the rise of the redback-a guide to renminbi

By Qu Hongbin, Sun Junwei and Donna Kwok

As the Americans pursue QE and the world worries about the dollar’s future…

…the internationalisation of the renminbi is set to take off

A third of China’s foreign trade – dominated by links with other emerging

nations – could be settled in the renminbi within 5 years

The rise of the redbackA guide to renminbi internationalisation

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

Macro

November 2010

Qu Hongbin

Co-Head of Asian Economic Research, Chief China Economist

The Hongkong and Shanghai Banking Corporation Limited

+852 2822 2025

[email protected]

Qu Hongbin is Managing Director, Co-Head of Asian Economic Research, and Chief Economist for Greater China. 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 China

Banking Association. He previously worked as a senior manager at a leading Chinese bank and other Chinese institutions.

Sun Junwei

Economist

Sun Junwei is an economist for China in 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 London School of Economics and a BA in Economics

from Peking University.

Donna Kwok

Economist

The Hongkong and Shanghai Banking Corporation Limited (HK)

+852 2996 6621

[email protected]

Donna is an economist on HSBC’s Greater China economics team. Before joining HSBC in July 2010, she worked as an economist

for the Hong Kong-China equities research arm of a global financial services provider. Prior to that, she served as East Asia analyst

at Strategic Forecasting Inc. (US) and as a strategy consultant at Deloitte Consulting (London). Donna holds an MA in International

Relations (Economics and China Studies) from the Johns Hopkins University School of Advanced International Studies, and a BA

(Hons) in Economics and Management from Oxford University.

1

Macro China Economics 9 November 2010

abc

If there is to be a rival to the dollar as the world’s reserve currency in the 21st century, it surely must be

the Chinese renminbi. Already the world’s second largest economy, China is likely to be the biggest by

the 2030s. It is already the world’s biggest exporter. To date, its currency has been severely under-

represented in global trade and capital markets. Yet we may be on the verge of a financial revolution of

truly epic proportions.

The Chinese talk about the internationalisation of the renminbi. Their aim is doubtless helped by

America’s pursuit of quantitative easing, a policy which has been interpreted in many emerging nations as

a direct attempt to export US economic problems to the rest of the world via a much weaker dollar.

Whether or not this interpretation is correct, it surely will only encourage governments, reserve managers,

companies and individuals to think about alternatives to the dollar. Given China’s heightened

gravitational pull in the world economy, the renminbi is an increasingly credible rival. The world

economy is, slowly but surely, moving from greenbacks to redbacks.

This document offers updated versions of HSBC publications on the renminbi produced over the last 2

years. For those interested in China’s role on the world stage, and its relationship with other G20 nations,

it is essential reading.

Demand for the renminbi as a trade settlement currency lies in emerging, not developed, economies.

Emerging markets now account for nearly 55% of China’s total trade, versus 47% ten years ago. As the

centre of global economic gravity shifts further towards EM countries, we anticipate an increasingly rapid

rise of this share. Yet most emerging trade is invoiced in neither the renminbi nor their own currencies. A

switch from the dollar to the renminbi for trade settlement is likely to be an appealing option for emerging

nations eager to bolster their relations with the fast-growing Middle Kingdom.

As a strategic priority, Chinese policymakers have already (and will continue to) introduce multiple

accommodative taxation, trade finance and capital account measures to facilitate the RMB

internationalisation process. More importantly, cost savings on foreign exchange transactions and the

appreciation of the renminbi should increasingly encourage exporters and importers, both in and out of

China, to switch to the renminbi at the dollar’s expense.

Sniffing the potential for business, banks – especially multi-national ones – have also been eager to get

involved in renminbi cross-border trade; their early participation effectively helped launch a global

clearing system for the renminbi within a matter of months. Supported at the highest political levels, this

catalytic mix of drivers means that the acceleration and contours of the renminbi internationalisation

process will be faster and more varied than many expect.

Summary

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If the current trend continues, we expect that at least half of China’s trade flows with EM countries could be

settled in renminbi within 3-5 years, from less than 3% currently. In other words, nearly USD2trn worth of

trade flows could be settled in renminbi annually, making it one of the top three global trading currencies.

The renminbi trade settlement scheme is triggering a chain reaction in China's capital markets. Rising

demand for the renminbi overseas is smoothing the path for Chinese corporations to invest abroad with

the renminbi. As renminbi trade revenue accumulates outside China, so too will the path be smoothed for

foreign companies wishing to invest in China with the renminbi.

More than five Chinese and foreign institutions have issued benchmark renminbi-denominated bonds in

Hong Kong over the last three months, ranging from McDonald’s to China Development Bank to the

Asian Development Bank. Recent steps towards the easing of restrictions on offshore renminbi use have

also created the first ever offshore renminbi interbank market and deliverable spot trading of the currency,

in Hong Kong.

At the same time, the pool of offshore renminbi cash deposits has seen an impressive upsurge, most noticeably

in Hong Kong where total renminbi deposits in the banking system rose 240% to nearly RMB150bn in the first

nine months of 2010. Combined with the gradual opening of onshore renminbi capital markets to selected

foreign institutions, this offshore build-up will help widen and lengthen the runway for more renminbi product

launches in Hong Kong for years to come. Future products just around the corner include RMB-denominated

IPOs, RMB-denominated QFIIs (a share licence programme for Qualified Foreign Institutional Investors), and

offshore RMB bonds issued by non-financial mainland corporates.

These developments are firing up the rapid expansion of the renminbi’s role in both trade and investment

flows, upping its attractiveness to reserve managers. A few central banks have already expressed an

interest in holding renminbi assets as part of their foreign exchange reserves. That said, China will

unlikely free up the renminbi to full convertibility until it has put its internal financial house in order.

Recent initiatives – to micro-reform the state banks, develop foreign exchange markets and deepen local

capital markets – are steps in the right direction. PBoC Governor Zhou Xiaochuan recently promised that

China would gradually make the renminbi convertible for capital account items in the next few years.

Given China's economic and trade power, as the country moves closer to the currency full convertibility,

it will only be increasingly natural for the renminbi to become a reserve currency.

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China to shrink surplus, but not the Geithner way 4

Two big misconceptions 7 1. China must revalue to contain inflation 7

2. Rising trade surplus means RMB still undervalued 8

From greenbacks to ‘redbacks’ 10 Crisis and internationalisation of the renminbi 10

Matching China’s rising economic power 11

The latest moves 14

The roadmap 15

The implications 16

Ready, steady, go! 20 Renminbi trade settlement goes global 20

Potential lies in non-G3 countries 21

Where to park the renminbi? 21

Increased flexibility encourages use of renminbi 22

Offshore renminbi products take off 23 What’s new 23

A renminbi interbank market created 23

New Hong Kong renminbi rules: the low-down 24

New platform for renminbi product development 24

Pre-empting future bottlenecks 25

Revving up the engine 25

Completing the on/offshore RMB circle 26 Onshore RMB bond market opens up to offshore funds 26

Internationalisation of the RMB is maturing: from the first to

second of three stages 27

Why Beijing decided to open its interbank bond market first28

Implications for Hong Kong as an offshore RMB centre 28

Snapshot: China’s interbank bond market 32

RMB trade settlement takes a breather 33 What has happened? 33

FX takeaways 34

Macro takeaways 35

From trade to investment 37

Connecting the dots for RMB internationalisation 39 A long march 40

Where it’s heading… 41

Market-driven bank interest rates 42

Reserve currency: still decades away 47

Now is a good time… 48

Disclosure appendix 50

Disclaimer 51

Contents

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This is an updated extract from an article

originally published on 25 October 2010

China and other countries have rejected US

Treasury Secretary Geithner’s proposal of limiting

the current account balance at 4% of GDP at the

G20 finance ministers meeting. In fact, it was Yi

Gang, Vice Governor of the PBoC, who first said

China would lower the current account surplus to

GDP ratio from 5.8% in 2009 to 4% in three to

five years’ time at an IMF meeting in early Oct.

That said, China never likes being pushed into

anything. While they both agree on the “what” (a

lower trade surplus), they disagree fundamentally

on the “how”. But there is a key difference here:

Geithner wants to see faster renminbi

appreciation, but Beijing wants to see a broader

and better-staggered policy package that would

also boost domestic demand, push through

structural reforms, accelerate wage growth, and

liberalise resource prices.

China’s current account (and trade) surplus as a

percentage of GDP has been shrinking over the

last three years amid faster recovery in Chinese

demand. Its current account surplus to GDP ratio

almost halved to 5.9% in 2009 from a peak of

10.6% in 2007. Between 2007 and 2009, its trade

surplus to GDP ratio dropped from a peak of 7.5%

down to 4%, largely due to Beijing’s RMB4trn

stimulus package which substantially boosted

imports of raw materials and machinery

equipment. In stark contrast to the negative

growth rates seen across the developed world in

2009, China’s economy staged a sharp V-shaped

China to shrink surplus, but not the Geithner way

It was a PBoC official, not Tim Geithner, who first touted a 4% of

GDP target for China’s current account surplus

Geithner urges faster renminbi appreciation, but Beijing wants to

see a broader and better-staggered policy package

If China’s domestic demand growth continues to outstrip its main

trading partners, its trade surplus should shrink further

1. Trade surplus and CA balance as % of GDP

Source: CEIC, HSBC

0

2

46

810

12

2000 2002 2004 2006 2008 2010f

As % of GDP

Trade balance Current account balance

Source: CEIC, HSBC

Qu Hongbin Chief China Economist The Hongkong and Shanghai Banking Corporation Limited +852 2822 2025 [email protected]

Sun Junwei Economist

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recovery last year to expand 9.1% y-o-y (real

terms). The second-round impact of the stimulus

package continues to ripple through the economy,

both fuelling job creation and domestic

consumption. For the first nine months of 2010,

China’s import growth rate continued to outstrip

that of exports, averaging 42.4% y-o-y versus

34% y-o-y for the latter. By the end of 3Q,

China’s total trade surplus had narrowed to

USD120.6bn, or 10.5% less than the same period

last year.

We expect China’s domestic demand to stay strong

in the coming years, maintaining a substantial

growth differential with its major trading partners

to further narrow its trade surplus (via robust

import growth). As Premier Wen said at the World

Economic Forum in January 2009, China’s steady

and fast growth itself is an important contribution

to global financial stability and world economic

growth. Indeed, in view of the sluggish recovery of

Western countries, China’s growth matters a lot for

the global economy. Stronger Chinese domestic

demand will likely lower the current account to

GDP ratio to around 4% by 2011.

China’s domestic demand growth engine should

support a growth rate of around 9% next year,

despite slower global economic growth and thus

cooler external demand. Regardless of recent credit

tightening measures on new infrastructure projects,

we expect continued investment into massive

ongoing infrastructure projects to provide a floor to

fixed investment growth. This, plus improving

labour market conditions, should underpin solid

domestic demand growth through 2011.

Three trends underlie our forecast for China to

continue outpacing world economic growth in the

coming years: continued urbanisation, continued

industrialisation, and rapid productivity growth.

The shift in Beijing policy makers’ attention from

quantity to quality means that the 12th Five-Year

Plan (2011-16) will likely deliver a lower growth

target. This complements China’s ongoing

transition towards a more sustainable and balanced

growth path. We anticipate domestic demand

growth to average 8-9% for the next few years.

Policy making is set to revolve around “inclusive

growth” for the next five years. Wage growth is

already on the rise, and should continue upwards

as the government seeks a more equitable

distribution of the benefits of economic growth.

As labour compensation is pushed up via income

distribution reforms and faster wage growth, so

consumption’s contribution to growth should rise.

Wages form the dominant income source for urban

households and hold the key to spurring private

consumption. But wage income growth has lagged

productivity growth in recent decades, something

which allowed unit labour costs to fall for so long.

Through various measures including minimum

wage growth and labour union consultations,

Beijing’s plan is for wage growth to catch up with

productivity growth by 2015. This, plus expected

improvement in social security provisions, should

increase the share of labour compensation to GDP,

so lifting private consumption.

Inflationary pressures should alleviate as the pace

of GDP growth slows to below its full potential

(estimated at 10%), giving Beijing more room to

continue its liberalization of resource price

controls – an important structural adjustment.

Resource price reforms should help close the gap

between domestic and international resource

prices, minimize inefficient manufacturing

capacity and ultimately help slow down exports in

related sectors.

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2. Real effective exchange rates for China and others

60

80

100

120

140

00 01 02 03 04 05 06 07 08 09 10

REER Jan 2005=100

China Australia IndiaJapan Korea

appreciation

Source: CEIC, HSBC

Beijing is confident about realising both rapid

domestic demand growth and a narrower surplus

in its own way. But it is reluctant to make a

binding target based on Geithner’s proposal,

which is solely targeted at currency adjustment.

Beijing’s solution of fostering stronger domestic

demand with more reliance on private

consumption should help increase import demand,

to keep China’s domestic demand growth rate

above those of its main trading partners and thus

its trade surplus on a downward trend for the next

five years.

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originally published on 6 May 2010

1. China must revalue to contain inflation There’s no doubt that rising global prices for

commodities and resources have been a key driver

behind the strong rebound in producer price levels

during 1H. Chart 1 shows how PPI increases have

historically been passed-through in part to

consumer price inflation.

This leads many analysts to believe that a

meaningful appreciation in the RMB is necessary for

China to control inflation. However, this argument

overlooks a simple fact – China is already a price

setter in global commodity and resource markets,

which means RMB appreciation alone won’t be

enough to contain imported inflation in China.

China is the world’s largest consumer of

commodities and resources. Over the last five years

it has accounted for over 55% of global incremental

demand for crude oil, and almost 150% of global

incremental demand for iron ore. Hence, any change

in China’s demand is likely to affect global prices for

commodities and energy, as already demonstrated in

recent quarters. An appreciation lowers RMB prices

of imported commodities in China on the one hand

but simultaneously pushes up overall Chinese

demand on the other, which ultimately increases

global commodity prices.

