dagong credit monitor · from over 4% for a one -year tenor, according to bloomberg, following...

Overview

The offshore Renminbi (as known as “CNH”) bonds outstanding grew to over

RMB400bn in 2014 from RMB300bn in 2013, according to Reuters. Despite

China’s slowing economic growth, trade flows settled in the Renminbi (“RMB”)

continue to increase and so does the use of RMB as a currency of choice.

We are of the opinion that increasing importance of RMB in the international

arena will continue to grow the RMB-denominated debt market, both onshore

(CNY) and offshore (CNH). The Chinese government has an intention to

internationalize the RMB as evidenced by the recent stock market access

liberalization between Mainland China and Hong Kong (i.e. the Hong Kong-

Shanghai stock connect), a Free Trade Zone (“FTZ”) expansion, and an

expansion of various qualified investment schemes.

We believe an increasing flow between CNY and CNH will ensure narrower

CNY and CNH exchange rates and yields. Rising demand for CNH to invest

in China should ensure continued demand for CNH loans. Bond investors’

need to diversify their portfolios away from G3 currencies (particularly the US

Dollar) should support CNH bond supply. We expect the CNH bond market to

grow in size and attract more investors despite a few challenges such as rising

defaults by Chinese issuers, a lack of credit due diligence, and an illiquid

secondary market. We view rising defaults in China as a positive indicator for

a more efficient capital allocation within the CNY and CNH bond markets.

Recent Developments

RMB is gaining popularity. IMF is studying whether the currency should be

included in the Special Drawing Rights (“SDR”) later this year. The setup of

the Asian Infrastructure Investment Bank (“AIIB”) and the FTZ expansion to

cover Shanghai’s business district, Tianjin, Guangdong, and Fujian all bode

well for the future adoption of RMB as a reserve currency.

Rising CNH liquidity which, in our view, emanates from: (1) rising trade flows

between China and the World; (2) Expansion of channels to move RMB in and

out of China; (3) Rising CNY liquidity: (4) Our expectation of resilient RMB

value against the US Dollar; (5) Continued RMB-based fixed income product

developments; and (6) Seasonality.

Contacts

Warut Promboon

Chief Rating Officer

(852) 3192 7069

[email protected]

Summary

Category Market Overview

Location Hong Kong

Date 27/MAY/2015

Dagong Credit Monitor

Offshore RMB Bond Market – Growth to resume after a speed bump

REMO40/20150527/1204

2

Offshore RMB Bond Market – May 2015

REMO40/20150527/1204

Growing Renminbi Popularity

The Renminbi (“RMB”) has overtaken the Swiss Franc (“CHF”), the Australian

Dollar (“AUD”), and the Canadian Dollar (“CAD”) in 2014 to become the 5th

global payments currency in term of value since last November, according to

Society for Worldwide Interbank Financial Telecommunication (“SWIFT”).

RMB was 8th in December 2013 and 14th in December 2012. The People’s

Bank of China (“PBOC”)’s expansion of global CNH clearing centers help

increase transactions in RMB, in our view.

Global trade settled in RMB grew to 2.2% in 2014 from 0.3% in 2011 (Exhibit

1), versus 44.6%, 28.3%, 7.9%, and 2.7% for the US Dollar (“USD”), the Euro

(“EUR”), the British Pound (“GBP”), and the Japanese Yen (“JPY”),

respectively. We believe RMB should at least take over JPY and claim the 4th

spot this year.

EXHIBIT 1: Trades settled in RMB as % of global currencies

Sources: SWIFT

IMF officials said the RMB would be considered in October for the inclusion

into the SDR alongside the USD, EUR, GBP, and JPY. Though we believe the

allocation into the basket could be small, it is a major step toward the future

adoption of the RMB as a reserve currency.

The Chinese government’s initiative to set up AIIB and the FTZ expansion to

cover Shanghai’s business district, Tianjin, Fujian, and Guangdong also tells

us the government is stepping up to liberalize international trade flows.

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

2011 2012 2013 2014

3


REMO40/20150527/1204

Rising CNH Liquidity

CNH deposits in Hong Kong grew on rising trade with China (Exhibit 2 and 3).

