Picking up pace

Renminbi Capital Markets: Showing new strength Source: REUTERS A shaolin monk breaks an iron sheet with his head during a performance at a temple in Quanzhou, Fujian. A little volatility can be a good thing. For years, since China began opening its currency to overseas buyers, investors have had a free ride. The renminbi has steadily gained about 25% against the US dollar, making the overseas Dim Sum market one of the world’s biggest one-way bets. That appreciation trend helped drive international interest in the renminbi, turbo-charging Beijing’s efforts to make the currency more internationally acceptable. After the early surge in trading, however, doubts quickly took hold. Did China’s “internationalisation” of the renminbi – and with it the opening of the country’s entire financial system – depend entirely on expectations of appreciation? Certainly, the early crop of unrated Dim Sum bonds catered more to fast money than to long-term credit investors, but the question had bigger implications. Was China’s growing clout in the global economy a fleeting figment of the imagination, founded on nothing more than international speculation on its currency? This year’s sudden reversal in China’s official exchange rate has provided the answer. The ferocity of the engineered correction was a nasty surprise, but it has banished any remaining speculators and, with it, all lingering doubts as to the extent of real demand for the renminbi. After a near 4% slump in little over three months to April, opinions are divided as to the direction of the currency for the remainder of 2014 and beyond, but deal-making in the currency has continued throughout the year. Offshore renminbi bond sales are running at a record pace, albeit mostly from very high-rated issuers. Firms still need funding, and the universe of long-term investors has grown deep enough to provide it – regardless of short-term fluctuations. Currency trading now flows in two directions. For China’s regulators, the short-term pain has already produced long-term benefits. Having driven away the speculators, China can be more confident in the extent of true demand for its currency at a time when it is moving slowly towards full convertibility. However, despite the stronger foundation, that moment remains some way off. Interest rates must be freed, and domestic capital markets strengthened to cope with the transition, while overseas players need better hedging tools and longer-tenor assets to embrace the renminbi as a reserve currency. The recent volatility has also shown, without any doubt, that Beijing still determines the currency’s future and, if China’s regulators continue to see value in volatility, renminbi investors may be in for a bumpy ride. To see the digital version of this report, please click here. Contents OVERVIEW Picking up pace China is taking steps to open its capital account and internationalise the renminbi, putting it on track to become one of the world’s top international currencies. OFFSHORE CENTRES Hub rivalry The competition between the world’s financial centres to establish their offshore renminbi trading credentials has emerged as one of the most visible signs of the currency’s internationalisation. FOREIGN EXCHANGE Two-way traffic The renminbi is on track for its worst year against the US dollar since the peg was partially removed in 2005 after rising steadily for years. What used to be a one-way bet is now more volatile than ever. DOMESTIC BONDS Opening doors China’s capital markets are set to become deeper and more transparent as regulators allow more foreign investors to purchase domestic securities. REGULATION Testing the ground The Shanghai Free Trade Zone has become a testing ground for China’s efforts to open its capital markets and to accelerate the transition towards a freely convertible currency. DIM SUM BONDS Growing up fast A record feast of offshore renminbi bonds and the shift to a more stable investor base is unde

Two-way traffic Source: REUTERS/David Gray Cars drive along a main road in central Beijing. After winning Asia’s emerging-market currency race last year with a 2.9% rise against the US dollar, it took less than three months for the renmimbi to wipe out those gains. The weakness was seen as deliberate attempt in Beijing to thwart illicit inflows and lay the groundwork for a more flexible foreign-exchange trading band. It was, however, the severity of the decline that spooked investors, who were already nervous about lingering risks in the credit and property markets, as well as signs of slowing economic growth. Before this year, the renminbi had handed investors a 25% return with minimal volatility in the nearly a decade since the partial removal of the currency’s peg to the US dollar, and a positive weekly return of 66% at the time, according to the Peterson Institute. A 3.6% slide come April has changed that picture completely. The renminbi is no longer a one-way bet. Such a