Chart 1. PPI partial pass-through to CPI

-4

-2

0

2

4

6

8

10

97 98 99 00 01 02 03 04 05 06 07 08 09 10

(% yr)

-10

-5

0

5

10

15(% yr)

CPI (Lhs) PPI (Rhs)

Source: CEIC, HSBC

Chart 2. PPI aligned with international commodities prices

200

250

300

350

400

450

500

97 98 99 00 01 02 03 04 05 06 07 08 09 10

(%yr)

-20

-10

0

10

20

CRB index (Lhs) PPI (Rhs)

Source: CEIC, HSBC

Two big misconceptions

First, China has to revalue meaningfully to contain inflation – Wrong

Second, trade surplus implies that the RMB is still significantly

undervalued – Not really



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2. China vs. global incremental demand for commodities

2009 China Global

Crude oil (000’ barrel/day) 512 445 Iron Ore* (kt) 170 14 Aluminium (kt) 1,319 -2,668 Copper (kt) 1,259 -1,150 Steel (mt) 106 -48

Source: BP, IEA, WMBS, EIA, Ministry of Commerce, Ministry of Land Resources, HSBC

However, as a price setter, China does have a

unique policy option to check imported inflation –

unwind its infrastructure boom to cool demand for

commodities and energy. In doing so, China can

also take some heat out of the overheated

economy to ease pressure on the domestic supply

of electricity, food and other resources.

Beijing has already announced plans to slow

growth in the central government’s total spending

to 6.3% for this year from 24% last year, with

infrastructure leading the slowdown. Meanwhile,

the central authorities are also checking the pace

of new infrastructure projects by provincial and

municipal governments by curbing bank lending

and re-regulating local government investment

corporations. All these measures, once

implemented, are likely to slow growth in

infrastructure investment and, in turn, growth in

Chinese demand for commodities and energy in

the coming quarters.

Chief among other policy tools for fighting

inflation is quantitative tightening on credit and

property (see Asian Economics Quarterly 2Q

2010: Time to cool off, published 19 April 2010).

After 100bps in reserve ratio hikes and lending

restrictions, loan growth has slowed from over

32% at the end of last year to 21.8% as at the end

of March. More needs to be done to achieve the

target of slowing loan growth to 17% y-o-y by the

end of the year.

We expect the PBoC to continue to lift reserve ratios

by another 50-100bps in the coming quarters, while

restrictions on new lending will stay in place.

Meanwhile, following the State Council’s latest

measures to curb property speculation, we expect

local authorities to introduce more detailed rules to

dampen the investment demand for property and

increase the supply of affordable housing in the

coming quarters.

2. Rising trade surplus means RMB still undervalued First, let’s get the facts straight. No, China’s trade

surplus is not on the rise. On the contrary, it has

been shrinking for the last five months in absolute

terms. As a share of GDP, the trade surplus has

been falling fast, from about 7.5% in 2007 to 4%

last year. And we expect it to drop further to less

than 3% in 2011.

The bigger issue is whether this trade surplus should

taken as hard evidence that the RMB is seriously

undervalued. Though possible, the nature of China’s

trade surplus is quite different from that in most

other countries.

First, over 80% of China’s total trade surplus is

created by processing trade, a sector dominated by

Mainland-based foreign companies. This implies

1. China’s share in global demand for major commodities (%)

2004 2005 2006 2007 2008 2009 2010e

Crude oil 8.3 8.4 8.8 9.1 9.5 10 10.5 Iron Ore* 33.1 38.8 41 44 49.7 67.9 64.4 Aluminium 20.2 22 25.4 32.5 33.2 39.5 41.8 Copper 20.9 2.3 22.7 25.3 27.4 36.6 na Zinc 23.5 26.9 28.4 30.9 33.9 39.9 38.5 Nickel 12.4 15.1 17.3 23.1 22.4 30.1 na Steel 28.3 32.8 32.8 34 35.5 46.2 43.4

Source: BP, IEA, WMBS, EIA, Ministry of Commerce, Ministry of Land Resources, HSBC

http://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=3yzayyqp2v&n=265343.PDF

http://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=3yzayyqp2v&n=265343.PDF

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that China’s own domestic companies generate only

a fraction of the total trade surplus.

Second, global manufacturers have been shifting

their labour-intensive stage of productions into

China to capitalise on China’s massive labour

pool. These foreign-owned factories import parts,

components and materials to assemble them into

finished products before final shipment to global

markets. Their value of the final assembled

exported goods often exceeds the sum of its

imported components and materials; with the

difference being the value added in China (aka

profit margins, rentals and wages). But under the

existing international system of trade statistics,

this value added portion is recorded as a trade

surplus for China.

Hence, instead of being a key indicator for the

undervaluation of its currency, China’s trade

surplus is perhaps more a by-product of vertical

integration in global manufacturing activities.

Or more specifically, the migration of

manufacturing assembly lines from more

expensive (labour cost wise) developed

economies into China. Of course, this vertical

integration in turn has spurred the development of

China’s massive and well-disciplined labour pool,

substantial infrastructure improvements and the

associated economies of scale.

3. Trade surplus as % of GDP

0

50

100

150

200

250300

1995 1997 1999 2001 2003 2005 2007 2009 2011f

(USD bn)

0

2

4

6

8(%)

Trade balance (Lhs)

Trade balance as % of GDP (Rhs)

Source: CEIC, HSBC

4. Trade surplus dominated by processing trade

-500

50100150200250300350

2000 2002 2004 2006 2008

(USD bn)

Processing trade by foreign joint v entures

Ordinary trade by domestic companies

Source: CEIC, HSBC

5. Key reasons for doing business in China

0 5 10 15 20 25

Access to regional market

Presence of suppliers

Cheap labour

Size of local market

Grow th of market

(%)

Source: UNTCAD, HSBC

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originally published on 6 July 2009

Crisis and internationalisation of the renminbi Aside from the slowdown, the global economic

crisis has also led to unprecedented risks to China’s

more than USD1.8trn of USD assets. The Fed’s

remedy of quantitative monetary easing is causing

concerns about inflationary risk and is weighing on

the value of the greenback. This has prompted

Chinese policymakers to rethink the root causes of

the ‘dollar trap’. There is a growing consensus in

Beijing that one of the fundamental reasons the

country has fallen into the trap is that its own

currency – the renminbi – is not yet an international

currency, which means Chinese exporters and

importers have to rely on the dollar for invoicing

their foreign trade. We estimate that over 70% of

China’s USD2.6trn annual trade flows (2008) are

settled in the US dollars, with the balance being

settled in the euro, yen and other currencies. With

China’s exports surging nearly 30% annually in the

previous boom cycle of global demand (2002-7), the

country rapidly accumulated export earnings in

dollars. Meanwhile, government controls on outward

investment by domestic corporations and households

meant that most of the dollar receipts can be

recycled out of the country through just one channel

– the central bank’s FX reserve accumulation. To

find an ultimate solution to this issue, apart from

gradually loosening controls on capital outflows

(please refer to our reports From People’s Banks to

people’s hands, 8 March 2006, and Recycling

China’s trade dollars, 7 May 2007), Beijing realises

it is time to push forward the internationalisation of

the renminbi.

As in many emerging market countries, the US

dollar is still the dominant currency for settling

cross-border trade flows in China. The global

crisis and unconventional policy responses by the

world’s major central banks will likely lead to

greater uncertainty over the exchange rates of the

major currencies, especially the dollar.

Meanwhile, with global demand contracting,

exporters and importers in China and in counter-

party countries are finding it much tougher to

From greenbacks to ‘redbacks’

China is kick-starting the internationalisation of the renminbi to free

itself from the ‘dollar trap’ and better facilitate long-term growth

Trial renminbi trade settlement, if successful, could result in nearly

USD2trn of annual trade flows being settled in renminbi

We analyse future implications for China’s export recovery, its

dollar assets, the renminbi and the Hong Kong SAR



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remain profitable. They are likely to do whatever

they can to expand revenue and control costs,

including lowering the transaction costs of settling

trade. This is likely to prompt corporations in both

China and its major trade partners to use a local

currency rather than the US dollar for settling

cross-border trade.

Matching China’s rising economic power What does the internationalisation of the renminbi

really mean? Simply put, the internationalisation

of a currency is the process of promoting its use

outside of the home country.

The international uses of a currency can be

categorized in three key areas: 1) international trade,

as a pricing and invoicing currency; 2) international

debt markets, loan and deposit business, as a

financing and investment tool; and 3) foreign

exchange markets, as a payment vehicle. An

internationalised currency implies a currency that is

widely accepted for investment, as a financing and

payment vehicle and as a reserve, intervention and

anchor currency in all countries across the world.

Table 1. Measuring international currencies in terms of function

Currency use in global markets Currency use in other countries

International debt markets, loans & deposits (financing & investment)

Official use (reserves, intervention, anchor)

Foreign exchange market (payment vehicle)

Private use (investment & financing, payment vehicle)

International trade (pricing & invoicing)

Source: HSBC

What are the key criteria to fulfil if a currency is

to internationalise? Past empirical studies1

conclude that the international acceptance of a

______________________________________ 1 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.

currency goes hand in hand with the rise and fall

of a country’s economic power. In the 19th

century, 60-90% of international trade was priced

in British pounds. After eclipsing Britain’s

economy in the late 19th century, the US rose in

economic power and turned into a net creditor

from a net debtor. Meanwhile, the dynamics of

economic power were reflected in the strength of

the US dollar, which overtook sterling as the

international reserve currency after World War II.

The dominant role of the US dollar continues to

hold despite the rise of potential future

alternatives such as the euro and now the

renminbi. Although the recent financial crisis

undermines investors’ faith in the US dollar to

some extent, the primacy of this currency across

international markets means that it should retain

its standing as the world’s top international

currency for the foreseeable future.

The internationalisation of the deutschemark,

which was the second-largest international

currency after the US dollar before the circulation

of the euro, can be attributed to 1) Germany’s

economic power and 2) the stability of the

deutschemark. Germany became the third-largest

economy after the US and Japan in 1968, due to

its post World War II growth spurt which saw its

competitiveness in machinery exports shoot up.

Germany’s robust trade record helped the

deutschemark appreciate against the US dollar

and British pound, as the liberalisation of trade

and capital paved the way for internationalisation

of the deutschemark. More importantly, the

Bundesbank, known as the most independent

central bank in the world, pursued a stable

currency as one of its most important objectives,

for fear of inflation. By limiting the growth of

money supply, the Bundesbank backed a strong

and stable currency that foreign investors and

central banks chose to hold to minimize exchange

rate losses. In this way, the deutschemark

accounted for up to 18% of the world’s foreign

exchange reserves by the early 1990s.

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The internationalisation of the yen began in the

1970s, when Japan became the world’s second-

largest economy after two decades of around 10%

growth. However, fearing the potential negative

impact of the yen’s internationalisation on

domestic financial markets, Japanese

policymakers did not actively push for yen

internationalisation until the Asian financial crisis

and launch of the euro. Thus, the international use

of the yen is not as wide as it perhaps could be.

This reflects the 1) initial passive attitude of the

Japanese authorities towards internationalising the

yen; 2) less open nature of Japan’s domestic

financial markets which hindered efficient yen

internationalisation; and 3) big swings in the

JPY/USD exchange rate which effectively

undermined the international use of the yen in

global trade and investment flows.

Long overdue

If history is a guide, the internationalisation of the

renminbi is long overdue given China’s rising

global economic presence versus the limited use of

its currency overseas. China’s nominal GDP topped

USD4.9trn in market exchange rates (2009 year

average of USD1=RMB6.83) last year and is set to

reach USD5.6trn this year, which means China

may finally take over Japan as the world’s second-

largest economy in 2010. Moreover, China is also

probably the most globalised of all major

economies; the value of its foreign trade has risen

at a pace of 23% annually for the last decade, more

than double the average growth rate of global trade

in the same period. China surpassed Germany as

the world’s second-largest trading country in 2009.

There is a common misconception that China’s

cross-border capital inflows are still insignificant

owing to strict Chinese capital controls. But these

controls are both carefully calibrated and targeted.

Despite the global financial crisis, China was the

largest developing world foreign direct investment

(FDI) recipient and among the top five global FDI

recipient in 2009 (USD92bn in 2008 and USD94bn

in 2009). At the same time, six years after Beijing

first started to ease outward capital controls,

Chinese outward direct investment (ODI) hit a

record USD56.5bn in 2009. With the country’s

growing appetite for natural resources, technology

and brand names in the global markets, this uptrend

in China’s ODI will likely continue, possibly

reaching USD100-150bn per annum by 2012. In

the light of the global financial crisis, China should

and will likely maintain the gradual pace of its

capital market liberalisation. An anticipated surge

in ODI and FDI out/inflows will keep China’s

cross-border capital flows widening in the coming

years, but policy makers will likely stay cautious

on the speed of the current.

Chart 1. China’s rising economic power Chart 2. China’s trade and FDI as % of world total

0

1000

2000

3000

4000

5000

1990 1992 1994 1996 1998 2000 2002 20042006 2008

(USD bnr)

0

2

4

6

8

China GDP at current price(Lhs)

China as % of world GDP

0

2

4

6

8

10

1992 1994 1996 1998 2000 2002 2004 2006 2008

(%)

0

5

10

15

20

25(%)

Trade (Lhs) FDI (Rhs)l

Source: Bloomberg, HSBC Source: EcoWin, Bloomberg, HSBC

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Supportive factors in place

China’s rapid integration with neighbouring

economies and rising outbound tourism provided

an effective kick-start to the use of the renminbi

overseas. Border trade has been on the rise for a

number of years, with reserve-short neighbouring

countries generally favouring the renminbi for

trade settlement given its relative stability. At the

same time, rising income levels are sending

increasingly more Mainland tourists abroad,

armed with their overseas renminbi-denominated

shopping budgets. These trends ultimately pave

the way for the renminbi’s evolution into a

regional hard currency.

More importantly, the Chinese government

continues to reform the foreign exchange system

and deregulate the capital account. Since the sharp

exchange rate reform move of July 2005, China

has allowed the renminbi to float flexibly with

Table 2. China’s capital account reform measures

Date Measures Applicable to Capital flows

Nov 2002 Introduce foreign capital in SOEs reform corporate inward Nov 2002 Launch qualified foreign institutional investor scheme non-residents inward Dec 2002 Reform of Mode of Exchange Administration related to Domestic Foreign Exchange Loans corporate outward Jan 2003 Allow domestic individuals’ foreign exchange mortgage RMB loan individuals outward Jan 2003 Foreign debts management corporate inward Feb 2003 Foreign-invested companies to establish investment companies non-residents inward Mar 2003 Improve foreign exchange management on foreign direct investment non-residents inward Mar 2003 Simplify the investigation on the sources of overseas foreign investment corporate outward Jul 2003 Refund of the security deposit on remitted back overseas investment profits corporate outward Sep 2003 improve foreign exchange administration of overseas listing corporate inward Oct 2003 Deepening the reform of foreign exchange administration on overseas investment corporate outward Jun 2004 the administration on foreign debts of foreign-funded banks in China corporate inward Oct 2004 the management of internal operation of foreign exchange fund of multinational companies corporate inward/outward Nov 2004 the administration of purchase and payment of foreign exchanges due to transfer of individual properties

to foreign countries individuals outward

Feb 2005 foreign exchange administration of overseas listing corporate outward Mar 2005 the preliminary reporting system for the overseas merger and acquisition corporate outward Mar 2005 the administration of foreign exchange for overseas investments of border areas corporate/individuals outward Apr 2005 Foreign exchange guarantees for RMB Loans corporate outward May 2005 Nationwide extension of the pilots reform regarding the administration of foreign exchange for overseas

investment corporate outward

May 2005 Amend the operative procedures of foreign exchange administration in overseas futures hedging business of SOEs

corporate outward

Oct 2005 Improve foreign debts administration corporate inward Oct 2005 Engage in financing and in return investment via overseas special purpose companies for domestic

residents corporate/individuals inward

Dec 2005 Strategic investment in listed companies by foreign investors non-residents inward Apr 2006 Launch qualified domestic institutional investor scheme corporate/individuals outward Apr 2006 Commercial banks to provide overseas financial management services on behalf of clients corporate outward Jun 2006 Adjusting some foreign exchange management policies concerning overseas investments corporate outward Jul 2006 Regulating the entry of foreign investment into the real estate market non-residents inward Aug 2006 Domestic securities investment by qualified foreign institutional investors non-residents inward Aug 2006 Overseas securities investment by fund management companies corporate/individuals outward Aug 2006 Provisions on the takeover of domestic enterprises by foreign investors corporate inward Sep 2006 Regulating the administration of foreign exchange in real estate market non-residents inward Nov 2006 The operating rules for commercial banks to provide overseas financial management services on behalf

of clients corporate outward

Jun 2007 Further strengthening and regulating the examination, approval and supervision of foreign direct investment in real estate industry

corporate/individuals inward

Jul 2007 Insurance funds to invest in overseas markets corporate outward Aug 2007 Domestic individuals to directly invest in overseas capital markets individuals outward Aug 2008 Registration of foreign debts under the trade in goods of enterprises corporate outward/inward May 2009 Adjust the examination and approval power for some foreign exchange businesses under capital

accounts corporate/individuals outward/inward

Jun 2009 The foreign exchange administration of overseas loans granted by domestic enterprises corporate outward

Source: The State Administration of Foreign Exchange (SAFE), PBoC, HSBC

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reference to a basket of currencies, which

enhanced the flexibility and credibility of the

renminbi. In addition to the full convertibility of

current account, Beijing has gradually loosened

capital account controls. Via the qualified foreign

institutional investor (QFII) and qualified

domestic institutional investors (QDII) schemes,

cross-border capital flows have found another

outflow channel via the capital account. For

individuals, the limit on renminbi that can be

carried by Chinese citizens going abroad or

foreigners entering China was in 2005 raised to

RMB20,000 from RMB6,000.

These factors demonstrate that favourable

conditions for the wider usage and acceptance of

the renminbi already exist. The question is

whether and to what extent Beijing accelerates the

pace of renminbi internationalisation. Recent

moves indicate that the pace was intentionally

sped up amidst the global financial crisis.

The latest moves It is in this context that the internationalisation of

the renminbi has become a leading item on

China’s policy agenda, as illustrated by the recent

announcements of a series of policy measures

designed to jumpstart the international use of

the renminbi.

Kick-starting a pilot programme…

Following the announcement of renminbi

settlement on cross-border trades between 1)

Hong Kong/Macau and the Pearl River

Delta/Yangtze River Delta, and 2) ASEAN and

Guangxi/Yunnan in December 2008, the State

Council selected five major trading cities in

mainland China to kick off the pilot programme in

June 2009. These cities included Guangzhou,

Shenzhen, Dongguan and Zhuhai in the

Guangdong province and Shanghai, which

accounted for 45% of China’s total trade in 2008.

Initially, 300 enterprises in Guangdong province

and 100 in Shanghai were selected to participate

in the programme. Companies in Hong Kong or

Macau were given the green-light to settle trade in

renminbi with selected enterprises in China, with

no upper limit.

…and swap deals to provide seed money

To provide seed money for its trading partners, as of

end-3Q, the PBoC has also signed a total of

RMB803.5bn bilateral currency swap agreements

with six central banks (Republic of Korea, Hong

Kong SAR, Malaysia, Indonesia, Belarus and

Argentina). Moreover, the PBoC is still in talks with

other central banks to form more bilateral currency

swap agreements. We believe they are likely to

include China’s major neighbouring countries such

as Thailand, Vietnam and the Philippines.

The start of the global financial crisis created an

opportunity for China to sign currency swap

agreements, as shrinking capital flows and exports

evacuated foreign funding initially cut into the

foreign exchange reserves of most emerging

market countries. These currency swap lines

garnered additional foreign exchange reserves for

counter-party countries, shoring up their defences

against near-term financial risks and lending their

domestic importers PBoC loans to pay for imports

from China.

Table 3. Bilateral currency swap agreements between the PBoC and other central banks

RMBbn Bilateral currency swap

Total trade with China (2009)

Korea 180 1067 HK 200 *2521 Malaysia 80 354 Belarus 20 5.5 Indonesia 100 193 Argentina 70 53

Singapore 150 327

Iceland 3.5 0.6

Source: PBoC, CEIC (* total exports and imports between China and Hong Kong, including re-exports)

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The roadmap How can China achieve the ultimate goal of making

the renminbi an international currency? The strategy

is best summarised as a double-layered three-step

process. The geographical expansion plan extends

the use of the renminbi first to neighbouring and

regional countries, then to other emerging market

countries, and finally to all countries globally. In

parallel to this geographical dimension, there is

another a three-stage process that sees the use of the

renminbi seeping first into global cross-border

trade, then global investment flows, and ultimately

reserve holdings.

The 2009 pilot programme to expand the

renminbi’s role in trade settlement was a crucial

milestone in the process of RMB

internationalisation. We foresee more than half of

China’s total trade flows, primarily bilateral trade

with emerging market countries, being settled in

RMB within the next three to five years, from less

than 3% currently. If we are right, then it means

that nearly USD2trn worth of cross-border trade

flows would be settled in renminbi, making it one

of the top three currencies used in global trade.

Chart 3. China’s top five trading partners (2009)

US

14%

others

43%

Japan

11%

Hong Kong

8%

EU

17%

South

Korea

7%

Source: CEIC, HSBC

Once the renminbi is widely accepted for

international trade settlement, it can be used in

cross-border investment. Chinese enterprises have

been accelerating the pace at which they invest

overseas for over a decade. Even before the

renminbi trade settlement scheme kicked off,

direct investment by mainland enterprises

overseas almost doubled in 2008. Renminbi trade

settlement should expand the currency’s

circulation and acceptance in overseas markets,

thereby supporting its wider use in outward

investment. Foreign enterprises ultimately need to

invest the renminbi they accrue in trade

settlement, which necessitates the development of

more sophisticated capital markets either in

offshore renminbi centres or the mainland. The

evolution of Hong Kong as an offshore renminbi

centre, as well as domestic capital market reforms,

should offer foreign investors the renminbi-

denominated financial tools or hedge foreign

exchange risks they need as an incentive to

engage (further) in renminbi trade settlement.

More importantly, the strong growth potential of

China’s economy points to the renminbi’s rise as a

reserve currency. Empirical research2 has suggested

that every one percentage point increase of GDP as a

share the world total (measured at actual exchange

rate) leads to 0.55ppt of 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

renminbi) over the next ten years, this would suggest

at least a 5.5ppt increase in central banks’ renminbi

holdings. Therefore, as long as China’s GDP growth

stays above global growth, the renminbi should

increase its share in central banks’ reserves,

eventually making it one of the most important

reserve currencies.

______________________________________ 2 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, 1996.

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Does the internationalisation of the renminbi require full convertibility?

The short answer to this question is: no, at least not

initially. It is worth noting that the renminbi

officially became convertible under the current

account (for all trade and profit repatriation

purposes) over 10 years ago. So the current rules

place few restrictions on converting the renminbi

into other currencies for trade purposes, leaving

plenty of scope for exporters and importers in both

China and other countries to buy and sell the

renminbi for the purposes of invoicing trade.

Moreover, rapid expansion of the renminbi

business in Hong Kong is also likely to help

facilitate renminbi trading offshore. (See

Expanding the renminbi’s role in foreign trade,

18 March 2009, and Renminbi business goes

beyond trade settlement, 30 June 2009). To

expand the renminbi’s role to the area of global

capital flows, the full convertibility of the

renminbi will obviously be very helpful. But with

a small modification in China’s existing

regulations, foreign direct investment

denominated in the renminbi becomes possible

without full convertibility. That said, for the full

potential of the renminbi as a global investment

currency to be unleashed, eventual full

convertibility is required.

The implications The internationalisation of the renminbi will have

significant implications for China and the global

economy over the long term. In our view, even the

initial phase of expanding the currency’s role in

trade settlement is likely to lead to nearly USD2trn

worth of annual cross-border renminbi flows in

three to five years. This, in turn, will have a

significant impact on global markets by 2013.

Table 4. China’s capital controls: not as tight as you think

Current framework of capital controls:

Current account Convertible since 1996 Inward direct investment Subject to the Foreign Investment Industrial Guidance Catalogue Outward direct investment Investments over USD100m, or in countries with which China hasn’t established diplomatic relationships, or

specific markets (listed by MoFCOM) are subject to approval by the Ministry of Commerce (MoFCOM); investments between USD10m and USD100m or in the areas of minerals and energy should get approval from provincial authorities

Inward portfolio flows The Qualified Foreign Institutional Investor (QFII ) scheme was launched in November 2002. The quota for QFII has been expanded to USD30bn

Outward portfolio flows The Qualified Domestic Institutional Investor (QDII) scheme was introduced in April 2006. A scheme allowing individuals to invest in overseas securities markets was initially introduced in August 2007 but no further progress has been made since then

Source: HSBC

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Lifting trade flows

Settling cross-border trade in renminbi rather than

the dollar helps Chinese exporters and importers

cut transaction costs and minimize foreign

exchange rate risk. Given the uncertain outlook

for the US dollar in the coming years, this benefit

will likely be substantial. Although the worst of

the global trade contraction seems to be over, the

recovery will likely be gradual, which implies

fierce competition for all exporters. As a result,

anything that enables Chinese exporters to control

costs will be important for gaining market share.

Despite a 14% contraction in China’s total trade

value in 2009, Chinese exporters continued to

expand their market share as other countries saw

even deeper contractions. Renminbi trade

settlement will ultimately make Chinese exporters

and importers more competitive, helping them

expand their market share in the coming years.

We consequently expect China’s total trade flows

to continue to grow by around 15% annually in

the next three years.

Boosting China’s trade with other EM

countries

Moreover, renminbi trade settlement should

increase trade flows between China and other major

emerging market countries. Compared with still-

struggling developed economies, China’s earlier

and faster recovery – led by infrastructure

investment – looks set to generate massive demand

for raw materials and commodities. For commodity

exporting nations, the gain will not just come from

China’s rising imports, but recovering commodity

prices will also improve their terms of trade. This in

turn will help those economies cope with the

financial crisis and enable them to buy more

Chinese manufactured products. (See Riding on

China’s recovery, 27 May 2009). Going forward,

Beijing will likely include more commodity

exporting nations in Latin America, the Middle East

and Asia in the trial scheme for renminbi trade

settlement. This will likely reinforce trade cycling

between China and commodity exporting nations in

coming years, setting the stage for changes in global

trade patterns.

Chart 4. Dominant and rising share of basic goods in China’s imports from major commodity-exporting EM countries

0%

20%

40%

60%

80%

100%

World AR BZ ME IR SAR UAE KU EG SAF RU TU

2002 2007

Source: UN COMTRADE, HSBC

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Chart 5. China’s rising imports of crude oil and iron ore (in volume terms) benefited from stimulus plan

-40

-20

0

20

40

60

80

01 02 03 04 05 06 07 08 09

(% yr, 3mma)

Crude oil Iron ore

Source: CEIC, HSBC

Slowing China’s dollar accumulation

China has been piling up its foreign reserves at a

pace of USD334bn per year since 2005, with the

trade surplus and net capital inflows contributing

63% and 25% to the increase, respectively.

Expanding the renminbi’s role in trade settlement

will effectively reduce China’s export earnings in

dollars. So even if the trade surplus continues,

growth in China’s dollar receipts should slow as the

scheme expands in coming years. Given that the

pilot programme already covers regions that account

for over 40% of China’s total exports, the impact on

trade income in dollars is likely to be substantial in

coming years, though renminbi settlement in imports

may offset some of this impact.

Meanwhile, China is also introducing policy

initiatives that allow foreign companies to issue

renminbi bonds and shares in the domestic stock

markets. This should reduce their need for

bringing in dollar funds to finance their

investments in China. This will only reinforce the

slowdown in China’s dollar accumulation in

coming years. Combined with growing outward

direct investment, growth in China’s purchasing

of dollar assets is likely to slow even more

substantially in the next three years.

Hong Kong to become the offshore centre for renminbi trading

The potential USD2trn worth of cross-border

RMB clearing/settlement each year not only

means enormous transaction banking business,

but it also paves the way for Hong Kong to

become the “go to” renminbi offshore centre.

Hong Kong’s policymakers are committed to

strengthening the SAR’s status as a regional

financial centre.

Under the latest administrative rules of the pilot

renminbi-trade settlement scheme, banks across

the world can now settle renminbi-denominated

trade either through designed offshore clearing

banks such as Bank of China (Hong Kong) or

through agent banks in China.

In addition to the above, as we argued in our

previous note (Expanding the renminbi’s role in

foreign trade, 18 March 2009), allowing renminbi

trade settlement is likely to further attract capital

inflows to Hong Kong in the medium term

because those companies whose home countries

do not have a renminbi clearing bank will have to

settle their trade with China through a third

county. Hong Kong serves as an ideal choice as a

major international finance centre free of capital

and exchange controls.

The above will likely help drive the expansion of

Hong Kong’s renminbi deposit base to over

RMB400bn (from the current RMB150bn) within

three years as companies here increasingly settle

trade in renminbi rather than US dollars.

This will also likely lead to more renminbi-

denominated capital market products issued and

traded in Hong Kong. To encourage companies to

use the renminbi in trade, there must be

instruments that Hong Kong and foreign exporters

can invest in with the renminbi they receive.

Expanding renminbi bond issuance and trading

will be the first option (especially promoting the

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issuance of different tenors because, up to now,

the duration of issues has mainly been 2-3 years).

The State Council allowed Hong Kong banks’

subsidiaries on the mainland to issue offshore

renminbi bonds in Hong Kong as of April 2009. A

renminbi repo market is also needed for short-

term liquidity management. In addition, rising

global demand for managing renminbi foreign

exchange risks will significantly boost the

liquidity of renminbi NDF markets in Hong Kong.

This opens the door for broadening existing

renminbi banking services (deposit-taking, currency

exchange, remittances, debt/credit cards, and

personal cheques) and trade financing. Given the

sheer size and growth prospects (around 15%

annually over the next five years) of China’s trade

flows, this implies huge business for renminbi trade

financing in coming years. With its well-developed

cross-border settlement system and global reach,

banks in Hong Kong are materially better positioned

to take advantage of the opportunities.

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originally published on 25 June 2010

Renminbi trade settlement goes global In June the PBoC expanded renminbi cross-border

trade settlement from Hong Kong, Macau and

ASEAN to all countries and domestically from

five cities (Shanghai, Guangzhou, Shenzhen,

Dongguan, and Zhuhai) to 20 provinces. Since the

pilot programme in July last year (see our report

of 6 July 2009, From greenbacks to ‘redbacks’:

China kick-starts plan to internationalise the

renminbi), the operation of renminbi settlement

and clearance has been smooth, export tax rebate

procedures have been transparent, and the customer

base has steadily expanded. More importantly,

companies have seen increasing demand for

renminbi in their trade settlement transactions.

This implies that the time is ripe to expand the

pilot programme to domestic provinces more

widely and to all trading partners (see table 1).

The rising demand for renminbi trade settlement

is reflected in the recent surge in volume. Monthly

renminbi settlement volume jumped to more than

RMB50bn in August/September from less than

RMB2bn in 2H09, according to the PBoC’s 3Q

monetary policy report (see chart 1). A total

settlement value of RMB197bn was recorded by

end-September. The use of renminbi in imports

settlement topped RMB18bn, or 83% of the total

settlement value, while exports settlement

represented only 9%, due partly to impeded

facilitation of export tax rebates. That said, as

procedures become more streamlined and trade

rebounds strongly, we expect the surge in renminbi

trade settlement to continue in the coming months.

Ready, steady, go!

Big potential for emerging markets …

… but offshore renminbi investment products and access to

onshore markets must be developed

More flexible renminbi encourages renminbi cross-border trade

settlement



Table 1. Summary of expansion of the pilot programme

New Previous

Trading countries All countries Hong Kong, Macau and ASEAN Domestic cities/provinces Shanghai, Guangdong, Beijing, Tianjin, Inner Mongolia, Liaoning,

Jilin, Heilongjiang, Jiangsu, Zhejiang, Fujian, Shandong, Hubei, Guangxi, Hainan, Chongqing, Sichuan, Yunnan, Tibet, Xinjiang

Shanghai, Guangzhou, Shenzhen, Dongguan and Zhuhai

Source: PBoC, HSBC

http://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=75o3c5h6kx&n=245670.PDF



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Chart 1. Monthly renminbi trade settlement surging

0

10

20

30

40

50

60

Oct-09 Jan-10 Apr-10 Jul-10

(RMB bn)

Value of renminbi trade settlement (Rhs)

Source: PBoC, HSBC

Potential lies in non-G3 countries As everything is ready to roll out to all countries,

(versus only Hong Kong, Macau and ASEAN in

the pilot scheme), we expect a further leap in

renminbi trade settlement. We see much potential

in the emerging economies (non-G3).

Firstly, China has seen substantial growth in trade

with the emerging markets (chart 2). The imports

from these represent c70% of China’s total imports,

compared with 52% in the 1990s, while China’s

exports to these account for 55% of total exports,

higher than less than 50% in 1990s. The likelihood

of rapid growth in emerging markets in the coming

years implies increased demand for China-made

products. We expect more than half of China’s

total trade flows, primarily bilateral trade with

emerging markets, to be settled in renminbi in the

next three to five years.

Chart 2. Strong potential for renminbi trade settlement with emerging markets

40

50

60

70

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

(%)

EM countries' share in China's imports

EM countries' share in China's ex ports

Source: CEIC, HSBC

Secondly, as the emerging markets supply key

commodities or intermediate goods for assembly

before final shipment to the developed world, we

expect imports from these economies to account

for an increasing share of renminbi trade settlement.

Where to park the renminbi? It is crucial to develop offshore renminbi products

and expanded channels by which foreign investors

and enterprises may park their renminbi. Otherwise,

there is less incentive for the offshore investors

and enterprises to hold and trade in renminbi,

especially when the trading volume becomes

sizeable. More importantly, to become an

international currency, the renminbi must be used

widely for investment as well as for payment.

Therefore, we believe more measures are needed

in the coming quarters to facilitate offshore

renminbi investment. First and foremost, we

expect China to speed up the development of

renminbi products offshore to offer instruments to

foreign investors. Chief among other actions is the

development of practical investment products and

schemes for foreign renminbi holders through

Hong Kong, which we believe is best positioned

as the offshore renminbi centre. A mini-QFII

(qualified foreign institutional investors) scheme

is on the agenda. Like the current QFII scheme,

which allows foreign investors to invest in the

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local capital market in US dollars, the mini-QFII

scheme should be a separate renminbi-version of

the QFII that allows foreign investors to invest in

mainland capital markets through Hong Kong. It

is reported that technical obstacles have been

resolved in Hong Kong, and the scheme awaits

corresponding policies and measures from the

central bank and other regulators.

In addition, we expect further liberalisation and

opening up of the domestic market to give wider

access to foreign investors using renminbi. In theory,

the areas opened to foreign investors should also

be accessible for overseas renminbi capital.

Increased flexibility encourages use of renminbi Flexibility is the watchword after the resumption

of renminbi exchange rate reform. Unlike its

handling of the previous crawling peg against the

US dollar, the PBoC’s emphasis will now be on

referencing to a basket of currencies. Although

the renminbi is likely to gradually appreciate

against many currencies, in the post-crisis era we

are likely to see more volatility in renminbi, or

even temporary depreciation against the US dollar

if, for instance, the euro weakens against the US

dollar, as the renminbi is linked to a basket of

currencies (see From the Horse’s Mouth: PBoC

advisers on the renminbi de-peg, 22 June 2010).

We believe the more flexible renminbi will

encourage its use in cross-border trade settlement.

In view of rising renminbi volatility, domestic

companies are likely to use more renminbi in

trade settlement transactions to minimise interest

rate risks and to take advantage of lower foreign

currency exchange costs.

Chart 3. A more flexible renminbi after de-pegging

6.6

6.65

6.7

6.75

6.8

6.85

Jun Jul Aug Sep Oct Nov

USDCNY

Announcement of de-

pegging on 19 June

Source: Reuters, HSBC

Moreover, the resumption of the renminbi exchange

rate reform should also fuel expectations of renminbi

appreciation, though the magnitude is likely to be

much smaller than in the pre-crisis era. This should

give more incentive to the foreign trade partners

to choose renminbi as the settlement currency.

In the long run, liberalisation of the renminbi

exchange rate is a prerequisite for achieving the

ultimate goal of making renminbi an international

currency. The expansion of the renminbi trade

settlement programme comes right after the

renminbi de-peg, implying the authorities’ resolve to

speed up the renminbi’s internationalisation process.

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This is an updated extract from an article originally

published on 22 July 2010

What’s new Global roll-out of renminbi trade settlement

Geographical boundaries for the clearing of cross-

border renminbi trade settlement transactions

were significantly widened on 13 June 2010. This

came shortly after the People’s Bank of China

(PBoC) and Hong Kong Monetary Authorities

(HKMA) extended a scheme allowing companies

to settle trade contracts in renminbi with their

counterparts in China from just those in Hong

Kong, Macau and ASEAN to companies in all

countries, and domestically from five cities

originally (Shanghai, Guangzhou, Shenzhen,

Dongguan, and Zhuhai) to 20 provinces. In the

first year of the original scheme total volume of

renminbi trade transactions jumped to more than

RMB10bn in March 2010 from less than RMB2bn

in 2H09. The success of the scheme has clearly

spurred China’s timetable for speeding up

internationalisation of its currency. (See our note,

Ready, steady, go! Renminbi trade settlement goes

global, 25 June 2010).

A renminbi interbank market created

On 19 July, the PBoC and Bank of China (Hong

Kong) Limited (BOCHK), the Renminbi Clearing

Bank, inked an agreement lifting the last

restrictions on Hong Kong’s renminbi interbank

market. This gave the green light to non-bank

financial institutions to open renminbi accounts

without limits, enabling corporate, institutional

and individual retail investors to transfer funds

between renminbi accounts held in different Hong

Kong banks, for any purpose. But note: Beijing

hasn’t thrown away all control – clearing with

mainland banks must still pass through BOCHK,

and can only take place for settlement of trade

specific transactions.

By allowing banks to circulate renminbi amongst

themselves on behalf of both retail and corporate

clients, a new platform has been created for renminbi

financial product development. Not only does this

consolidate Hong Kong’s role as a renminbi

Offshore renminbi products take off

Limits on offshore renminbi circulation are being loosened at an

accelerating pace

Hong Kong’s new renminbi interbank market is launched

This creates a new platform for renminbi product development,

and new vehicles in which foreign investors can hold and circulate

China’s currency, internationally

Donna Kwok Economist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6621 [email protected]


http://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=pz8838vcat&n=271087.PDF

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offshore centre, but more importantly it also opens

up new ways in which foreign investors can hold –

and thus invest in – the renminbi offshore.

New Hong Kong renminbi rules: the low-down All restrictions and caps lifted on the

transfer of renminbi funds between different

renminbi accounts held within the same, or by

different, authorised financial institution(s).

Conversion limits unchanged for personal

and designated business customers at

RMB20,000/day for renminbi deposit

accounts for personal customers; up to

RMB20,000 per transaction per person in

banknotes for walk-in personal customers and

one-way conversion from renminbi to other

currencies for designated business customers.

Renminbi-denominated investment products,

except for renminbi loans to personal customers

and designated business customers, can now be

offered by all financial institutions.

Restrictions on opening of renminbi

corporate accounts by non-bank financial

institutions scrapped.

Key limitation: authorised institutions’

ability to cater to demand will be capped

by their capacity to square their position in

Hong Kong’s renminbi interbank market.

BOCHK retains key control of renminbi

supply flowing into the interbank market.

Renminbi supply (on a smaller scale) can also

be deposited in the interbank system via

renminbi trade settlement transactions and

conversions made by personal and designated

business customers within the

RMB20,000/day limit.

New platform for renminbi product development The agreement signed by the PBoC and BOCHK

revised the Settlement Agreement on the Clearing

of Renminbi Businesses in Hong Kong, an act that

had previously forced all participant banks to

clear/settle any renminbi transactions for retail

accounts via BOCHK. Under the new rules,

participant banks can now clear and settle

transactions among themselves (subject to

availability in the interbank market) – so creating

the first offshore renminbi interbank market.

More critically, the lifting of this barrier means

that the trading of renminbi investment products

Chart 1. Transaction volumes under the renminbi cross-border trade settlement programme

0

10

20

30

40

50

60

Jul-09 Sep-09 Nov -09 Jan-10 Mar-10 May -10 Jul-10 Sep-10

(RMB bn)

Value of renminbi trade settlement

Source: PBoC, HSBC

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such as fund and life insurance offerings in Hong

Kong is now possible.

Banks in Hong Kong wasted no time in launching

a new renminbi structured products the day after

the signing – which sold out within the first day.

Moreover, in a sign of things to come, banks have

also started offering more competitive preferential

time deposit rates for customers who placed new

renminbi funds with them. Fiercer competition for

renminbi deposits should spur faster accumulation

of renminbi in the local banking system. This new

pool of renminbi retail funds is also likely to

intensify demand for pre-existing renminbi-

denominated products (e.g., renminbi bonds) and

catalyze the introduction of other instruments

such as renminbi-denominated QFIIs, which we

expect to take off in the coming quarters. Pre-empting future bottlenecks The introduction of renminbi-denominated

investment instruments may be construed by some

as an attempt by Beijing to attract offshore funds

back into Chinese equity markets. But such a view

is misplaced – with 18% y-o-y growth in money

supply in 1H10, the country is hardly strapped for

cash. Given the recent resumption of renminbi

exchange rate reform (see It is all about flexibility,

20 June 2010; From the Horse’s Mouth: PBoC

advisers on the renminbi de-peg, 22 June 2010),

China has more reasons to keep capital out, not in.