However, the annual year-on-year growth rate has dropped from 86.9% in

2012 to 46.2% in 2013 to 16.6% in 2014. CNH deposits contracted from May

to October last year. This year, CNH deposits declined again in February

(according to HKMA’s most recent reading) to RMB 973mn (vs. RMB 981mn

in January).

EXHIBIT 2: CNH deposits in Hong Kong (RMB mn)

Sources: HKMA

However, there are signs that CNH liquidity is on the rise. Some Hong Kong

banks have recently cut CNH deposit rates about 15 to 20 bps for the first time

from over 4% for a one-year tenor, according to Bloomberg, following strong

CNY inflow to Hong Kong on the newly-introduced Shanghai-Hong Kong stock

connect. One-year interbank CNH deposit rate dropped to below 4% at press

time while one-month interbank lending rate in CNH has dropped 227bps from

a peak of 6.35% on 6-Feb, according to Bloomberg.

We expect CNH liquidity to improve due to the following factors:

(1) China trade flows

(2) Expanding channels to move CNH onshore and CNY offshore

(3) CNY liquidity situation

(4) RMB value relative to USD

(5) CNH-denominated fixed income product developments

(6) Seasonality

350,000

450,000

550,000

650,000

750,000

850,000

950,000

1,050,000

20

11

20

12

20

13

20

14

20

15

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REMO40/20150527/1204

Trade flows in and out of China to pick up

China is embracing slowing economic growth and a series of economic

reforms. The National People’s Congress (“NPC”) has already lowered 2015

GDP growth target to 7%, down from 7.5% for last year and announced the

“new normal” economic growth policy. The lowered target essentially tells us

the following:

(1) The government has already acknowledged that the economic growth

is indeed slowing down;

(2) Beijing is willing to tolerate a slowing growth; and

(3) The government will work hard to defend the lowered 7% target and

there will be a new economic stimulus if the GDP falls below 7%.

We believe China needs to grow in order to maintain social orders amid

reforms. To say the least, we do expect more rate and reserve ratio

requirement cuts this year.

Slowing economic growth in China has already reduced China’s imports which

has led to a declining need to hold CNH. The government’s need to safeguard

7% GDP growth this year means more stimulus will be coming to spur the

economy which will eventually boost CNY money supply. In our view, rising

CNY money supply will find its way to alleviate CNH’s tight liquidity this year.

Looking into 2016, we believe the Central government’s infrastructure

spending plan on “One Belt One Road” could encourage banks to stockpile

CNH deposits.

Expanding Channels to Invest in CNH

The Chinese government’s move to further liberalize the RMB such as the

Hong Kong-Shanghai stock connect scheme, the FTZ expansion, the

establishment of more offshore RMB centers, and the expansion of qualified

investment schemes will help improve CNH liquidity, in our opinion.

Hong Kong-Shanghai stock connect

The Hong Kong-Shanghai stock connect (started on 27th November last year)

has generated CNH arbitrage opportunities which led to a convergence of

CNY and CNH yields. We understand there is a plan to launch a stock connect

between Hong Kong and Shenzhen later this year.

The southbound capital inflow to Hong Kong has exceeded the northbound

outflow to Shanghai since the second half of March this year. We expect this

trend to continue and the net capital inflow to Hong Kong to boost CNH

liquidity.

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REMO40/20150527/1204

Free Trade Zone expansion

The Chinese government announced in December 2014 that it would expand

the FTZ in Shanghai to 120 km2 from 28 km2 (originally set up in 2013) to

include the city’s commercial center where many foreign companies and

banks are located. The existing FTZ in Shanghai is near the airport and quite

isolated, in our view, and this expansion to include the business district will

attract more businesses into the FTZ. The government has recently expanded

its FTZs to include Guangdong, Tianjin, and Fujian, officially launched on the

21th April.

The expansion, in our view, means there will be more trade liberalization and

more trade flows with Taiwan (through Fujian), Hong Kong (through

Guangdong), Japan and Korea (through Tianjin). We also view the FTZ

expansion as a gradual effort by the Central government to lift capital controls.

The Central Bank has allowed a free capital flow between CNH accounts and

free trade accounts (“FTA”) in CNY and other foreign currencies, established

within FTZs. The FTZ expansion will likely boost CNH financing to borrowers

in the expanded FTZ, in our opinion. Rising CNH lending means banks will

stock up CNH deposits which will boost CNH liquidity, in our judgment.

Establishment of new RMB centers

Besides Hong Kong, the Chinese government has expanded offshore RMB

centers to include Canada, Qatar, UK, Luxembourg, Germany, France, UK,

Switzerland, Singapore, South Korea, Taiwan, and Australia. The transactions

between currencies of the offshore RMB centers and RMB should increase

CNY liquidity (which will lead to rising CNH liquidity, in our view). The latest

expansion into Canada and Qatar also represents trade potentials between

China and North America/Middle East, respectively.

Expansion of qualified investment schemes

The Chinese government has been granting quotas to invest onshore under

Qualified Foreign Institutional Investors (“QFII”) since 2006 and RMB Qualified

Foreign Institutional Investors (“RQFII”) since 2011. These two programs

continue to expand in size and allow more and more access to onshore

investment opportunities.

The latest RMB Qualified Domestic Instructional Investor (“RQDII”) (launched

last November) allows selected onshore companies to use onshore money to

invest in CNH assets. We expect RQDII to help boost CNH liquidity.

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REMO40/20150527/1204

CNY Liquidity on the Rise

China’s M2 money supply rose 11.6% year-over-year in March but the figure

was still below the median estimate of a Bloomberg economist survey of

12.4%. In an attempt to boost money supply (and CNY liquidity), the PBOC

lowered its reserve requirement ratio (“RRR”) twice to 18.5% (100bps earlier

this month and 50 bps in February). China’s RRR had been 20% from May

2012 to February 2015.

Falling inflation in China also enables the PBOC to cut rates to spur the

economy. Last November’s 40-bp one-year benchmark lending rate cut by the

Chinese Central Bank was the first time since July 2012. PBOC has cut the

benchmark lending rate twice by 25bps each time on 28th Feb and 11th May

to 5.1%. PBOC also cut a one-year benchmark deposit rate twice on 28th Feb

and 11th May by 25bps each to 2.25%.

We believe the market is expecting more RRR and rate cuts this year to further

spur the Chinese economy. Rate and RRR cuts will increase money supply

and demand for bonds or interbank assets, all of which will lower onshore

yields, in our view. The rates cycle in China marks an opposite cycle to the

one in the US (The US Federal Reserves (“the Fed”)’s hikes versus PBOC’s

cuts). China’s rate cuts are positive for RMB-denominated bonds, in our view.

We expect global bond investors to increase their portfolio weight in RMB-

denominated bonds. Since not all investors will have access to CNY bond

market, we expect more demand for CNH bonds in the next 12 months. Rising

demand for CNH bonds means more CNH liquidity, in our opinion.

Stabilizing RMB versus the US Dollar

The US Dollar continued to strengthen against major currencies, including

RMB in 2014. Strong US economic data in 2014 has also led the unwinding a

short USD position on the USD-RMB carry trade. Strong US Dollar

encourages USD holdings.

Slowing economic growth in China led to RMB depreciation against USD from

RMB6.1/USD at the end of last November to RMB6.3/USD in early March.

Needless to say, RMB softness against USD last year led to a declining need

to hold CNH deposits, in our view.

On the other hand, RMB softness encouraged borrowing in RMB. Rising

demand in RMB loans has led to commercial banks stocking up CNH deposits,

in our view. We note a third consecutive quarterly decline in China’s foreign

exchange reserves and believe the decline could stem from the PBOC’s

selling the US Dollar to slow down RMB depreciation against the USD. We

believe PBOC’s intervention (to buy USD) and rising foreign direct

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REMO40/20150527/1204

investments has led to appreciation of the exchange rate to RMB6.2/USD at

the time of this review.

A median projection of economists surveyed by Bloomberg projects the

RMB/USD exchange rate at RMB6.21/USD by the end of 2015. We are of the

opinion that RMB will maintain the current value against USD toward the end

of the year.

We believe two factors argue for RMB to maintain its value against the USD.

First, the Fed’s recent dovish comments and the market expectation of the

Fed’s “gradual and careful” rate hike toward the end of the year could slow

RMB outflows. Second, more economic liberalization should lead to rising

foreign direct investments and that is positive for RMB value against USD.

Rising CNH Bond Supply and Demand

Tightening CNH liquidity from slowing China trade flows led to rising

USD/CNH cross currency swap rates (“CCS”). The USD/CNH CCS rates on

the 3-year and 5-year tenors rose from 2% and 2.5% to about 4% in March.

The CCS rate has recently dropped below 4% at the time of this review as

CNH liquidity increases.

Rising USD/CNH rates have made foreign debt issuers’ cost of funding

cheaper when they issue debt in CNH and convert the proceeds back to USD.

CNH bond issuances have increased to CNY272bn in 2014 from CNY129bn

the year before (Exhibit 3).

EXHIBIT 3: CNH bond issuance (RMB bn)

Sources: HKMA

0

50

100

150

200

250

300

2011 2012 2013 2014

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REMO40/20150527/1204

From an investors’ perspective, tightening CNH liquidity since last year has

made CNH yields attractive versus CNY and USD yields even on bonds

issued by the same issuers. China is undergoing a rate cut cycle, (versus a

rate hike cycle in the US) and the rate cuts should encourage investors to lock

in yields on CNH bonds.

Rising investors’ demand for CNH bonds should sustain CNH bond issuances

even after the CCS rate normalizes. In addition, we expect the type of issuers

to change from overseas issuers (which took advantage of the widening CCS

rates) to Chinese issuers (which will come in to take advantage of rising CNH

liquidity.

We expect rising issuances from the Chinese real estate sector and local

government financing vehicles (“LGFV”). The former looks for attractive

financing amid a slowdown in the Chinese property sector while the latter finds

it difficult to borrow onshore as a result of the government’s on-going clamp

down on local government debt.

Seasonality of CNH Flows

Exhibit 4 and 5 shows rising CNH deposits after summer every year, except

in 2008, the year of the global financial crisis. That said, the CNH liquidity

situation should also improve until after summer on seasonality.

EXHIBIT 4: CNH Deposit (RMB mn)

Sources: HKMA

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

Jan Feb Mar Apr May June Jul Aug Sep Oct Nov Dec

2004

2005

2006

2007

2008

2009

9


REMO40/20150527/1204

EXHIBIT 5: CNH Deposit (RMB mn)

Sources: HKMA

Challenges to CNH Bond Market

Rising defaults by Chinese issuers

Slowing economic growth in China has already taken its tolls on asset quality.

We have started to see defaults, starting with the first on-shore coupon default

by Shanghai Chaori Solar Energy Science & Technology (“Chaori) in March

2014. Eventually, China Great Wall Asset Management, one of the four state-

owned “bad bank” asset management companies, bailed out Chaori.

Last year, we witnessed Hidili Industry International Development (“Hidili”) and

Renhe Commercial Holdings (“Renhe”) buying back their bonds at discounts.

Recent cases this year include Cloud Live Technology Group (“Cloud Live”),

Winsway Enterprises Holdings (“Winsway”), Kaisa Group Holdings (“Kaisa”),

and Baoding Tianwei Group (“Baoding Tianwei”).

Cloud Live defaulted on 5th April on the principal repayment of CNY400mn

bonds it sold 3 years ago and has become the first onshore principal default.

Notably, Cloud Live so far has not received any form of a government bail-out.

Winsway defaulted on a USD13.15-mn coupon payment on its USD bonds

due April 2016 on 8th April and did not manage to cure the default within the

30-day grace period. The coking coal producer asked for a debt standstill

agreement from bondholders in exchange for a potential equity injection.

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

800,000

900,000

1,000,000

Jan Feb Mar Apr May June Jul Aug Sep Oct Nov Dec

2010

2011

2012

2013

2014

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REMO40/20150527/1204

Kaisa announced on 20th April it did not make its USD bond coupon payments

of USD16.1mn and USD35.5mn within the 30-day grace period after the

scheduled dates of 18th March and 19th March, respectively. The defaults

came after a long saga since last December when Kaisa’s property sales were

blocked by the Shenzhen local government, the resignation of key executives

(including the founding Chairman), a loan default and a subsequent waiver,

Sunac’s proposed 49.3% stake purchase in Kaisa if offshore bondholders

agree to extend the maturities of the USD bonds, and, most recently, the

return of the founding Chairman, and a new loan from Sino Life.

The last two events indicate there are some agreements being reached with

the Shenzhen local government, in our view. The default, however, hit the

market with a surprise, in our view, as it is the first ever Chinese property

developer to default on USD bonds.

Last but not least, Baoding Tianwei, a subsidiary of China’s state-owned

China South Industries Group Corporation, announced on 21th April that it

missed RMB 85.5mn coupon payments on its CNY bonds maturing 2016.

The Chinese government has come in to bail out or arrange a bail out of

defaulters in the past and we believe the market has priced in that possibility.

However, the recent onshore defaults by Cloud Live and Baoding Tianwei

could underline a financial reform intended to enforce more market disciplines

and deal with moral hazards, in our view.

In essence, while it could mean that “not every” defaulter will be bailed out by

the government, we believe the following characteristics increase the

possibility of a government bail-out (without any explicit guarantees):

(1) Systemic importance to regional or local economies (In our view, a

bankruptcy of systemically important companies could damage a local

economy in terms of employment and consumer spending)

(2) Business or products which are supported by the central government

(i.e. renewable energy)

In the case of Cloud Live, the defaulter had been in a restaurant business

before it switched over to technology last July. We do not believe Cloud Live

fits the two criteria mentioned above. The fact that the government has not

stepped in to rescue Cloud Live is positive for the development of CNY and

CNH bond markets. Winsway’s default also did not fit into the two criteria

above.

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REMO40/20150527/1204

Kaisa’s events leading to the 20th April default led the market to believe Kaisa

may have had a chance to avoid defaults, in our judgment. The eventual

default indicates either a failed attempt by the local government to rescue

Kaisa or a change in the government’s policy to abandon the rescue plan.

Baoding Tianwei has incurred losses in the past 2 years and warned

investors last month of its cashflow difficulties. We consider the company as

a “non-strategic” state-owned enterprise and we believe Baoding Tianwei fits

into the two criteria we cited previously on why the government has less

incentive to bail out the company.

However, China Construction Bank (“CCB”) , an underwriter and a holder of

the defaulted bonds, announced on 26th April to lend Baoding Tianwei in order

to pay the defaulted coupon payments. Prior to CCB’s rescue plan, the market

had expected Baoding Tianwei to be let default, in our view. We believe CCB’s

rescue plan highlights CCB’s unwillingness to take losses, as well as attempt

to deflect its responsibility as the defaulted bond underwriter.

We believe, for the bond market to develop further, investors need credit

disciplines which include their abilities to correctly assess and price

creditworthiness of issuers and bond structures. Said differently, a bond

should have a yield that reflects its default probability and associated recovery

rate to ensure a proper capital allocation. Defaults generate recovery rate

database which are crucial to bond pricing. Defaults will also enable China to

improve its bankruptcy process, in our view.

The Asian USD bond market rebounded quickly on Kaisa’s series of bad news

since last December. In addition, there was not an indiscriminant sell-off on

Baoding Tianwei’s, Cloud Live’s or Winsway’s missed payments.

On one hand, the Asian USD bond market seems to be maturing and investors

seem to be able to differentiate between defaulters and “good” Chinese credits.

Primary bond market has not been shut down despite the defaults. Perhaps,

investors also expected the government to come in with a bail-out package.

On the other hand, it could be a sign that investors are not aware of the

inherent corporate governance risk and/or could not price the risk properly.

Rising demand for Asian bonds versus limited supply could overshadow credit

due diligence, in our view.

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REMO40/20150527/1204

Lack of credit due diligence on CNH (and CNY) bonds

The RMB bond market development needs knowledgeable and well-informed

investors who can price bonds efficiently, in our view. Bond investors, in turn,

gain knowledge from public information which includes rating reports and

research. About a third of CNH bonds are unrated and CNH bond research is

difficult to find. There are also issues of transparency with Chinese bond

issuers. Moreover, Chinese bond issuers do not always meet international

disclosure standards.