turnaround, however, was not completely unforeseen and market reforms are likely to determine the renminbi’s future direction for some time to come. Beijing had already signalled in November its desire to speed up currency reform, fuelling speculation of a squeeze to introduce greater two-way flows. In the weeks leading up to the widening of the trading band in March, it was clear that the People’s Bank of China was pulling the renminbi’s official rate lower, and asking the major state-owned banks to buy dollars. “China’s commitment to achieving slower, more sustainable, quality growth implies that the renminbi will continue to trend higher, even if that path will be volatile.” The eventual doubling of the trading band on March 17 exceeded expectations and occurred a little sooner than many had envisaged. Still, it did not stop the downtrend and some saw a weaker renminbi as a form of economic stimulus at the end of China’s property boom and declining factory output. Indeed, if the authorities aimed to provide an extra boost to struggling exporters, the efforts appear to be working. June data from HSBC shows that the smaller, export-oriented factories have returned to growth after a five-month hiatus, and analysts expect further improvements as global demand recovers. China’s GDP grew 7.5% in the second quarter from 7.4% in the first three months with full-year expansion either set to meet or even surpass Beijing’s 7.5% target. That assessment would provide scope for the renminbi to resume its gradual appreciation as China’s economy stabilises. The unit has risen nearly 1.0% against the dollar since the end of April. Returning to trend? In a July 15 report, Nomura analysts called for further appreciation towards the year-end with second-quarter forex reserve data highlighting the PBoC’s success in significantly reducing speculative capital flows. Goldman Sachs also sees the renminbi’s upward potential against the dollar, with a three-month forecast of 6.16 and six-month projection of 6.15 from around 6.21 currently. However, further down the track, Goldman Sachs sees one-year non-deliverable forwards – considered the best available proxy for forward positions on the tightly controlled currency – slipping to 6.26. UBS, which expects growth to dip below 7.0%, also believes the renminbi will slip to 6.25 as at end-2014 and 6.35 as at end-2015. The Swiss lender says a weaker renminbi will be especially appealing for China, with the US dollar likely to rise and China to face further upward utility and resource-cost adjustments and higher unit labour costs. The renminbi is also no longer undervalued, according to UBS. Similarly, ANZ has warned that China’s accelerated efforts to liberalise the capital account may also see increasing capital outflows and a depreciation in the renminbi over the next few years. Long-term gains Yet, from a long-term perspective, China’s commitment to achieving slower, more sustainable, quality growth implies tha

Opening doors Source: REUTERS/Jason Lee Waiters open a Chinese traditional red door inside a luxurious furniture museum in Beijing. China is opening its domestic capital markets to a widening group of foreign investors as it seeks to unlock its capital account and expand the use of the renminbi. The total amount of foreign investment permitted remains relatively small at Rmb1trn (US$161.5bn), compared with the Rmb60trn outstanding in China’s capital markets, and the arrival of more overseas participants is expected to result in greater transparency and sophistication. “The gradual increase in these programmes’ quotas will partially remove barriers and reduce market segmentation,” said Emir Hrnjic, director of education at the National University of Singapore Business School’s Centre for Asset Management Research and Investments. “This, in turn, will likely increase liquidity (most obviously via a decrease in bid-ask spreads) and improve price discovery in the market. The gradual opening of the market to global players certainly is the right thing to do. Currently, China’s economy is over-reliant on domestic banks.” For investors, access to China’s markets cannot come soon enough. The country’s onshore bond market stands at Rmb30trn, more than 40 times the Rmb730bn outstanding in the offshore renminbi, or Dim Sum bond, market. The domestic market not only offers better liquidity, but higher yields. “The main driver for investors to invest through the [renminbi qualified foreign institutional investor] programme on the fixed-income market is the yield pick-up over offshore Dim Sum bonds, although the gap has narrowed to less than 1% this year due to better liquidity conditions onshore,” said Patrick Wong, head of China sales and business development at HSBC Securities Services. “The gradual opening of the market to global players certainly is the right thing to do. Currently, China’s economy is over-reliant on domestic banks.” Yields on the long-end largely had converged between similar-tenor onshore and offshore bonds, but, in the short end, there was still a spread differential of about 130bp–140bp, said Becky Liu, senior rates strategist at StanChart. Foreign investors can buy domestic Chinese securities through the renminbi qualified foreign institutional investor programme, or RQFII, the qualified foreign institutional investors programme, or QFII, and the interbank bond programme. The aggregate quota approved for the three programmes exceeded Rmb1trn as at the end of 2013, already larger than the entire offshore Dim Sum bond market, according to data from StanChart. The programmes, however, restrict who can invest and how much. QFII, which started in 2002, allows investors to buy Chinese securities with foreign currency, US dollars converted to renminbi to be invested onshore. The RQFII programme, begun in 2011, allows investors to buy stocks and bonds with offshore renminbi. The interbank bond programme, set up in 2010, gives foreign investors direct access to the APRC’s onshore interbank bond market within a People’s Bank of China-assigned quota. As of last November, the quota stood at about Rmb600bn, assigned to 138 investors, according to the central bank. The programme offered the most flexibility, but was limited to six types of foreign investors, namely foreign central banks, sovereign wealth funds, renminbi clearing banks, renminbi settlement banks, supra-nationals and insurance companies, StanChart analysts said in a June report. The interbank bond market in China handles 96% of daily trading volumes. “This programme is likely to expand very fast as more renminbi-clearing banks would want to join,” said Liu at StanChart. RQFII versus QFII RQFII is the programme with the most momentum as China continues to expand its availability to more cities. South Korea and Germany are recent additions with new Rmb80bn quotas each. Other cities with approved RQFII quotas are Taiwan, Singapore, London and Paris

Testing the ground Source: REUTERS Villagers stand around an ancestral tomb, which is being relocated from a construction site of a residential compound in Taiyuan, Shanxi. Although the pace of development in the Shanghai Free Trade Zone has underwhelmed international market participants, they remain convinced that the business district offers too much potential to ignore. The 29-square-kilometre trade zone officially opened in September 2013. It is a key pillar in Premier Li Keqiang’s plans to reform China’s capital markets. Chinese authorities have advertised the zone as a testing ground for reforms of currency, interest rate, trade and financial policies, such as relaxed ownership rules for foreign banks and credit rating agencies. The best practices adopted in the zone are expected to be expanded and replicated throughout the world’s second-largest economy. Foreign institutions now present in the zone expect to gain valuable on-the-ground experience and relationships in more open and, hopefully, profitable renminbi capital markets within the liberalised district. This should give them an advantage over competitors currently without presence in the district. “If you are a believer that the leadership is committed to these financial and economic reforms, then getting into the Shanghai Free Trade Zone and participating in those opportunities will give you an edge over your competitors” said Andrew Whitford, head of Greater China at Westpac. Westpac and other Aussie majors have been especially active in the Greater China market of late. All are trying their best to take advantage of the PRC’s status as Australia’s biggest trading partner. “If you are a believer that the leadership is committed to these financial and economic reforms, then getting into the Shanghai Free Trade Zone and participating in those opportunities will give you an edge over your competitors” Last year, China accounted for 31.6% of Australia’s exports and 18.8% of its imports, according to Australia’s Department of Foreign Affairs and Trade. That factor should make the renminbi’s expected emergence as an international currency even more beneficial for Aussie firms. The free-trade zone is one way to tap into that potential. “We absolutely believe that rules and regulations will be relaxed in the free-trade zone to enable China to test these new policies,” Whitford said. The new regulations include plans, announced in May, to allow companies and individuals, based in the district, to open special accounts for financial transactions that the zone sanctions, such as offshore investments. Bankers view this as a critical, albeit small, first step for dealmakers keen to enjoy the more liberal business environment. Now that the zone has been in operation for about 10 months, many Chinese and international banks have hired staff and opened up offices. Several thousands of businesses also have registered there, all of which are potential customers for the banks that could, in turn, also benefit from China’s gradual opening of its capital account. However, most of those institutions are not yet doing business. They are, instead, waiting for some more clarity on new regulations from Chinese regulators. For many – especially financial institutions – the rate of liberalisation is uncomfortably slow. “There has been some progress, but the financial-market progress is not as dramatic as many had been expecting from the very beginning,” said Haibin Zhu, chief China economist at JP Morgan. Zoning out What is more, some businesspeople are irritated that, while Chinese regulators are allowing them to set up branches in the zone, the same regulators are also introducing new market opportunities outside of the zone, such as Shanghai-Hong Kong Stock Connect. The Stock Connect will allow foreign firms that have not applied for business licences in the zone to enjoy a more lenient Chinese regulatory regime without having to deal with the red tape of the Shangha

Growing up fast Source: REUTERS A feeder holds a giant panda cub, the only survivor of the triplets giant panda Jiaozi had last August, at the Chengdu Research Base of Giant Panda Breeding in Chengdu, Sichuan. The offshore renminbi bond market is growing fast as global deposit pools deepen and demand for overseas investments grows. Sales of Dim Sum bonds, maturing in one year or more, reached Rmb213bn (US$35bn) in the first half of 2014, already comfortably exceeding the Rmb190bn in the full year 2013, according to Thomson Reuters data. Beyond volumes alone, there are many other signs that the market is maturing rapidly. The investor base has transformed, with fund managers playing bigger roles than in previous years, according to a research report from BOC International. Banks dominated new issues in the early years, buying 46% of Dim Sum bonds sold in 2010. That share, however, slipped to 22% in 2013 and stands at 24% for this year to date, according to BOCI. At the same time, investment funds have taken over the leading position, with an average allocation of 49% in 2013. The two are now close to the long-term average for Asian new issues in the US dollar market, suggesting that the buyer base for Dim Sum bonds has become more stable. The expanded participation from investment funds is attributable to two sources. The number of overseas renminbi-dedicated funds is rising and even more existing multi-currency credit funds have started to include offshore renminbi bonds as investable products in their portfolios. “We believe Hong Kong will remain the most favourable avenue for global investors to gain exposure to Chinese currency and credit. Investors prefer to access more liquid markets with diversified issuers.” The participation of private banks has remained fairly stable over the years, while that of insurance companies has varied. However, the participation of insurance companies has helped to bring out some long-tenor bonds for a market where two- to three-year maturities still dominate. In the multi-tranche offshore renminbi offering of Rmb2bn from Bank of Communications, Hong Kong branch, sold in both Hong Kong and Taiwan in June, Taiwanese investors took big chunks of all three tranches at 83% of the three-year, 87% of the five-year and 81% of the seven-year. Insurance companies and pension funds bought 66% of the five-year tranche and 74% of the seven-year piece, underlying the popularity of offshore renminbi bonds in that segment, and the merging of Dim Sum and Taiwan’s Bao Dao markets. Geographically, BOCI also noted that the market was still mainly an Asian phenomenon. On average, 87% of new issues was allocated to Asia, with 8.2% going to Europe, 1.3% to US buyers and 3.1% to the rest of the world. However, the geographic distribution is gradually improving. For example, America Movil became the first company to target US buyers with a Rmb1bn SEC-registered renminbi bond in February 2012. This year, as more offshore renminbi centres emerge in Europe and Asia, the market has seen many Chinese banks printing Dim Sum bonds through their European branches, such as those in Paris, Frankfurt, London and Luxembourg. The latest sizable one was a Rmb2bn bond from the Paris branch of Bank of China, which marked the first Dim Sum bond to have a dual listing in the French capital and Frankfurt. Anchor orders from high-quality buy-and-hold investors helped to give strong momentum to the bookbuilding process and resulted in a final order book of Rmb7.3bn and over 100 investors for the Paris deal. Final allocations went to a diversified investor base with strong participation from bank treasuries, insurance companies and corporate buyers, as well as funds and asset managers. European investors accounted for about a third of the offering. The latest piece of encouraging news was from Switzerland. On July 21, the Swiss National Bank and the People’s Bank of China signed a bilateral swap agreement of Rmb150bn.

The competition between the world’s financial centres to establish their offshore renminbi trading credentials has emerged as one of the most visible signs of the currency’s internationalisation. PRC regulators have stoked that rivalry in recent months with approvals for an increasing number of international renminbi-clearing banks, key components in China’s steady push to widen the use of its currency. Since mid-June, the People’s Bank of China has approved renminbi-clearing banks in London, Frankfurt and Seoul, and signed memos of understanding with Paris and Luxembourg, which are expected to lead to the creation of clearing banks in those cities. The Reserve Bank of Australia said in July it was also in the process of preparing a memo of understanding for a clearing bank in Sydney. There already are clearing banks in Hong Kong, Macau, Taipei and Singapore. The frenetic pace at which these hubs are being set up reflects the financial stakes involved in making it easier for companies and banks to do business in renminbi in major financial centres across the globe. “It goes in two ways – the Chinese Government wants to expand the usage [of the renminbi], as a result of the economic and trade activities, and foreign countries see this as an opportunity to boost financial services in their own countries,” said Jimmy Leung, banking and capital markets leader for China at PwC, which did a comparative study of cross-border renminbi centres in February titled “Where do you Renminbi?” Trade settlement in renminbi is clearly on the rise as more Chinese corporations seek to settle accounts in their own currency, “and, because [China’s] rates are higher than the rest of the world, they can offer a discount for settling in RMB,” said Andrew Seaman, portfolio manager of the Renminbi Bond Fund at Stratton Street Capital. The recent MoU between the PBoC and Banque de France to set up a clearing bank in Paris is leading to more inquiries into how the renminbi can facilitate trade between China and French companies, said Julien Martin, Hong Kong-based head of BNP Paribas’ RMB Competence Centre. “The growth potential for RMB is still fantastic, and the overall volume whether it is in Asia or in Europe can be expected to grow exponentially,” Martin said. “We see more and more customers asking for renminbi, in Paris, for example, and this is a significant advantage of offshore centres – creating a buzz and encouraging conversation about the currency.” There are intangible benefits of spreading familiarity with the renminbi across the globe, where individuals in far-flung cities can conduct transactions in the currency in their own language and in the same time zone. It makes it easier to roll out innovations or for traders to talk to one another, said Ashley Davies, senior economist and strategist at Commerzbank in Singapore. “Having the confidence that liquidity will be available in times of crisis is also an important consideration,” Davies said. Most financial centres are expected to have some renminbi capabilities in the years ahead, but each will likely have their speciality. Hong Kong will remain one of the most important centres because of its geographical proximity to China, PwC’s Leung said, but the city with the potential to win the race for the biggest offshore trading centre – and it is often described as a race – is London. “When you talk about being a successful currency centre, you need to have flows of funds in and out,” Leung said. “The volume in and out London is bigger than other cities you can name.” To see the digital version of this report, please click here.

Shanghai and beyond Source: REUTERS/Carlos Barria Michael Norris of Australia performs during a presentation at the World Extreme Games in Shanghai. Greater China market participants have high hopes that a pilot cross-border agreement between the PRC and Hong Kong on stock investments will be expanded beyond Shanghai once regulators iron out a few early stage wrinkles. The China Securities Regulatory Commission and Hong Kong’s Securities and Futures Commission announced the link between the two financial centres, dubbed Shanghai-Hong Kong Stock Connect, in April. The initiative allows for limited mutual stock-market access to the two cities’ exchanges. The programme is expected to benefit both markets. Investors based in Hong Kong and Shanghai will be able to purchase a far greater variety of shares than before. However, market participants have said that the PRC markets may have the most to gain from the project in the longer term – especially if, as some anticipate, it is extended to Shenzhen and to other securities and products besides equities. Allowing a greater number of international investors to buy shares and other securities of companies listed in Shanghai and Shenzhen via Hong Kong will help create a more liquid and more transparent PRC market, sources say. “I believe the next phase is to include Shenzhen’s exchange and stocks in the plan,” said a Shanghai-based head of China equities. Brokers in both cities are preparing for the pilot project’s expected launch in October. It is intended to complement, and not replace, existing international investment schemes, such as the qualified foreign institutional investor and qualified domestic institutional investor programmes. “Transparency and disclosure are pretty lacking in the mainland stock market, but expected to improve over time. So, for longer-term investors, this [stock programme] presents a good opportunity.” Brokers preparing for the new market access say they expect the development of the project to start off slow. However, once dealmakers get comfortable with the rules, the scheme can be expanded to include more securities, they say. