to 110% of benchmark. Source: PBoC, HSBC Latest moves Beijing is already taking steps to speed up the process of interest rate liberalisation. They include: When the PBoC cut interest rates twice last year, it also loosened controls on lending and deposit rates. In July it expanded the lower limit of lending rates to 30% below the benchmark rate from 10% and raised the upper limit of deposit rates to 10% above the standard rate. This in theory allows banks to offer more attractive terms to companies with good credit profiles and tougher terms to riskier clients. The move implies that Beijing believes the banks are now sophisticated enough to cope with these changes and will not indulge in irrational interest rate price wars. The PBoC recently upgraded its open market operations (OMO). On 18 January it introduced a short-term liquidity operation (SLO), making shorter-term repurchase agreements (repos) and reverse repos available to 12 commercial banks, in addition to the instruments it already routinely offers during OMO. This will ease the seasonal cash shortages that typically occur around holiday and quarter-end periods and make interest rates in driven much more by monetary policy expectations (see: reforms its money market: Reverse repos to be made available daily to 12 banks, 18 January 2013). The PBoC s annual work conference in January reiterated that interest rate liberalisation remains a policy priority. The next steps Freeing up interest rates is a step-by-step process. We think the next moves will include: Further expanding the floating band for lending and deposit rates and freeing up deposit rates. Despite the widening of the floating band to 30% in July at the end of 2012, nearly 60% of loans were still above benchmark rates. And of the 14% that were lower than the benchmark, they were only 10% below, not the full 30%. A gradual rise in the upper ceiling of deposit rates will help correct the pricing distortion in financial markets and increase competition 44

46 between banks, improving efficiency (i.e., the banks that are better at pricing risk will outperform peers.) Reducing the number of categories of lending rates that are regulated from five to three and finally to only one the benchmark lending rate; at the same time cut the number of categories of regulated deposit interest rates from seven to five or fewer. The long-term deposit rate is likely to be liberalised first and the demand deposit rate, which accounts for about 50% of total liabilities in the banking system, last. Eventually, the ceiling on the interest rate for deposits will be completely removed, letting bank rates float freely. The establishment of a deposit insurance scheme. Competition between banks will intensify during the process of freeing up interest rates, putting smaller banks under pressure. A deposit insurance scheme and transparent bankruptcy procedures for commercial banks will protect depositors interests and ensure financial stability. Enhancing SHIBOR s role as a pricing benchmark. SHIBOR, introduced in January 2007, is already a good reference for short-term (less than 3-month) money supply and demand. It is widely accepted as the benchmark rate for discount bills, wealth management products and asset management. However, there is still too big a difference between offer and transaction prices for funding for periods longer than three months, which suggests that factors other than supply and demand are at work between market counterparties. There s more work to be done to enhance SHIBOR s role as a pricing benchmark. Building a stronger institutional framework An efficient, well-supervised bond market would reduce transaction costs and lower risks in the financial system. We believe corporate governance, the legal framework and regulatory supervision all need to be improved. The following would help build the right institutional framework: Information disclosure: Better transparency is needed to accelerate the development of the local government bond market. The balance sheets of many local governments lack clarity and need higher accounting standards. The current accounting law only applies to companies and it should also be applied to local governments. This will help price the risk of local government bonds. A credit evaluation system: A proper credit ratings system is vital, especially in a market which has a short history (the four major domestic rating agencies are inexperienced) and lacks statistics on default ratios. Consolidation of the fragmented bond markets is a major challenge and will take time. The current segmentation splits liquidity and prevents the formation of a complete yield curve. Improving yield curves: A properlyfunctioning yield curve provides the benchmark for pricing risk. s yield curves need further improvement through: 1) the strengthening of market makers; 2) more diversified products and maturity; 3) deeper liquidity; and 4) interest rate liberalisation. The challenge for banks While reforms of the past decade have helped banks stand on their own feet, they still face a number of challenges. Interest rate liberalisation, the pressure from a developing bond market and the expansion of 45