Credit due diligence on CNH bonds is, therefore, more difficult compared to

most USD bonds. We, however, expect the availability of research and ratings

on CNH bonds to grow in tandem with a rising demand and supply of the CNH

bonds.

The big three rating agencies 1 dominated the CNH bond rating’s market

shares. While 54.2% of CNH bonds are investment-grade rated and 8.2% are

non-investment-grade rated, 37.7% of the outstanding are unrated (Exhibit 6).

EXHIBIT 6: CNH bond outstanding by ratings

Sources: Bloomberg

The high percentage of unrated bonds (37.7%) reflects three factors, in our

view. First, many asset managers have already raised CNH funds and have

put in place reverse inquiries. The fact that these funds have already done

homework on the particular CNH bond issuers makes it less necessary for

CNH bond issuers to obtain ratings. Second, some CNH bond issuers have

already had ratings on USD debt and investors have already presumed the

CNH bond rating from the USD bond rating. Last, many CNH bond issuers are

Chinese State-Owned Enterprises and investors presume that the Chinese

1 S&P, Moody’s, and Fitch

AAA, 3.3%

AA, 19.7%

A, 24.6%

BBB, 6.6%BB, 4.9%

B, 3.3%

Not rated, 37.7%

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REMO40/20150527/1204

central and/or local government will step in for a bail-out if necessary. This

presumption, in our view, is changing as more default cases in China surface.

As the CNH bond secondary market expands, we expect a rising need for new

issuers to have ratings.

As China liberalizes its capital markets, more and more foreign investors will

have access to invest in CNY bonds. More access to invest onshore will

encourage investors to compare yields and ratings of CNH versus CNY bonds.

Thus, we believe a CNY bond rating development is also instrumental to the

development of a CNH bond market.

China’s onshore debt rating is a different universe where only the Chinese

domestic rating agencies are allowed to rate CNY debt issues. Chinese

regulators and an onshore market convention have regarded any CNY bonds

rated below “AA-“(by the Chinese domestic rating agencies) as “High Risk”.

For example, investors who want to trade CNY bonds rated below AA- on the

Shanghai Stock Exchange would need to have financial assets of at least

RMB5mn and sign a statement that they understand the higher risk.

99% of CNY bond outstanding, excluding commercial papers, at the end of

2014 was rated “AA-” or above (Exhibit 7). We primarily attribute this

coincidence to three rationales. First, domestic ratings could reflect a potential

government bail-out. Second, borrowers with poor credit standing may be

discouraged from issuing bonds and, instead, seek to borrow loans. Last and

not least, domestic rating quality could be compromised.

EXHIBIT 7: CNY bond outstanding (excl. CPs) breakdown by local ratings at the end of 2014

Sources: WIND

AAA, 61.1%AA+, 18.9%

AA, 17.8%

AA-, 1.1% Others, 1.1%

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REMO40/20150527/1204

The evolution of the CNY bond market and offshore investors’ better access

to CNY bonds mean more investors will seek to understand CNY bonds and

compare them with CNH counterparts.

Besides credit ratings, we note that not many brokers have dedicated

research on CNH bonds since CNH bonds are not liquid and trading

profitability may not be sufficient to support CNH bond research.

In our view, CNH bond research is, therefore, provided by few brokers with

CNH debt capital market capability. CNH market is also a specialized market

where banks which can attract CNH deposits have the advantage to expand

its CNH bond business.

Illiquid secondary market

CNH bonds are quite illiquid compared to USD bonds. The participating

brokers are usually brokers with debt capital market capability in CNH bonds.

Many CNH bond investors are the buy-and-hold type or do not trade CNH

bonds frequently since a wide bid-ask spread reduces short-term mark-to-

market gains. The wide bid-ask spread reflects illiquidity of the CNH bonds.

Given CNH bonds’ thinner liquidity and much smaller outstanding versus that

of Asian Dollar bonds, there are not many brokers that make markets on CNH

bonds.

This is a “chicken and egg” problem, in our view, where illiquidity has led to

even more illiquidity. However, we expect the secondary market liquidity to

increase through time as RMB gains more popularity and more CNH issues

come to the primary market. Rising CNH bond issuances and rising demand

to diversify a bond portfolio away from USD will encourage more secondary

trading eventually.

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Disclaimer

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