Instead, we see Beijing’s efforts to support and

facilitate the introduction of renminbi-

denominated products by Hong Kong financial

institutions as an attempt to pre-empt a potential

bottleneck in the renminbi trade settlement

scheme. The development of offshore renminbi

products expands the number of vehicles in which

foreign investors and enterprises can park

renminbi earnings and funds. Without an

incentive to hold and trade in renminbi, the

number of offshore investors and enterprises

willing to settle trades in renminbi will simply not

keep pace with the growth in numbers of willing

and approved onshore enterprises – especially

once trading volumes become sizeable. To date, demand for renminbi settlement has been

heavily skewed towards imports settlement. Such

deals formed a large majority (83%, RMB18bn) of

total renminbi settlement value by the end of

March 2010; exports settlement made up only 9%.

Hiccups in the facilitation of export tax rebates are

likely to have dampened onshore renminbi exports

transaction demand, but stronger foreign trader

appetite for the scheme would no doubt have

helped. As procedures become more streamlined,

the export tax rebate issue should eventually be

ironed out. But for offshore demand to truly take

off, a system of attractive offshore investment

channels for China’s currency is critical.

Revving up the engine Looking ahead, the frequency and size of Beijing’s

steps towards renminbi internationalisation look set

to increase. China is currently the world’s largest

exporter and second-largest trader, seeing

USD2.45trn worth of goods (88%) and services

(12%) traded across its borders in 2009. The biggest

potential for renminbi settlement lies in China’s

trade with non-G3 economies, most of which is

settled in a third party currency – USD – rather than

their own currencies. Based on our forecast that half

of China’s total foreign trade with those countries

will be settled in renminbi within three to five years,

even if we assume a modest average annual rate of

growth of 15% to 20% for trade (from 2003 to

2007, China’s annual trade growth rate averaged

almost 30%), that would translate into annual

renminbi-denominated trade flows of nearly

USD2trn per year. This would make the renminbi

one of the top three currencies in global trade.



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originally published on 18 August 2010

Onshore RMB bond market opens up to offshore funds The People’s Bank of China on 17 August gave

the green light for foreign central banks and all

RMB clearing banks participating in the RMB

trade settlement scheme to enter its RMB20trn

onshore interbank bond market with immediate

effect. This is the fourth move in less than two

months by Beijing towards the eventual

internationalisation of the RMB, and comes just a

month after the liberalisation of RMB transactions

in Hong Kong. Similar to last month’s move, this

change does not alter the existing capital account

regime, but is a critical (even incremental) step

towards full internationalisation of the RMB.

An initial read of the rules indicate that only

offshore RMB obtained through existing primary

channels – trade settlement and central bank

swaps – will be eligible, and only direct

counterparties of such channels, namely RMB

clearing banks and central banks, can participate.

Moreover, the PBoC will be holding on to its

reins of control over such investments via quotas,

though the exact details have yet to be clarified.

We expect this move to accelerate the take up rate

of the RMB trade settlement scheme, which

picked up noticeably over 2Q and 3Q. Although

the size of such flows will unlikely move markets

just yet (from August to September, over

RMB100bn of trade was settled in RMB, versus

the total of RMB 1.7trn of goods exported), the

closer these flows move towards critical mass, the

closer the RMB will move along the road to

eventual reserve currency status.

Even with the accelerated schedule we pencilled in

for this process (See our note, Offshore renminbi

products take off, 22 July 2010), the move was more

aggressive than expected. This is because it opens

up China’s onshore interbank market which

accounts for over 99% of all trading activities,

rather than the much smaller stock exchanges in

which QFII investors can already invest in bonds, or

in offshore RMB bond markets such as Hong Kong.

Completing the on/offshore RMB circle

Offshore RMB flow circuit links up with its onshore equivalent, via

China’s interbank bond market

Internationalisation of the RMB is maturing: from the first to

second of three stages

Foreign holders of RMB accrued from trade can now invest both

in and outside of China


Zhi Ming Zhang Analyst The Hongkong and Shanghai Banking Corporation Limited +852 2822 4523 [email protected]

Yi Hu Analyst The Hongkong and Shanghai Banking Corporation Limited +852 2996 6539 [email protected]

Daniel Hui Currency Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2822 4340 [email protected]



http://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=Mlf74nAc7e&n=273170.PDF

http://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=Mlf74nAc7e&n=273170.PDF

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As such, we expect the pace at which new RMB-

investment channels are being opened up to foreign

RMB holders to further steepen.

Internationalisation of the RMB is maturing: from the first to second of three stages Beijing’s game plan for accelerating RMB

internationalisation can be broadly defined in

three stages. The first is to make the RMB a

global trade settlement currency; the second an

international investment/debt currency; and the

third an international reserve currency. The world

is currently being coaxed along from stage one to

stage two. Stage three, however nationalistically

enticing, is still more symbolic than material at

present. It will take many years before the RMB

attains the required characteristics of a reserve

currency. But the acceleration and contours of the

process towards this goal will continue to surprise

markets, in our view.

Stage one (turning the RMB into a global trade

currency) kicked off in June 2009 with the launch

of the RMB trade settlement pilot scheme. But it hit

teething problems early on, with foreign traders

reluctant to switch into RMB cash flows when

buying from China for lack of attractive vehicles in

which to park RMB funds accumulated from/for

trade deals. To date, the growth in the number of

offshore enterprises willing to purchase mainland

exports in RMB significantly lags that of approved

onshore enterprises using RMB to settle import

transactions. Year-to-date, Chinese importers make

up for 80-90% of RMB-denominated settled deals.

To address this imbalance, Beijing did two things:

1) loosen the geographical limits on the scheme by

rolling it out to 20 mainland provinces/cities and

the rest of the world in June 2010; and 2) kicking

off stage two a month later.

In July 2010, all Hong Kong financial institutions

received the green light to open RMB accounts and

to offer RMB-denominated products, barring certain

types of loans. Barriers to the free flow of RMB

(between same/ different corporate/ institutional/

individual accounts) inside Hong Kong were also

lifted, creating the first true offshore RMB products

platform for foreign RMB holders.

Then, in August 2010, stage two was pushed along

a second dimension in the on- as opposed to off-

shore direction. The PBoC opened the door to its

RMB20trn onshore interbank bond market to

foreign central banks, RMB-clearing banks in Hong

Kong and Macau as well as offshore institutions

with RMB accounts through participant banks of

the RMB-trade settlement scheme. The opening of

this door provided a channel (albeit narrow) for

foreign investors to a new world of onshore RMB

investment options. Within weeks, Malaysia’s

central bank had put in an order for an undisclosed

amount to fold into their foreign reserves. Since

then, official entry passes have also been granted to

local Hong Kong banks seeking entry into China’s

interbank bond market.

In the end, all such moves are designed to step up

the pace of circulation of offshore, and ultimately

onshore, RMB held by foreign investors – with

both circuits linked up via a channel tightly

supervised by the PBoC. In closing this link, the

progress of each stage is heavily interdependent.

With regard to the third stage of promoting the

RMB as an international reserve currency, this

move should be considered as more symbolic than

material. The RMB still lacks (and will lack, for

many years to come) many of the required

characteristics of a reserve currency. Nonetheless,

the push and acceleration of the process towards

this goal will likely make forecasters pull in

projected timelines as to when markets might

expect the RMB to be a serious alternative as a

global reserve currency.

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From an FX perspective, it is important to

recognise that the announcement does not change

the existing capital account regime in China. As

such, it will have little to no implication for the

supply and demand of USD-RMB and spot FX.

China’s progress towards RMB

internationalisation should be interpreted as

distinctly separate from capital account

liberalisation. As long as a consensus view of the

RMB being undervalued holds in Beijing, and

policymakers continue to worry about the

potential for speculative capital inflows, we

emphasise that any move to further liberalise

cross-border FX channels will be limited

primarily to outflows.

One notable detail in the announcement was the

fact that central banks holding RMB obtained

through various FX swap agreements

(RMB803.5bn outstanding) signed in recent years

have now also been granted access to China’s

onshore bond market.

Why Beijing decided to open its interbank bond market first Compared to China’s smaller exchange or Hong

Kong’s offshore market for RMB bonds, China’s

interbank bond market is more opaque. More

importantly, it is large enough to allow investors

to put on relatively bigger interest rate positions.

Two key reasons drive Beijing’s preference for

opening up its interbank bond market to offshore

RMB capital, in our view:

First is the need to close the widening US

Treasury and RMB government yield gap. After

crossing with the RMB government rate at around

3.6% (10-year) in April, the US Treasury

government rate continued to drop towards 2.6%,

in contrast to the long-end of RMB rates which

edged down only slightly. Based on our forecast

for low inflationary pressures and no rate hikes

until 2012 at the earliest, demand needs to go up

in China’s interbank bond market if the RMB

government yield is to be driven down further.

Second is Beijing’s agenda to push through the

recapitalisation of its banks. To supplement their

IPO fund raising activities (RMB300bn of which

are still pending), the PBoC has also reversed its

drainage of liquidity from the interbank bond

market into positive injections. Introducing more

buyers into China’s interbank bond market should

further boost these efforts.

Implications for Hong Kong as an offshore RMB centre Hong Kong’s role in the internationalisation of the

RMB is not to function as the final stop for where

all RMB funds will be parked, but as a key inter-

1. Progress to date of the RMB trade settlement scheme 2. RMB cross-border trade settlement breakdown by region (as of May 2010)

0

10

20

30

40

50

60

Sep-09 Dec-09 Mar-10 Jun-10 Sep-10

RMB bn

Value of renminbi trade settlement (Rhs)

2

2

2

3

12

21

58

0 15 30 45 60

Others

Japan

Macau

Indonesia

Sw itzerland

Singapore

Hong Kong

%

Source: PBoC, HSBC Source: PBoC, HSBC

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stop in Beijing’s wider game plan for

internationalising the RMB. The long-term goal is

for foreign holders of RMB to have the capacity

and desire to retain and invest their RMB funds

both in and out of the mainland, not to accumulate

it on one side of the border. Closing the on/offshore

RMB loop and keeping it flowing is key.

But by opening up the onshore interbank RMB

bond market to foreign buyers, is the PBoC

diverting demand away from Hong Kong’s own

nascent RMB bond market? Not really. First,

Hong Kong’s RMB bond market is also too small

to absorb bond flows on an institutional scale. As

of 30 September 2010, total RMB deposits in

Hong Kong amounted to just under RMB150bn,

accounting for little more than 3% of total deposits

in Hong Kong. Second, Hong Kong’s RMB bond

market (ranging from bullet bonds to bank-issued

certificates of deposit (CDs)) is still valued at only

RMB40bn, barely a drop in the bucket versus the

potential pool of approximately RMB800bn that

foreign central banks can theoretically tap into

from outstanding FX swap contracts. Third, Hong

Kong’s RMB bond market tends to be

predominantly driven by retail investors, who

typically have a very limited appetite for bonds. In

sum, liquidity is too low, and retail demand too

satiated in the territory’s RMB bond market.

Recall the Ministry of Finance had to issue its

debut sovereign RMB6bn bond at a yield higher

than its onshore borrowing cost last October.

Hong Kong received a unique first-mover

advantage when the first offshore RMB-interbank

market was created there in July. The opportunity

to position itself as a unique offshore launch-pad

for RMB products has effectively given Hong

Kong’s financial services-driven economy a new

lease on life. We estimate that about half of the

trade that China settles in RMB with emerging

countries (or USD1trn) could be transacted in

Hong Kong in the next three to five years.

Hong Kong was the obvious choice in Beijing’s

selection of its first offshore RMB centre for many

reasons, including geographical proximity,

economic ties, political/language/cultural

similarities, and internationally reputable and

competitive financial/legal/institutional systems.

The last point is especially important from a

logistical standpoint as it lessens the amount of

preparation that needs to be done in upgrading

existing financial/regulatory systems before each

regulatory change or pilot programme is announced.

For example, the Hong Kong Stock Exchange has

yet to see its first RMB-denominated IPO but is

reportedly ready for the first deal as soon as the

go-ahead is given. Offshore RMB bonds can also

already be settled via Euroclear (as of

3. Outstanding bonds, by market type (as of end-Jul 2010) 4. Outstanding bonds by tenor (as of end-Jul 2010)

Interbank

market

92%

Others

6%

Over the

counter

1%

Exchange

market

1%

Interbank

market

92%

Others

6%

Over the

counter

1%

Exchange

market

1%

1yr - 3yr

20%3yr - 5yr

12%

5yr - 7yr

9%

7yr - 10yr

14%

Less than

1yr

30%

Over 10yrs

15%

1yr - 3yr

20%3yr - 5yr

12%

5yr - 7yr

9%

7yr - 10yr

14%

Less than

1yr

30%

Over 10yrs

15%

Source: China Bond, HSBC Source: China Bond, HSBC

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13 September), although the first such transaction

has yet to take place.

The key impediment where speed is concerned

traces back to regulatory hurdles. Access to the

onshore RMB bond market, for example, still

requires a QFII (Qualified Foreign Institutional

Investor) quota to be approved by the CSRC

(China Securities Regulatory Commission), as

does the remittance of RMB funds raised by

offshore bond issuances back into China. One of

the reasons Beijing wants to retain an onshore

market is to exert control over developments in a

hands-on manner, but it looks like Beijing is

doing a good job keeping a tight lid on activities

in offshore markets too. The expiration of the

Bank of China (HK)’s RMB conversion quota in

late October is a prime example. The imposition

of quotas, a necessity for case-by-case approvals

for the remittance of RMB funds raised offshore,

and the opacity of China’s onshore interbank bond

market all serve as reminders of the Chinese

government’s intention to keep the global

evolution of the RMB tightly under its control.

The mainland authorities’ gradual strategy has

thus far been successful in generating media

interest and foreign investor appetite for RMB

products, but bite-sized strategies can only have a

limited impact.

Ultimately, markets need more depth and scale if

participants are to stop talking and start acting.

For the whole thing to take off in Hong Kong, we

need to get sizeable flows going and institutional

investors moving. Although the retail demand for

RMB products is there, the scale of institutional

demand and supply of RMB products remains

negligible for two key reasons: a lack of

transparent and predictable channels to re-invest

RMB funds back into the Chinese market and the

limited ability of Hong Kong-based product

sellers to square their positions with BOCHK (the

clearing bank) as per their needs. Only once these

two criteria are addressed can a much larger-scale

and more varied range of RMB product offerings

be turned into reality.