47 Chinese enterprises overseas mean that further innovation is needed if the banks are going to be able to meet these challenges. Interest rate liberalisation inevitably means heightened competition between banks. The experience of many other countries shows that the net interest margin (NIM) tends to narrow after lending and deposit interest rates are liberalised. As NIM represents 70-80% of the banking sector s operating profits, these lenders will have to seek other sources of revenue by introducing new products and attract more business by improving the quality of service. At the same time, they will have to learn how to properly price their products and manage interest rates risks. With growing competition from the bond market banks must be prepared to shift their focus away from big infrastructure projects and SOEs to retail customers and SMEs. Banks also need to follow their corporate customers overseas (see s Big Bang, 5 November 2012). s banks are still very much domestic businesses with a limited global presence. They have to build up their international franchises as well as attract and train talent, all of which takes time. Unless the banks take action on this front the risk is that international banks will muscle in on their business. Financial risks Local government debt and shadow banking top the list of key financial risks in. Local government debt At 54% of GDP the overall level of local government debt is still manageable. Some 70% of these loans have been invested in infrastructure assets, most of them useful, so local government balance sheets are in better shape than many think. The duration mismatch between repaying the loans and generating returns needs to be addressed but Beijing has three feasible options issuing municipal bonds to enable local governments to pay back bank loans, selling local government assets and improving the tax split between the central and local governments. We see bond issuance as the best option. Shadow banking Shadow banking defined by Financial Stability Board as credit intermediation involving entities and activities outside the regular banking system can include off balance sheet lending by banks, short-term wealth management products sold by banks and high-interest loans to one company by another. We do share market concerns about the risks in the shadow banking system, particularly with regard to the lack of disclosure, provisions and capital cushions and the fact that banks may still be liable for potential losses if there are defaults in these off-balance sheet credit channels. However, the regulator is keeping an increasingly close eye on this issue. While the size of the market is estimated to have risen from RMB19.5trn in 2012 to around RMB25trn at end 2012, or 48% of GDP and 39% of RMB loans (see s shadow banking system: Watch the yield, 22 January 2013), the banking regulators has been enhancing the supervision of off balance sheeting lending and bank-trust credit transfers, as well as tightening oversight of wealth management products. At the same time, the term shadow banking can be misleading as shadow banking in the mainland is not identical to that in the developed markets in terms of regulation, business structure and risks. Apart from the ongoing enhancement of regulation, in practice, wealth management products are also relatively straightforward and do not include the high levels of leverage and complex financial instruments that 46

48 created havoc in other parts of the world during the global financial crisis. Moreover, most of the wealth management products issued by banks have implicit guarantees of the principal invested a key distinguishing feature. We view the development of wealth management products as a very important step along the road to interest rate liberalisation. The development of shadow banking financing activities is complementary to bank loans as the funds raised through these channels are fed into the real economy. For example, the trust companies assets totalled RMB7.47trn at the end 2012, an increase of 55% from They are heavily involved in supplying finance to the real economy (see Chart 4.8), with over 50% of the funds going to infrastructure and industrial sectors, up from 42% in Chart 4.8. Trust loans profile Others Real estate 18% 10% Industrial Financial and markets commercial 12% enterprises 27% Infrastructure 24% Financial institutions 10% Source: Trust Association, HSBC The solution to dealing with the risks associated with shadow banking is to strengthen supervision. This includes limiting leverage, requiring better disclosure on wealth management products, improving transparency and requiring stronger internal controls. Paving the way for capital account convertibility The ongoing financial market reforms will strengthen the bond market, improve the institutional framework and help resolve the financial risks. Building a stronger institutional framework can be achieved in many ways enhanced regulation, increasing co-operation with overseas exchanges and regulatory authorities, looking after the interests of domestic investors and the nurturing of domestic rating agencies. But, for us, the best way is to attract top global institutional investors and professionals who are more capable of identifying, pricing and managing risks. Their participation would encourage companies to improve the quality of disclosure and help domestic rating agencies raise their standards to international levels. As financial reforms deepen, Beijing is likely to become more confident about stepping up measures to further open the system to foreign investors. This can be achieved by expanding the QFII and R-QFII schemes and further opening bond markets to foreign central banks and international organisations. As discussed in chapter one, there are signs that this is already starting to happen. This will prepare s onshore markets for further opening to foreign investors, in turn paving the way for the RMB to gradually achieve capital account convertibility and truly reflect s economic power and the rise of the redback. 47

49 Appendix: Timeline, RMB products and regulations RMB timeline 1978 Paramount leader Deng Xiaoping, architect of the socialist market economy that supersedes the centrally planned economy, begins reforms As part of 's opening up, government begins foreign exchange retention quota system to encourage exports, allowing firms to retain a percentage of foreign exchange claims First round of RMB devaluation. The official exchange rate co-existed with the trade-related settlement exchange rate of 2.80 to the dollar. The more realistic exchange rate is based on 's average export cost per dollar plus a 10% margin The State Council decides the PBoC should function solely as central bank, not a commercial bank as well Trade-related settlement exchange rate abolished. sets rate at RMB2.80/dollar, for both trade and non-trade settlement. A foreign exchange retention quota remained for a portion of export proceeds. On 20 November 1985, authorisation was granted for Chinese residents to hold foreign exchange, to open foreign exchange accounts, and to deposit and withdraw funds in foreign currency In November 1986, a foreign exchange swap rate was created for foreign investment corporations at over 100 foreign exchange adjustment centres and for Chinese enterprises in the four Special Economic Zones (Shantou, Shenzhen, Xiamen, and Zhuhai) The swap rate was expanded to all domestic entities authorised to retain foreign exchange earnings. The swap rate and official rate co-existed until the single rate regime was established in Dual exchange rates unified in 1994, managed floating exchange rate regime established based on market supply and demand. First foreign exchange trading centre opens in Shanghai, starting 's inter-bank foreign exchange market. Exchange rate is set around RMB8.7 to the USD allows RMB convertibility on current accounts. It maintains foreign exchange controls on the capital account, particularly outflows Government keeps RMB de facto pegged to USD at around USD8.3 (until 2005). Resisting the temptation to devalue in line with its neighbours during the Asian Financial Crisis, provides some stability to the global monetary system joins World Trade Organization Qualified Foreign Institutional Investor (QFII) programme launched Hong Kong becomes the first offshore centre to develop personal RMB services moves to a managed floating exchange rate regime based on market demand and supply with reference to a basket of currencies. The revaluation puts the RMB at 8.11 to the USD, an appreciation of 2.1% OTC transaction mode introduced in the interbank spot foreign exchange market, while at the same time retaining the automatic price-matching transaction mode. Market-makers were introduced. Launch of the Qualified Domestic Institutional Investor (QDII) programme 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 The PBoC signs bilateral currency swap agreement with the Bank of Korea, providing each other with RMB180bn in short-term liquidity. The State Council allows cross-border trade between Guangdong, Yangtze Delta, Guangxi and Yunnan with Asian countries to be settled in RMB. signs bilateral currency settlement agreement with neighbouring countries, including Mongolia, Vietnam, and Myanmar RMB trade settlement pilot scheme Hong Kong, Macau and ASEAN launched in five pilot mainland cities. Hong Kong participating banks can provide trade finance to foreign traders settling trade with Chinese traders in RMB. First offshore RMB sovereign bond issued in Hong Kong by the Ministry of Finance. Mainland subsidiaries of Hong Kong banks allowed to issue RMB bonds in Hong Kong. PBoC sets up a new department responsible for exchange rate policy. One of its key functions is to "develop the offshore RMB market in accordance with the evolution of internationalisation of RMB". PBoC signs bilateral currency swap agreement with Malaysia. PBoC signs bilateral currency swap agreement with Belarus, Indonesia and Argentina. Six government departments jointly launch pilot programme for cross-border trade transactions. World Bank chief Robert Zoellick calls the USD s role as a reserve currency "relatively secure," but says over the next years the RMB will provide an alternative once it is internationalized. 48

50 2010 Pilot scheme for RMB trade settlement expanded to 20 provinces and municipalities. Overseas trade settlement rolled out to rest of the world. The first offshore RMB product platform created in Hong Kong. Bank of (HK) can clear personal RMB business, trade settlement, RMB bond issue expenses and mainland approved deals. RMB inter-bank bond market opened to selected offshore RMB holders. RMB settlement for capital account items proposed for Shanghai. RMB Overseas Direct Investment trial launched. Trade settlement between and Russia to switch to their domestic currencies A PBoC circular on cross-border RMB transactions states that FDI in RMB settlement business is at a pilot stage. R-QFII scheme launched 2012 PBoC expands the USD-RMB daily trading band from 0.5% to 1%. The City of London launched an initiative to make London a centre for RMB business. The first RMB Qualified Foreign Institutional Investor (R-QFII) quotas were allocated to clients of Hong Kong-based mainland brokerages. Taiwan s central bank announces that it has signed a deal with Beijing to set up a clearing system for the RMB to create a new offshore market (the CNT). Bank of s Taipei branch won the right to clear RMB transactions in Taiwan. Taiwan will have its own offshore RMB spot rate called CNT, as opposed to CNH in Hong Kong. announces it will let companies in Qianhai, an area of Shenzhen, take out RMB loans from banks in Hong Kong, with tenors and interest rates to be set independently. RQFII and QFII schemes expanded significantly HKMA loosens NOP and liquidity risk management rule; RMB lending facility introduced 2013 The Bank of England and the People's Bank of agree to sign a three-year GBP-RMB swap agreement. RMB business started in Taiwan ICBC nominated as the RMB clearance bank for Singapore The PBoC and Monetary Authority of Singapore extended currency swap to RMB300bn, effective three years. HSBC forecasts Upsurge in global RMB trade settlement transactions - USD2trn annual trade flows settled in RMB Rising growth differential between and its main trade partners supports gradual appreciation RMB s role in global trade cycle reinforced Upsurge in global RMB denominated non-trade transactions Expanding non-usd trading inside to range of other currencies Further financial reform to put internal financial house in order paving the way for full RMB convertibility Sources: HSBC, PBoC, HKMA 49

51 Offshore RMB products available outside CNH business category Offshore product/service 1 Cross-border trade (import and export) settlement Offshore RMB (CNH) trading account opening Documentary credit (DC): issuance, advising and collection Export DC advising Export bills Import DC issuance Import DC bills Export collections Import collections Internet Trade Services (ITS) RMB trade financing facilities Non-financial guarantee/sblc (Standby Letter of Credit) Financial guarantee/sblc Reimbursement finance 2 Payments & Cash management Savings/current accounts with deposit taking and RMB exchange services Remittances (TT/RTGS/AutoPay) Payments / Collections advising Cheques / Cashier s order Bill payment Cheque collection solutions Time deposit, certificate of deposit Currency exchanges Liquidity management Online RMB transactions 3 Investment Certificates of deposit (typically issued by HK branches of mainland banks. Documentation is less complicated than MTN cash notes/bonds) Primary issuance and secondary trading of RMB bond issued by corporates and banks incorporated both in and outside of, sovereign and supranational entities (including World Bank, Asian Development Bank and 's Ministry of Finance) FX linked structured deposit Interest rate linked structured deposit Equity linked structured deposit/note Gold/Commodity linked structured deposit RMB investment funds (including: RMB funds invested in overseas RMB products and R-QFII funds invested in onshore RMB fixed-income and equity products) RMB exchange-traded funds (e.g. R-QFII A-share ETF listed on the Stock Exchange of Hong Kong and RMB Gold ETF) RMB equities/online securities and IPO (includes for dual currency listed stock) RMB savings insurance plan Derivatives (including currency futures such as USD/CNH futures) 4 Exchange services and risk management RMB life insurance products Spot FX (for trade as well as for general purposes) Deliverable forward Deliverable FX swap Deliverable FX option Deliverable cross currency swap Non-deliverable forward Non-deliverable FX swap Non-deliverable FX option Non-deliverable interest rate swap 5 Borrowing and financing Non-deliverable cross currency swap RMB trade financing facilities (as above) and commercial loans Primary issuance of offshore RMB bonds (as above) and RMB bond indices FX neutral collateralised foreign currency lending (packaged loan) RMB repurchase agreement Source: HSBC 50

52 Offshore RMB regulations outside Category Regulations/guidelines Details/rationale 1 Overview Offshore RMB business is mainly subject to local laws. Different capital market regulations in each country necessitate a unique set of CNH regulations for each offshore RMB market with its own clearing bank. Regulations and guidelines will also to an extent be determined by agreements/negotiations struck between the People's Bank of and the particular central bank in question. 2 Definitional differences between key offshore RMB markets 3 Hong Kong, Taiwan: Clearing bank roles and rules Any offshore RMB transactions conducted in Taiwan is treated as CNT. Any offshore RMB transactions conducted in other locations outside Mainland is currently treated as CNH (e.g. if a non- Taiwan client trades RMB in Taiwan, it is subject to Taiwan s trading hours and holidays). Only four clearing banks have been appointed thus far: Bank of (Hong Kong), BOC (Macau); BOC (Taipei); and ICBC (Singapore). A detailed agreement for the last appointment is expected to be signed in the coming months. RMB participant banks in Hong Kong maintain a settlement account and a fiduciary account (in turn deposited with the PBoC Shenzhen branch, available since 2Q11) with BOC (HK) for excess funding. This framework was designed to avoid breaching participant banks' counterparty credit/risk limit towards BOC(HK) due to their RMB settlement account balance with BOC(HK). No fiduciary account system is needed in Taiwan as BOC (Taipei) is treated as an overseas branch and not a subsidiary, which means that participant banks credit limit towards it is based on the whole Bank of Group and thus much higher. The CNT market's trading hours are from 09:00-12:00 and 14:00-16:00 (HKT) for all working days in Taiwan/US/Mainland. The CNH market is open 24 hours for all working days in Hong Kong/US/Mainland. Only Taipei Forex/Comos can act as FX brokers for CNT, no restrictions on FX brokers for CNH. Clearing banks act as intermediaries between on and offshore entities. Their major responsibilities include: opening RMB settlement accounts for participant banks for the acceptance and withdrawal of RMB funds; opening a settlement account with PBoC s Shenzhen branch (for BOC Hong Kong) to centralise offshore RMB activities; collecting and distributing RMB banknotes; providing clearing services for RMB remittance and RMB cards issued by Hong Kong banks; providing services for offshore banks to square RMB open positions that result from the exchange between RMB and other currencies. BOC (HK) has direct access to s onshore payment system (High Value Payment System, HVPS). The clearing interest rate offered by RMB clearing banks is set by the PBoC. In Hong Kong it is currently at 0.72% (lowered at end-1q11 from 0.99%). Banks receive 0.648% (up from 0.629%) from the clearing bank for excess liquidity. In Taiwan, it is also currently at 0.648%. 4 Hong Kong, Taiwan: Clearing For eligible transactions/trades, the RMB clearing bank squares any bank currency conversion and RMB open positions held by participant banks as a result of position squaring limits conversions made in the conduct of foreign exchange business, via FX transactions in s interbank foreign exchange market. Time deposits are also offered to participant banks by the clearing banks in both Hong Kong and Taiwan. BOC(HK) currently offers interest rates of 2.2%, 2.3% and 2.4% for RMB time deposits in tenors of one month, two months and three months respectively. BOC(Taipei) currently offers interest rates within a range of 2.545% to 3.085% for RMB time deposits in tenors within a range of 7 days to one year. Eligible transactions: In Taiwan, residents and foreign aliens can buy/sell up to RMB20,000 per person per day through RMB savings accounts, which are eligible to be squared with the clearing bank. In Hong Kong, residents are subject to the same RMB20,000 limit, also eligible for clearing by the clearing bank. There is no limit on how much RMB non-residents in Hong Kong can buy/sell, but their FX transactions will not be eligible for squaring with the clearing bank. 5 Hong Kong, Taiwan: crossborder remittances into the Mainland 6 RMB remittances for crossborder RMB trade settlement and overseas direct investment purposes Taiwan citizens (i.e. excluding foreign aliens) can remit from their Taiwan account to any account in the Mainland for current account (i.e. NOT investment-related) items up to RMB80,000 per person per day. Hong Kong deposit accounts can remit to a "same-name" account in the Mainland up to RMB80,000 per person per day. All companies outside can settle trade in RMB for the import and export of goods and services, other regularly performed trading without limits. All companies in Mainland are able to settle trade in RMB for the import and export of goods and services, other regularly performed trading, and for offshore direct investments as permitted by relevant authorities. Mainland corporates that are on a "Watch list" are eligible to receive RMB but are subject to additional checking by Mainland settlement banks. Watch list enterprises are also not allowed to deposit RMB received from trade settlement abroad. For overseas direct investments in RMB, approval from relevant authorities and supporting documents are required. Eligible trades: Genuine cross-border trade of which one leg involves a Mainland counterpart, and for which the date of CNH-CNY conversion and remittance (handled by the same participating bank) are not more than 3 months apart. Non-residents in both Hong Kong and Taiwan are subject to onshore Mainland rules and requirements, on a case-by-case basis. For RMB inward and outward payments, Mainland -based companies must complete Cross-Border Trade RMB Settlement Import Payment Explanation and Cross-Border Trade RMB Settlement Export Payment Explanation forms. Generally, domestic customers must provide documents to prove the authenticity of a transaction (e.g. contract, invoice). For overseas direct investments (ODI) in RMB, approval from relevant authorities and supporting documents are required." 51

53 Offshore RMB regulations outside 7 RMB cross-border trade settlement: deferred receipt/payment 8 RMB offshore-onshore remittance process: for trade settlement purposes 9 RMB offshore-onshore remittance process: for nontrade settlement purposes In case of deferred receipt of export proceeds or deferred payment of import proceeds exceeding 210 days, a company must report the deferred payment amount and the relevant export declaration reference number to the RMB cross-border Payment & Collection System through their settlement bank within five business days. There is no restriction with regards to the use of the accumulated RMB funds by offshore corporate provided the funds are not remitted back into Mainland. There are also no restrictions on the maximum amount of each RMB denominated remittance or documentary credit, provided the amount corresponds to genuine trade transactions. For offshore-onshore remittance of RMB proceeds arising from nontrade transactions such as RMB trade settlement or the issuance of loans and bonds*, offshore corporates will need prior approval from the People s Bank of and State Administration of Foreign Exchange (SAFE) to remit RMB funds either as i) foreign direct investment (FDI), ii) a shareholder loan or iii) as investment under the RMB-denominated Qualified Institutional Investor (RQFII) scheme. * or from RMB profits remitted to overseas entities from Foreign Invested Enterprise in, or from RMB proceeds received from the share transfer, capital reduction, liquidation and dis-investment of onshore entities. Of the three non-trade settlement remittance channels available, the first two tend to be more common: (i) RMB remittance as FDI injection: Onshore Foreign Invested Enterprises (FIEs) are allowed to receive RMB-denominated FDI, either as a capital injection or as an equity injection. Equity injections tend to be rare and are usually used to service maturing debts and require approval from both the MOFCOM and SAFE, alongside materials documenting details of transaction (e.g. contract, invoice) must be provided. For RMB capital injections made into investment projects over RMB300m, case-by-case approval must be granted by the Ministry of Commerce (MOFCOM); all others can file for approval from the relevant Provincial Administrative Department of Commerce. PBoC approval is no longer required, but filing with the PBoC is still mandatory, and must be conducted by the entity receiving the FDI within 10 days of receiving the new company licence (for an initial capital injection) or within 15 days of filing a capital increase with the Industry and Commerce Administration (for an incremental capital injection). Documents required include: 1) Copy of Certificate of approval; 2) company licence; 3) Organisation code certificate. RMB FDI funding must come from legitimate sources, including crossborder trade settlements, RMB profits remitted offshore, share transfer, capital reduction, liquidation, Advance Recovery of Investment by Foreign Partners, offshore RMB bond issuance, RMB securities issuance and other legitimate channels. RMB FDI remittances cannot be invested, directly or indirectly, into negotiable securities and financial derivative, nor used for entrusted loans. Filing with SAFE is needed for every injection. Real estate related crossborder RMB FDI must comply with the existing rules and approvals concerning Foreign Investment in the Real Estate Industry. (ii) RMB remittance as shareholder loan injection: Foreign Invested Enterprises (FIEs) can receive cross-border RMB shareholder loans but require prior registration of foreign debt to SAFE. Documentation requirements may vary slightly between different local SAFE offices, however the following are usually required: A written application in free format Business licence Certificate of Approval and any other industry-specific approvals Company Memorandum of Association Shareholder's loan contract Latest capital inspection report Board Resolution approving the borrowing in the form of shareholder's loan Prior year company accounts (to be obtained from the company's auditor) FX registration card (IC card) Print out of FDI company s basic details PBoC approval is not required. Restrictions apply on foreigninvested real estate enterprises' ability to borrow RMB loans from foreign shareholders. (iii) RMB remittance as RQFII injection: Up to RMB270bn of offshore RMB funds can be invested in s domestic capital market via R-QFII. As of, the Hong Kong-based 52

54 Offshore RMB regulations outside 10 Hong Kong: CNH statutory liquidity requirements 11 Hong Kong: banks' RMB Net Open Position (NOP) 12 Hong Kong: Spot USD/CNH FX fixing 13 Hong Kong: CNY(HK) Interbank Offered Rates 14 Hong Kong: Hong Kong Monetary Authority (HKMA) RMB liquidity facility 15 Hong Kong/Taiwan: Offshore and cross-border RMB lending Source: HSBC, PBoC, HKMA, CBC, TMA Banks are required to maintain a statutory liquidity ratio of no less than 25%. The statutory liquidity ratio is calculated as the net weighted amount of its liquefiable assets to its qualifying liabilities. This requirement has been in place since June 2012, loosening from previous requirement of 25% risk management limit. Banks can now decide their own NOP, in consultation with the HKMA, rather than having a standard NOP imposed on the whole market. If it exceeds 20%, they will need to prove to HKMA that it is prudent. Taiwan does not have a NOP requirement, as the RMB is treated as a foreign currency (with a 0.125% required reserves requirement), hence is subject to normal foreign currency regulatory ratio requirements. The Treasury Markets Association (TMA) launched the Spot USD/CNH* Fixing in June The fixing provides a reference rate for the pricing of RMB products in the offshore market and serves as a benchmark for the market exchange rates of USD against CNH at 11am (HKT). Interest rates are also reported by individual banks for CNY (HK) in the Hong Kong interbank market at 11am (HKT) each business day (excluding Saturdays). A liquidity facility was introduced by the HKMA in June 2012, giving participant banks in Hong Kong a short-term "emergency" source of 7-day RMB repo funding with T+1day delivery. Eligible collateral include offshore CGBs, HK government bonds, and exchange fund bills/notes. Offshore RMB lending to residents and non-corporates in both Hong Kong and Taiwan is not allowed. Offshore RMB lending is only permissible for corporate customers in both markets. subsidiaries or branches of Mainland funds, securities firms, domestic commercial banks and insurers are allowed to participate in this scheme. In addition, all financial institutions registered and operate mainly in Hong Kong are allowed to apply for a QFII quota. In addition, a previous 20%: 80% - equity: bond allocation restriction was lifted in. Products available to RQFII investors currently include: exchange traded bonds, stocks, interbank bonds, warrants, IPOs, stock index futures and securities investment funds. The Securities Regulatory Commission is also currently considering a request submitted by Taiwan officials for a RMB100bn R-QFII quota for Taiwan financial institutions. The RMB liquidity ratio is expected to provide: 1) greater flexibility for the inclusion of more RMB liquid assets; 2) more accurate matching of maturity of RMB liquid assets and short-term liabilities. Local banks were allowed to use RMB assets in statutory liquidity ratio calculations from January 2012, subject to certain conditions. It encouraged banks to hold more RMB-linked assets such as bonds and short-term loans. The NOP is defined as the difference between a bank s total RMB assets and liabilities, by excluding any structural positions such as investment in mainland subsidiaries. A 10% limited has been in place since December 2010, although the rule had been relaxed in July 2011 by excluding certain items in the calculation of NOP. Self-determination of the NOP by banks enabled them to better manage their FX risk, allowing greater opportunities for CNH liquidity to grow. Fixing submissions are collected from 18 RMB participant banks at the close of the previous business day (excluding Saturdays). CNY (HK) rates are reported in the tenors of overnight, 1 week, 2 weeks as well as 1, 2, 3, 6, 9 and 12 months. Rates are provided by banks themselves, and the TMA makes no warranties, representations or undertakings, expressed or implied by law or otherwise, in relation to the displayed rates and are not responsible for any errors or omissions, or losses caused by disruptions in the service or late publication of the daily rates or inaccuracy of the daily rates or otherwise arising from the use of or reliance on these rates. This was designed to help local banks deal with short-term liquidity tightness (triggered by unexpected external capital market developments). Hong Kong: Approval for onshore-to-offshore RMB loans for local banks was granted in January 2013, when an agreement was signed by 15 Hong Kong banks enabling them to lend up to RMB2n to 15 enterprises incorporated in Qianhai for the financing of 26 projects. Taiwan: Mainland Chinese entities and any joint ventures which are more than 30% Mainland Chinese owned are currently not allowed to issue debt in Taiwan. 53