RMB offshore products now on offer in Hong

Kong can be broadly classified into the groups

below:

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5. Offshore RMB products available in Hong Kong as of November 2010

Type Date of first deal

Example Comments

Certificates of deposit Jul-10 Citic Bank. Coupon: 2.68%. p.a. Maturity: 1 year. Banks who are Authorised Institutions in HK can issue CNH debt in CD formats. At present, CNH CD market issuers tend to be the HK branches of mainland banks. Documentation is relatively less complicated versus MTN Cash Notes/Bonds.

Corporate – FIs incorporated in mainland China

Jul-07 China Development Bank Corporation. Coupon: 3.0% p.a. Maturity: 2 years.

Relevant rules currently only exist for financial institutions (FI) issuers incorporated in mainland China issuing in the CNH market. Issuance of this instrument dominated by Chinese state-linked banks and foreign banks incorporated in the mainland. The number of issuance remains low primarily due to the extended approvals process required by PBoC/NDRC before any issuance in the CNH market. However, relatively cheaper funding costs in HK’s offshore market still provides an incentive for onshore FI issuers to issue in the CNH market.

Corporate – foreign issuer

Jul-10 (1) Hopewell Infrastructure issued RMB 1.38bn. coupon: 2.98%. Maturity: 2 years. (2) McDonalds issued RMB 200mn. Coupon: 3.0% p.a. Maturity: 3 years.

No approval needed from either HK or China regulators for issuing CNH bonds in HK, unless repatriation of proceeds into China is desired by foreign corporate issuers. In the latter case, permission to repatriate funds must be applied via one of two channels: 1. foreign debt: PBoC; SAFE (or local SAFE); 2. registered capital: PBoC, Ministry of Commerce (or local bureau of MoC), SAFE (or local SAFE). Again, the relatively cheaper funding cost in the offshore market still provides an incentive for issuers to issue in the CNH market instead of the onshore equivalent.

Bonds

Sovereign Oct-09 Ministry of Finance issued a total RMB 6bn in 3 tranches on 2, 3, and 5yrs and coupon 2.25%, 2.7% and 3.3% respectively

Symbolically significant as it signalled the priority the Beijing government is giving to the offshore development of RMB bonds. The MOF issuance also established the first RMB sovereign yield curve outside China.

Structured deposits

Jul-10 BOCHK RMB leveraged structured deposit; HSBC equity linked note. Various maturities and coupons.

Typically linked to an underlying index that ranges from currency, to interest rate, to equity, to gold. Deposits referencing the RMB have been around for some time, whereas those denominated in RMB only from July 2010 onwards.

Insurance products

Late 2009 RMB insurance policies from Bank of China Group (BOCG) Life and China Life Insurance (Overseas). Maturity: mostly 5-10 years, some for life. Premium payments for RMB-denominated savings insurance plans could be settled in RMB as of July 2010.

Full potential has thus far been limited because insurers are restricted in their ability to locate assets with long-enough tenors to match those of the policies they are offering. The ADB RMB bond’s 10-year tenor helps to alleviate this by setting the first long term benchmark yield for future issuances of longer-termed products.

Investment funds

Aug-10 Hai Tong Asset Management’s launched the “Haitong Global RMB Fund” with a RMB 5bn ceiling, to be sunk into overseas fixed income RMB products including notes and bonds. Actual sales to date have yet to reach the limit.

Limited by the channels for re-investment into the mainland. The introduction of rules allowing “RMB denominated mini QFII”, possibly by year-end, could help catalyze the speed and depth of development for such funds.

Source: HSBC, Bloomberg

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Snapshot: China’s interbank bond market China’s interbank bond market is the largest

onshore market for RMB bond issuance and

trading. Of the total outstanding RMB20trn of

RMB bonds, around 92% stays in the interbank

market. Bonds in China’s exchanges and OTC

markets each accounted for 2% of the total as of

end-July 2010.

By trading volumes, the interbank bond market

accounts for over 99% of total trading activities.

Year to date, total transaction volume stands at

RMB33trn.

By maturity, most bonds are concentrated at the

front end, with tenors of less than 1 year and 1-3

years accounting for 30% and 20% respectively of

total outstanding bonds.

Central government and commercial banks are the

two major issuers in the interbank bond market,

followed by the PBoC. Their issuances account

for 32%, 30% and 23% of total outstanding

bonds respectively.

However, bank bonds and corporate bonds are

more active in the secondary market, making up

37% and 25% of total trading activities in the first

eight months of this year, with a turnover rate of

2.3x and 3.6x respectively, compared to 1.8x and

0.6x for central bank bills and government bonds.

6. Interbank bond market, by issuer type

End-Jul 2010 (RMBbn) ________Outstanding_________ ____ Trading volume (ytd)_____ ____ New issuance (ytd) _____

Government bonds 5,628 32% 3,144 10% 836 14% Central bank bills 4,027 23% 7,053 22% 3,518 59% Financial bonds 5,316 30% 12,112 37% 766 13% Policy bank bonds 4,649 26% 11,783 36% 705 12% Commercial bank bonds 607 3% 322 1% 58 1% Non-bank FI bonds 60 0% 7 0% 3 0% Corporate bonds 2,270 13% 8,096 25% 458 8% ST financing bills 588 3% 2,303 7% 395 7% ABS 18 0% 2 0% – 0% Others 7 0% 14 0% 1 0% Total 17,853 100% 32,723 100% 5,974 100%

Source: China Bond, HSBC

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originally published on 29 October 2010

What has happened? Bank of China Hong Kong (BoCHK), the CNY

(aka RMB) designated trade settlement clearing

bank, recently stated that its annual RMB8bn

settlement quota has been reached and that further

trade settlement services to Participating

Authorised Institutions (AIs) cannot be provided.

As far as RMB trade settlements goes, BoCHK is

the only settlement agent between the banks in

Hong Kong and the PBoC, i.e. the only designated

clearing bank in Hong Kong. As such, it is one of

the most significant channels for RMB to move

from the mainland to Hong Kong.

According to the Deputy Chief Executive of the

HKMA, since the trade settlement scheme started in

July 2009 until the end of September 2010, BoCHK

bought RMB4bn. This suggests that, interestingly,

the remaining RMB4bn was bought in October

alone. To limit the short-term impact, the HKMA

has announced that it has activated its RMB200bn

swapline with China. It plans to draw RMB10bn

from it to help any AIs that need to settle RMB

trade transactions immediately. This is to alleviate

demand pressure for immediate transactions only,

but does not necessarily represent a sustained source

of RMB supply. Barring further changes, the trade

settlement process in Hong Kong may slow in the

short term, although RMB can still be sourced from

the CNH market.

From a macro perspective, there seems to be a

widening gap between institutional demand for

the RMB and actual RMB trade settlement

volumes, fuelled by rising expectations for the

RMB’s appreciation. The immediate impact on

RMB trade business will likely be limited as the

HKMA has triggered its RMB200bn currency

swap agreement with the PBoC, offering

unlimited support to all RMB trade deals due for

immediate settlement. But supply constraints will

set in for any non-trade related institutional

demand. Recent conversations with the PBoC

indicates that it has no intention of slowing down

RMB cross-border trade. Moreover, the RMB

RMB trade settlement takes a breather

Recent development signals a more cautious approach to CNH

growth in the short run

Implying wider onshore-offshore (RMB/CNH) differential and

larger NDF discounts

In the long run, we expect Beijing to forge ahead with

internationalisation of the RMB


Richard Yetsenga Global Head of EM FX StrategyThe Hongkong and Shanghai Banking Corporation Limited +852 2996 6565 [email protected]

Perry Kojodjojo Asian FX Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6568 [email protected]


http://www.info.gov.hk/hkma/eng/guide/circu_date/20101028e1.pdf

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conversion quota under the scheme will likely be

increased, but before that happens, agency banks

will need to tighten the process through which

institutional purchases of the RMB for non-trade

purposes are filtered out. If the quota shortage

proves to be entirely trade-driven, we expect

Beijing to widen the quota. If not, once

unqualified use of the RMB trade settlement

system has been identified and stamped out, we

expect Beijing to forge ahead with its longer term

strategy for internationalisation of the RMB.

FX takeaways What this means in the short term

Given trade settlement was the key source of

RMB flows into the CNH market, the current

‘roadblock’ will result in USD-CNH moving

significantly lower. As stated in the HKMA press

release, the daily RMB20,000 per day conversion

by individuals remains unaffected since it runs via

a separate mechanism. In concert, the NDF curve

should also trade lower given the shift in the CNH

market and the perception that parity pricing

between the onshore and offshore curves will be

less forceful.

Broader considerations

BoCHK’s quota exhaustion could simply be an

administrative speed bump on the road to RMB

internationalisation. Once addressed, the

explosive growth in the CNH market that had

been underway should return. It is also possible

that there are broader forces at play – that the

explosive growth in the CNH market has

prompted an intentional pause in the process of

RMB internationalisation.

Consider this: RMB internationalisation

presumably had some broader geopolitical

objectives, but is also designed ultimately to take

some pressure off China’s balance of payments.

By creating a global pool of RMB, the intention

seems to have been to make domestic monetary

management less exchange rate-sensitive. The rub

here, of course, is that in the market build-up

phase, the RMB needs to come from China. There

is no other source. Since the 19 July

announcement creating the CNH market, the

volume and nature of trade settlement flows

between the mainland and Hong Kong have

changed fundamentally. Refer here to the

suggestion that more than half of BoCHK’s trade

settlement quota has been used in October alone.

Chart 1. Record reserve accumulation in 3Q

-80,000

-40,000

0

40,000

80,000

120,000

Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

Reserves C hg Int'n

USDm

Source: CEIC, HSBC

35


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Previously, because the RMB was non-

transferable between entities outside China, the

take-up of trade settlement was tiny. This also

meant that RMB flowed both out of China and

back in, through the trade settlement route.

Following 19 July, however, the volume of trade

settlement transactions increased sharply – now

you could actually do something with RMB

received. Moreover, rather than there being two-

way trade settlement flows with the mainland,

now there was only RMB coming out. With the

CNH rate stronger than the onshore RMB rate,

there is a natural incentive for RMB that comes

out of China for trade settlement to remain in

Hong Kong. In addition, the 19 June de facto de-

peg of the RMB has resulted in a return of

heightened RMB appreciation speculation. All of

these forces have resulted in sharply higher

demand for RMB trade.

Settlement, and consequently much stronger RMB

demand from the mainland. Notice here the record

rate of reserve accumulation in 3Q in China

(Chart 1).

On this basis, the latest step is likely to be an

intentional effort to temper the recent exponential

pace of market growth. It is certainly not a total halt,

but we expect this to proceed much more cautiously

going forward. The narrow differential between the

RMB and CNH rates (Chart 2) in evidence through

the latter stages of October is unlikely to return

anytime soon, therefore, and the NDFs are likely to

trade at a larger discount going forward.

Macro takeaways Immediate impact on trade settlement limited

If the HKMA’s pledge to support RMB trade

transactions needing “immediate” settlement

extends through year end, we expect limited

immediate impact on RMB trade settlement

business. However, supply constraints will kick in

for any institutional demand for the RMB that is

not explicitly and clearly trade-related. If this

shortage proves to be trade-driven, we expect the

annual RMB conversion quota to be widened to

further facilitate development of the RMB as a

global trade settlement currency. If not, once any

unqualified use of the RMB trade settlement

system has been identified and stamped out in the

short run, we expect Beijing to continue with its

longer term strategy for RMB internationalisation.

After all, this not the first, nor will it be the last,

time that the Chinese authorities have dealt with

upward pressure on the currency. To date, it has

Chart 2. USD-RMB and USD-CNH spot rate gap

6.4

6.45

6.5

6.556.6

6.65

6.76.75

6.8

6.85

6.9

Aug-10 Sep-10 Oct-106.4

6.45

6.5

6.55

6.6

6.65

6.7

6.75

6.8

6.85

CNY CNH

Source: Bloomberg, HSBC

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never derailed a national strategic priority on the

scale of the RMB internationalisation process.

RMB trade settlement to remain a long-term strategic priority for Beijing

Institutional demand for RMB has been surging at

a pace well beyond the initial expectations of both

the Chinese authorities and financial markets in

recent months, fuelled by the global roll-out of the

trade settlement scheme in June, the launch of the

CNH market in Hong Kong in August, and rising

expectations for RMB appreciation.

We define Beijing’s game plan for accelerating

internationalisation of the RMB in three stages.

The first is to make the RMB a global trade

settlement currency; the second to make it an

international investment/debt currency; and the

third to make it an international reserve currency.

The world is today being coaxed along from stage

one to stage two.

The global roll-out expands the number of eligible

players (from Hong Kong/Macau and ASEAN to

the rest of the world), while the creation of the CNH

market should encourage more foreign traders to

use RMB when trading with China given a wider

range of attractive investment options in which to

park their RMB. Year-to-date, the number of

offshore enterprises willing to purchase mainland

exports in RMB lags that of importers, with Chinese

importers accounting for 80-90% of RMB-

denominated settled deals as of June 2010.

Post-QE2, the PBoC will likely raise the vigilance

with which it filters out institutional purchases of

the RMB for non-trade purposes under the RMB

trade settlement scheme. That said, the PBoC has

no intention of slowing down RMB cross-border

trade, which means that once the filtering process

is refined, the annual RMB conversion quota

system will likely be renewed and the RMB

internationalisation process set back on course.

If the bulk of institutional demand for the RMB

under the trade settlement scheme proves to be

legitimately trade-related, we think it will be seen

by Beijing as a green light to step harder on the

accelerator in its drive to internationalise the

RMB. But if non-trade pressures were the primary

reason for the earlier than expected quota expiry,

then Beijing will use this as a means to impose

supply constraints on institutional demand for the

RMB that do not conform with its longer-term

plans for internationalising the currency.

37


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originally published on 6 September 2010

The Shanghai municipal government has

published a circular on promoting renminbi

settlement in the city. On top of more efforts to

facilitate renminbi cross-border trade settlement,

Shanghai is also encouraging trial renminbi

settlement in capital accounts, including overseas

project financing in renminbi, direct overseas

investment in renminbi and other trade-related

renminbi settlement items within the capital

account. This is a further step allowing outward

direct investment (ODI) in the renminbi after the

green light was given to inward renminbi

investment in the domestic bond market for

foreign central banks and trade clearance banks

(see Hong Kong Economic Spotlight: Completing

the on/offshore RMB circle, 18 August 2010).

By encouraging wider renminbi settlement business,

from cross-border trade to overseas renminbi direct

investment and project financing, Shanghai wants to

further sharpen its competitiveness to become an

international financial centre. Shanghai is one of the

first five cities allowed to participate in the pilot

programme of renminbi cross-border trade

settlement launched in July 2009. Since then,

renminbi cross-border trade settlement in Shanghai

accounts for nearly 50% of the national total.

More importantly, by allowing trial renminbi

settlement in overseas project financing and direct

investment, Shanghai’s move will give a further

boost to renminbi internationalisation. On the one

hand, there is a surging need for renminbi trade

settlement in overseas markets, in particular after

June’s expansion of renminbi cross-border trade

settlement to 20 provinces with all trading

partners (see Ready, steady, go! Renminbi trade

settlement goes global, 25 June 2010). On the

other hand, trial renminbi settlement for overseas

project financing and direct overseas investment

implies more renminbi supply offshore, matching

the rising demand for renminbi offshore. Note that

there is big potential in emerging markets, as they

have been the main destination for China’s rapidly

rising overseas direct investment (USD48bn for

non-financial overseas direct investment, or 48

From trade to investment

Renminbi trial settlement in some capital accounts, including

overseas project financing and outward direct investment, will be

launched soon in Shanghai

This is a further move to accelerate the pace of renminbi

internationalisation after June’s expansion of renminbi trade

settlement to all countries

Get ready for more initiatives to expand the renminbi’s role and a

related chain reaction in capital accounts



http://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=prVyP4F4M2&n=275954.PDF

http://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=prVyP4F4M2&n=275954.PDF

38


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times 2002’s level). Meanwhile, Beijing has been

encouraging SOEs to go abroad and further

increase in ODI. SAFE has also encouraged

domestic companies to use renminbi for ODI.

This, plus Shanghai’s trial settlement, means more

renminbi can be channelled into emerging

markets. In turn, this means that, with the easier

availability of renminbi, emerging markets can

buy Chinese products in renminbi or make

offshore renminbi investments.

As we argued earlier, the pace of renminbi

internationalisation will be faster than many

expect (See Chart 1 on page 22). Now the process

of renminbi internationalisation is evolving from

trade to investment and from inward to outward

investment. Combined with the anticipated steps

towards expanding renminbi bond markets and

related chain reactions on gradually easing capital

controls, this is likely to substantially advance

renminbi internationalisation in the coming years.

39


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originally published in The View, 6 August 2010

Summary

The campaign for the use of the renminbi

(RMB) in cross-border trade settlement

should be complemented by a similar drive

for a further and faster build-up of the RMB

bond market. The accumulation of RMB

offshore will create demand for safe and

liquid RMB assets, while the build-up of such

a liquid market will prompt wider adoption of

the RMB in trade and beyond.

The expansion of the offshore RMB bond

market in Hong Kong gives the mainland

market 3-4 years of build-up time while

absorbing initial offshore RMB holdings. The

issuance of sovereign RMB bonds will be

critical in signifying Hong Kong’s status as

the offshore RMB centre.

However, the continued accumulation of

offshore RMB will bring pressure to open the

domestic RMB bond market, improve market

liquidity, liberalise the exchange rate and

interest rates, and loosen capital controls – a

chain of interconnected actions essential for

RMB internationalisation.

Liberalising local interest rates or ending the

two-tier rate system (i.e., policy-driven bank

loan/deposit rates vs. market-driven bond

yields) is at the heart of the build-up as it

connects with and lays the foundation for the

rest of the actions.

Moreover, the liberalisation of interest rates is

a relatively low risk initiative compared with

the rapid expansion of exchange rate

flexibility or the opening of the bond market.

We believe concerns over the potential

adverse consequences of liberalising loan

rates are overblown, since the percentage of

loans extended at, below or above policy rates

has remained stable throughout the recent

credit easing and tightening cycles.

In the US, the liberalisation of bank deposit

rates in the 1970s and 80s did not squeeze

bank interest margins either, but led to a

much-desired and significant increase in non-

interest or fee earnings instead.

We believe current controls on bank interest

rates choke bond market liquidity, as market

turnover peaked at less than 100% of market

cap (vs. 20x in US), despite efforts to improve

liquidity such as the launch of SHIBOR, the

regular auction of treasury benchmarks, and

mark-to-market requirements.

Liberalising interest rates now has an added

benefit: since the latest rate action in

December 2008, bond yields have shot up 50-

100+bps across the curve, suggesting that

rates in the banking system have yet to catch

up with the market. The further easing of

Connecting the dots for RMB internationalisation

Zhang Zhi Ming Analyst The Hongkong and Shanghai Banking Corporation Limited +852 2822 4523 [email protected]

40


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administrative control over bank interest rates

should be part of the “market-based tools” in

fine-tuning the economy, in our view.

A long march In anticipation of its growing economic power in

GDP terms and import-export trade volumes,

China has initiated a series of carefully planned

initiatives to promote the RMB

internationalisation in coming years and recently

has picked up the pace of this endeavour.

An accelerating pace

Figure 1 shows some key developments in the

RMB internalisation endeavour since the 1990s.

As early as 1993, the People’s Bank of China

(PBoC) signed agreements with the central banks

of eight neighbouring countries for the use of

RMB in bilateral trade settlement, although of

limited scale. The pace of the substantive

promotion of the RMB for circulation outside the

mainland picked up in 2003 when individuals in

Hong Kong and Macau were allowed to freely

exchange and remit RMB (with daily limits).

The de-pegging of the RMB from the USD in

mid-2005, which resulted in a steady (or

controlled) appreciation of 20% in the RMB value

against the USD, was another major milestone in

RMB internationalisation. It raised the profile of

the RMB as an attractive currency with steady

value and potential for appreciation – a necessary

condition for RMB internationalisation. Each of

the more recent trio of initiatives – i.e.,

developing the offshore RMB bond market, the

signing of multiple RMB swap contracts with

China’s trading partners, and the launch of large-

scale use of the RMB in cross-border trade –

complement one other and could lift the offshore

circulation of the RMB to a new level, in our view.

Given the convenience and efficiency whereby

much of the foreign exchange risk can be

circumvented, plus the tax rebate incentives offered

by the government, up to USD2trn of trade led by

Chinese firms could be settled in RMB within three

years, according to an estimate by our Chief China

Economist, Qu Hongbin. This would represent a

major milestone for the officials that promote the

initiative. Unlike the RMB-USD de-peg in July

2005, which invited controversy both inside and

outside China, the use of the RMB as a trade

settlement currency has received nearly universal

endorsement, suggesting the trillion-dollar mark

could be reached in a short period of time.

RMB swap: not for emergency liquidity

With the exception of Hong Kong, recently signed

RMB bilateral swap contracts between the PBoC

and its counter-parties since December 2008 are

very different from those signed from 2001 to 2003.

Figure 2 provides a summary.

The average size of recent RMB swap contracts is

about 10 times as large as the average size of the

Figure 1. Development of the China bond market

Source: HSBC

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old ones. More importantly, the purpose of the

contracts has been gradually shifted away from the

provision of emergency liquidity to normal

operational use. In fact, only the use for trade

settlement is highlighted in the most recently

signed RMB swap contract with Argentina in April.

Where it’s heading… RMB swap contracts will provide initial funding

for the use of the RMB for cross-border trade

settlement. However, as offshore RMB holdings

increase over time, the pressure for places to park

them in liquid and safe RMB assets will build up.

Figure 3 shows how we envisage the process

might unfold from here.

The initial “parking lot” for offshore RMB in the

coming 3-4 years will be the offshore RMB bond

market in Hong Kong. As the domestic bond

market remains closed, the mainland gets 3-4

years of extra time to build up the local market

that ultimately requires the full liberalisation of

RMB interest rates and exchange rates.

Offshore bond market yet to grow

The total size of the Hong Kong RMB bond

market (the only offshore market developed since

2007) was RMB40bn at the end of 3Q10. It is

very small relative to Hong Kong’s RMB deposit

base of RMB149bn and annual trade flows of

RMB3trn. Beijing is encouraging more issuance

of bonds, especially by mainland banks (including

foreign-owned) subsidiaries in Hong Kong which

might need RMB funding to provide trade

settlement and trade financing services.

In addition to quantity, sovereign issuance by the

Ministry of Finance (MOF) will be critical for

establishing a genuine offshore benchmark and

signifying Hong Kong as the offshore RMB

centre where offshore RMB accumulated

Figure 3. Where it is heading...

Source: HSBC

Figure 2. RMB swap – Old vs new

___________ Old: smaller size for liquidity emergency __________ ______ New: much bigger size for normal liquidity, trade ______Date Country Amount (USDbn) Date Country Amount (USDbn)

Dec-01 Thailand USD2bn Dec-08 Korea RMB180bn (USD26.4bn) Jun-02 Korea USD2bn Jan-09 HK RMB200bn (USD29.3bn) Jun-02 Japan USD3bn Feb-09 Malaysia RMB80bn (USD11.7bn) Oct-02 Malaysia USD1.5bn Mar-09 Belarus RMB20bn (USD2.9bn) Dec-03 Indonesia USD1bn Mar-09 Indonesia RMB100bn (USD14.6bn) Dec-03 Philippines USD1bn Apr-09 Argentina RMB70bn (USD10.3bn)

Source: HSBC

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elsewhere via trade could seek refuge before they

are allowed to invest in the onshore market.

On the demand side, we should expect more

institutional buying, especially from non-bank

offshore companies engaged in RMB trade

settlement who can now open RMB accounts and

buy bonds offshore.

We expect that the size of the RMB bond market

in Hong Kong could grow well above RMB100bn

over the next 3-4 years, by which time:

Cross-border RMB trade settlement should

already have been extended to all direct

trading partners beyond those under the pilot

programme, and may even draw interest from

entities not trading directly with China, and

Pressure to access the local RMB bond

market is likely to have built up, while the

domestic market should be more resilient as

controls over local interest and exchange rates

are likely to have eased further.

Revisiting some difficult tasks

Rising offshore accumulation of RMB as a result

of cross-border trade may trigger a chain of

interconnected actions involving some difficult

structural issues in the local bond market’s

development, in our view. These interconnected

and inevitable actions include: the opening of the

RMB bond market, the liberalisation of RMB

interest rates and foreign exchange rates and the

loosening of capital controls, all of which are

necessary for the internationalisation of the RMB.

At least at the technocrats’ level, we believe that

Beijing is fully aware of these structural deficiencies

that must be resolved before the RMB can become

an international currency. For example, RMB funds

obtained via the QFII (Qualified Foreign

Institutional Investors) programme are largely

geared toward investing in the local A-share or

equity markets to prevent on- and offshore interest

rate arbitrage, where onshore RMB yields are much

higher than their offshore counterparts as the RMB

spot rate is still under government control and is

priced lower than what the offshore NDF markets

imply. This shows the inseparable interdependence

of interest rates and exchange rates.

The good news is that the use of the RMB in

cross-border trade settlement may kick-start a

chain of events that could help expedite the

structural reform process. Liberalising interest

rates in the banking system, as highlighted in

Figure 3, is of relatively low risk and should take

precedence over others, in our view.

Market-driven bank interest rates Domestic interest rate liberalisation is at the heart of

the structural issue as it relates to the extent of

flexibility in exchange rates (via on- and offshore

interest rate differentials) and domestic credit

allocation, hence bond market liquidity, in our view.

Slow and cautious…

An overwhelming percentage of China’s domestic

credit allocation is still intermediated via the

banking system, as shown in Figure 4. Stripping

away PBoC bills (used for mopping up onshore

liquidity), bank loans account for more than 90%

of total credit lending.

Figure 4. Interest rates driven by policy vs markets

Medium

-and long

term loan

39%

Short-term

loan

29%

PBOC bills

8%

Gov t bonds

11%

Financial

Bonds

9%

Corp bonds

4%

Policy-

driven

rates

Market-

driven

yields

Source: CEIC, CDC

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As such, reforms to liberalise domestic interest

rates in the banking system have been extremely

cautious and slow. Figure 5 summarises the key

developments in interest rate liberalisation over

the last 26 years.

Overblown concerns

The path to liberalising bank loan and deposit

rates has been long and treacherous, with

restrictions tightened up after easing in 1996 (see

Figure 5). The path is consistent with similar

experiences elsewhere. For example, Korea flip-

flopped twice in the 1980s before full interest rate

liberalisation. In the case of China, it has taken

time for banks, which originally were all 100%

state-owned policy vehicles, to develop a risk

management culture. The extremely slow and

cautious approach stretching over two decades has

served that purpose, in our view.

Little progress since 2004

By 2004, other than the maximum deposit rate

and minimum loan rate across tenor, all other

aspects of interest rates had been liberalised. The

maximum deposit and minimum loan rates have

been kept to insure bank interest earning margins

during a sensitive period in which the majority of

the former state-owned banks were in the process

of initial public offerings.

Other than the recent drop in the minimum

mortgage rate for first-time homebuyers as part of

the government’s aggressive stimulus policy,

there has been little progress in further liberalising

interest rates in the banking system over the last

five years. The lack of progress in easing interest

rate controls clogs developments in bond market

liquidity, the adoption of interbank interest rate

swap (SHIBOR) and FX forward markets, even

though the risk of interest margin squeezes has

eased as banks become more risk conscious, in

our view.

Stability of actual loan rates

Since 2004, banks have been allowed to apply a

maximum 10% discount relative to policy loan

rates while being free to float rates above policy

rates at any level.

Figure 6. Distribution of actual loan rates

0

20

40

60

80

100

Jan-

08

Apr-0

8

Jul-0

8

Oct

-08

Jan-

09

Apr-0

9

Jul-0

9

Oct

-09

Jan-

10

As Benchmark 10% below 10% abov e10-30% above 30-100% above

%

Source: CEIC, HSBC

Figure 5. Key developments in liberalising Chinese bank deposit/loan rates

Source: HSBC

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Figure 6 shows the distribution (or percentage) of

actual loan rates at (=1), below (<1, where rates

can be up to 10% lower than policy rates) or

above (>1, where there is no upside limit) for all

commercial banks in China since 1Q07.

This time period captured a persistent credit

tightening cycle, followed by a rapid easing cycle

where both policy loan rates (see Figure 7) and

loan quantity (see Figure 8) experienced large

fluctuations. Throughout the cycles, the

distribution of actual loan rates appeared to be

highly stable, suggesting that banks are largely

risk-conscious over the cycles.

For example, there is little evidence of a large

increase in loans extended to high margin/high

risk borrowers during the credit expansion for the

sake of immediate earnings growth. In addition,

there is no similar push during credit tightening in

an attempt to shore up interest earnings when loan

quantity declines.

On the flipside, competition for loan business has

not resulted in a large increase in the proportion of

loans offered at discount over policy rates in

either cycle. Although the effect of removing

minimum loan rates remains unknown, evidence

suggests that a further easing of downside

restrictions on loan rates may not entail too much

systemic risk due to excessive price competition.

How about deposit rates?

Deposit rates could be more vulnerable to

excessive competition among banks looking to

increase their retail funding. As such, deposit rates

are usually the last leg in the full liberalisation of

interest rates. The experiences of the US, Japan

and Korea all share this feature. However, upon

fully liberalising bank deposit rates, there was

little evidence that bank interest margins were

squeezed materially.

Figure 10. Steady US interest margin

0%

5%

10%

15%

34 39 44 49 54 59 64 69 74 79 84 89 94 99 04 09Av erage lending rate Av erage deposit rateDifferential

Interest-rate

liberalization

in the US

Source: FDIC, HSBC

Figure 9 shows that in the case of the US, interest

rate margins held steady at around 4% to 5%

during the deposit rate liberalisation period over

the 1970s to 1986, and might have edged a bit

higher overall since 1970.

Figure 7. Policy loan rates during tightening and expansion cycles

Figure 8. Loan quantity during tightening and expansion cycles

4.55

5.56

6.57

7.58

03/07 03/08 03/09 03/10

6M 12M 1-3Y 3-5Y 5Y+

0

500

1,000

1,500

2,000

Jan-

08

May

-08

Sep-

08

Jan-

09

May

-09

Sep-

09

Jan-

10

May

-10

Sep-

10

China new bank loans (RMB bn)

Source: PBoC Source: Bloomberg

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Interestingly, there has been a steady increase in

the percentage of non-interest or fee earnings for

US banks since 1970, suggesting a desirable

consequence of interest rate liberalisation:

competition has resulted in low-risk fee earnings

post-liberalisation while interest margins remain

unchanged, as shown in Figure 10

Non-interest earnings currently account for about

17-21% of banks’ total earnings (see Figure 11),

roughly in line with the ratio for US banks during

the interest rate liberalisation process over the

1970s to early 1980s, but much lower than the

post-liberalisation average of 20-36%. The

comparison gives a bit of comfort or at least eases

some concern about the consequence of liberalising

bank deposit rates in China: current fears might be

overblown, and more deposit rate liberalisation,

starting with large-denomination RMB deposits,

could be rolled out sooner rather than later.

In search of a liquid asset

Liquidity is another critical attribute much desired

by potential RMB holders. Neither the onshore

nor the offshore RMB bond market is liquid yet

by any measure.

Bond market liquidity trapped… Figure 12. RMB bond market size and annual turnover

0

5000

10000

15000

20000

98 99 00 01 02 03 04 05 06 07 08 09 10

Outstanding Turnov er

RMB bn

Source: ADB, HSBC

100%, of the market size throughout the last

decade and is trending down after some

improvements since 2007.

Turnover compares miserably with government

bond market turnover in the UK and US, where

turnover ratios vary from around 5x to 25x (see

Figures 13 and 14), respectively.

Whether by design or by accident, the deep, open

and liquid US bond market serves as a magnet

that draws in huge investments and underpins the

wide use of the greenback that dominates its

nearest rival, the euro, even though the underlying

eurozone economy is bigger both in terms of GDP

and trade size.

Figure 9. US bank fee income increases post rate liberalisation Figure 11. Non-interest income: China vs US

0%

10%

20%

30%

40%

34 39 44 49 54 59 64 69 74 79 84 89 94 99 04 09

US commercial bank non-interest income as % of total

Interest rate

liberalization

in the US

11% 12% 12% 11%14%

17%21%

36% 35%32%

29%26% 27%

34%

0%

10%

20%

30%

40%

2003 2004 2005 2006 2007 2008 2009

China NII/OI US NII/OI

Source: FDIC, HSBC Source: FDIC, HSBC

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Figure 15: Bid-offer spreads of government bonds (2009)

0

1

2

3

4

5

6

US Korea HK China

bp

Source: ADB, HSBC

Bid-offer spreads also indicate extremely poor

liquidity conditions in the RMB bond market as

compared to its counterparts in Korea, Hong

Kong and the US (see Figure 15). Moreover, bid-

offer spreads in the China bond market are highly

unstable, which creates another level of

uncertainty that reduces incentives to trade.

Need market-driven rates to unlock…

The authorities in Beijing are fully aware of the

poor liquidity of China’s domestic bond market

and have made efforts to improve matters. The

recent efforts include:

1 Regular issuance of key benchmark treasury

(MOF) bills and bonds

2 Mandatory requirement for mark-to-market

trading book using fair market value

3 Encouraging more non-bank institutional

holdings of bonds

4 Efforts to reconnect the interbank vs.

exchanges bond trading platform

5 Improving the bond price quoting system, and

6 The launch of SHIBOR to facilitate hedging

interest rate risk

However, as shown in Figure 12, these initiatives

only lifted market turnover by a limited amount,

peaking at less than 1x market size.

The main reason, in our view, is the dominance of

bank lending (see Figure 4) where interest rates

are still under administrative control. As such,

rates in the secondary bond market only play a

shadow role in credit allocation, therefore bond

trading and instruments such as SHIBOR only

serve to manage exposure to the shadow rates

rather than the main rates that really affect the

majority of the lending.

The limited growth over time in the volume of

SHIBOR (designed to be the Chinese version of

LIBOR) contracts despite the government push is

another good example.

Figure 13. US bond market annual turnover Figure 14. UK government bond market annual turnover

0

10

20

30

40

50

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

YTD

Turnov er ratio

0

2

4

6

8

10

95-96 97-98 99-00 01-02 03-04 05-06

Turnov er ratio

Source: SIFMA, CEIC, HSBC Source: UK Debt Management Office

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Reserve currency: still decades away The end-game for RMB internationalisation is for

the RMB to become one of the international

reserve currencies in addition to an exchange and

settlement currency. In our view, that end-goal

may still be decades away.

Aside from the daunting task of establishing safe

and liquid RMB asset markets, liberalising

interest rates and the RMB exchange rate, and

removing foreign exchange and capital controls,

China needs to allow large foreign holdings of its

domestic bonds while reducing its own holdings

of foreign currency reserves in the long term.

While China has yet to allow any meaningful

holdings of domestic RMB bonds by foreign

countries, Figures 16 and 17 show that foreign

ownership of US and UK bonds is rising and

account for 30% and 35% of the total amount

outstanding, respectively. Although the recent

sharp rise may not be sustainable, there is no

question that significant foreign ownership of

domestic bonds underpins the popularity and

reserve currency status for both the US dollar and

the British pound.

Figure 16. Overseas holdings of US Treasuries

0%

5%

10%

15%

20%

25%

30%

00 01 02 03 04 05 06 07 08 09

Foreign ow nership of UST (%)

Source: CEIC

Figure 17. Overseas holdings of Gilts

15

20

25

30

35

40

1996 1997 1999 2000 2002 2003 2005 2006 2008

Ov erseas holdings %Source: UK Debt Management Office

Large foreign holdings of domestic bonds also

pose significant foreign exchange and interest rate

risk, reducing the effectiveness of domestic

monetary policy and the functioning of the real

economy. This is a price to pay for becoming an

international reserve currency and a deep and

resilient domestic bond market is required to

buffer against any adverse shocks.

It could take decades before offshore entities are

able to hold substantial amounts of domestic

RMB bonds, and from that perspective it could

take a long time before the RMB can become a

genuine international reserve currency.

On the flipside of the issue is domestic holdings

of foreign reserves. Figure 18 shows the current

imbalance in levels of foreign reserve holdings by

China vs. the US, UK and eurozone.

Figure 18. Domestic holdings of foreign reserves (May 2009)

0

500

1000

1500

2000

2500

3000

US UK Eurozone China

USD

bn

Source: Bloomberg

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As a competing alternative reserve currency to the

USD and others, China must reduce its holdings

of foreign reserves where, by default, outsized

holdings of foreign reserves signifies the reserve

status of other currencies while weakening the

importance of the RMB in relative terms. To

narrow the gap, China needs to change the nature

of its real economic structure (i.e., shift away

from being an export-driven economy), which

may take decades to achieve.

Now is a good time… Long-term issues aside, we think now is a good

time to expedite a further easing of interest rate

controls, which could eventually lead to the full

liberalisation of bank loan and deposit rates.

First, liberalising interest rates is at the heart of

the developing and strengthening of China’s

financial system, including the internationalisation

of the RMB as it connects with RMB exchange

rate and RMB bond market liquidity. From the

perspective of policy consistency, one cannot

have widespread adoption of the RMB as an

international currency without having a relatively

open and liquid bond market.

Second, the further easing of interest rate controls

would be a relatively low risk initiative in

comparison with a rapid expansion of exchange

rate flexibility or opening up the local bond

market. Moreover, as we argued earlier, removing

restrictions on loan and deposit rates may not

trigger an excessive bank interest margin squeeze,

and may even have the desirable consequence of

inducing more fee-based earnings for banks.

Third, the further easing of interest rate controls

could be a long process with many twists and

turns, and therefore should start as early as

possible, at least before the internationalisation of

the RMB hits a wall when offshore RMB holders

become frustrated by the lack of places to park

their RMB holdings.

Lastly, accelerating interest rate liberalisation now

would have the added benefit of helping to fine-

tune the economy.

Out of touch

Figure 19 shows bank rates vs. the government

bond yield curve as of 22 December 2008 (the last

time the PBoC cut policy rates) and now.

Figure 19. China deposit/loan rate vs government bond yields

0

1

2

3

4

5

6

7

0 6 13 19 25Deposit LendingYield (Nov -2010) Yield (Dec-2009)

%

Tenor

Source: Bloomberg, CDC

Bond yields have shot up 50-100+bps across the

curve since the last rate cut, while bank loan and

deposit rates remain identical and “out of touch”

with the bond market reality.

The market reality (outside the banking system) is:

China’s MOF failed in three government debt

auctions in a two-week period in early July

The PBoC resumed the issuance of 1-year

bills on 9 July after an eight-month

suspension to help drain cash at banks, and

1-year RMB T-bill yields have hit 1.66%, the

highest in 2009 and 49bps higher than they

were immediately post the latest bank rate cut.

Rates in the banking system have yet to reflect

market concerns that China’s RMB4trn stimulus

might be causing bubbles in stock and housing

markets, forcing monetary policy down the road.

If bank rates are fully liberalised, they could have

49


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moved in tandem with market rates and played an

active role in fine-tuning.

What market-based tools?

On 29 July 2009, China’s domestic A-share market

had one of its largely daily declines, with the

Shanghai A-share index dropping 5% as rumours of

a pending hike in the bank reserve ratio may have

signalled the turning of accommodative monetary

policy. The sharp decline in China’s stock market

triggered a global sell-off, led by commodities and

emerging market shares.

The sharp decline prompted PBoC to issue a

statement that night which reiterated its adherence

to “appropriately loose monetary policy”, which

echoes the recent view expressed by top Chinese

leaders, including President Hu Jintao and

Premier Wen Jiabao. However, the PBoC did

emphasise that it will “rely more on market-based

tools”, as opposed to administrative ones such as

loan size controls, to guide credit growth and fine-

tune the economy. In our view, the further easing

of administrative restrictions on bank interest

rates should be part of those market-based tools

(in addition to T-bill issuance) used to fine-tune

credit expansion. Such initiatives have the added

benefit of laying the foundations for the

internationalisation of the RMB.

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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, Donna Kwok, Zhi Ming Zhang, Daniel Hui, Yi Hu, Richard Yetsenga and Perry Kojodjojo

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mailto:[email protected]





By Qu Hongbin, Sun Junwei and Donna Kwok

A third of China’s foreign trade – USD2trn per year – could be settled in the renminbi within 3-5 years

Offshore renminbi markets must be deepened to facilitate this process…

…ultimately spurring a chain reaction in domestic financial markets

A primer on RMB

internationalisationTouched up and improved

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

Macro

November 2010

Qu Hongbin

Co-Head of Asian Economic Research, Chief China Economist

The Hongkong and Shanghai Banking Corporation Limited

+852 2822 2025

[email protected]

Qu Hongbin is Managing Director, Co-Head of Asian Economic Research, and Chief Economist for Greater China. 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 China

Banking Association. He previously worked as a senior manager at a leading Chinese bank and other Chinese institutions.

Sun Junwei

Economist

Sun Junwei is an economist for China in 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 London School of Economics and a BA in Economics

from Peking University.

Donna Kwok

Economist

The Hongkong and Shanghai Banking Corporation Limited (HK)

+852 2996 6621

[email protected]

Donna is an economist on HSBC’s Greater China economics team. Before joining HSBC in July 2010, she worked as an economist

for the Hong Kong-China equities research arm of a global financial services provider. Prior to that, she served as East Asia analyst

at Strategic Forecasting Inc. (US) and as a strategy consultant at Deloitte Consulting (London). Donna holds an MA in International

Relations (Economics and China Studies) from the Johns Hopkins University School of Advanced International Studies, and a BA

(Hons) in Economics and Management from Oxford University.

the rise of the redback-a guide to renminbi

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