55 Glossary CIRC CBRC CNH CNY CNT CSRC Dim Sum bond FDI MoF NDF NDRC ODI Panda bond PBoC QDII QFII Qianhai R-QFII SAFE State Council Wenzhou Yuan Insurance Regulatory Commission Banking Regulatory Commission offshore RMB traded primarily in Hong Kong currency within mainland traded in the onshore market RMB traded primarily in Taiwan Securities Regulatory Commission An RMB denominated bond issued in Hong Kong Foreign Direct Investment Ministry of Finance the USD settled non-deliverable forward RMB market National Development and Reform Commission, s top economic planning body Overseas Direct Investment RMB-denominated bond from a non-chinese issuer, sold in The People s Bank of, the central bank Qualified Domestic Institutional Investor programme Qualified Foreign Institutional Investor programmes An area of Shenzhen designated to test further RMB reforms. The media are calling it the Manhattan of South RMB Qualified Foreign Institutional Investor programme State Administration of Foreign Exchange s cabinet, the highest executive organ of state power City in Zhejiang province where an important programme of pilot reforms have been launched The broad term for s currency, the renminbi (RMB) 54

56 Related research reports From People s banks to people s hands, 8 March 2006 Recycling s trade dollars, 7 May 2007 The rise of the redback A guide to renminbi internationalization, 9 November 2010 : Onshore RMB bond markets open up a crack, 17 August 2010 PBoC starts trial for RMB direct investment overseas, 14 January 2011 The southern silk road, 6 June 2011 Strategy: Reforms to drive slow-paced A-share market rerating, 13 March 2012 Asian FX: RMB band widening: even more flexibility, 14 April 2012 Offshore RMB bonds: Standardised issuance framework launched, 10 May 2012 A new look at CNH liquidity Just turned two and growing up fast, 7 August 2012 Inside Out: Slowdown more cyclical than structural, 28 August 2012 Banks Shadow banking conundrum, 19 October 2012 s Big Bang, New leaders ready to revolutionise the financial system, 5 November 2012 Asia FX Focus: Proof of evolution, 29 November 2012 A very special relationship How Hong Kong will benefit from s rapidly changing economy, 14 December 2012 The great rotation, 20 December 2012 reforms its money market: Reverse repos to be made available daily to 12 banks, 18 January 2013 s shadow banking system Watch the yield, 22 January 2013 Inside Out: Structural problems, practical solutions, 30 January 2013 : RMB Q&A: The top 10 questions investors are asking, 5 February 2013 Offshore RMB bonds: Dim Sum Tracker, 4 February 2013 Asia FX Offshore RMB: Introducing the CNT, 6 February 2013 Asian FX Offshore RMB: Next stop London?, 22 February

57 Notes 56

58 Notes 57

59 Notes 58

60 Disclosure appendix Analyst Certification The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report: Hongbin Qu, Jun Wei Sun, Paul Mackel, Xiaoping Ma, Ju Wang and Donna Kwok Important Disclosures This document has been prepared and is being distributed by the Research Department of HSBC and is intended solely for the clients of HSBC and is not for publication to other persons, whether through the press or by other means. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other investment products mentioned in it and/or to participate in any trading strategy. Advice in this document is general and should not be construed as personal advice, given it has been prepared without taking account of the objectives, financial situation or needs of any particular investor. Accordingly, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to their objectives, financial situation and needs. If necessary, seek professional investment and tax advice. Certain investment products mentioned in this document may not be eligible for sale in some states or countries, and they may not be suitable for all types of investors. Investors should consult with their HSBC representative regarding the suitability of the investment products mentioned in this document and take into account their specific investment objectives, financial situation or particular needs before making a commitment to purchase investment products. The value of and the income produced by the investment products mentioned in this document may fluctuate, so that an investor may get back less than originally invested. Certain high-volatility investments can be subject to sudden and large falls in value that could equal or exceed the amount invested. Value and income from investment products may be adversely affected by exchange rates, interest rates, or other factors. Past performance of a particular investment product is not indicative of future results. Analysts, economists, and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues. For disclosures in respect of any company mentioned in this report, please see the most recently published report on that company available at * HSBC Legal Entities are listed in the Disclaimer below. Additional disclosures 1 This report is dated as at All market data included in this report are dated as at close 08, unless otherwise indicated in the report. 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its Research business. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBC's Investment Banking business. Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or price sensitive information is handled in an appropriate manner. 59

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62 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 [email protected] 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 [email protected] 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 [email protected] 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 [email protected] 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 [email protected] 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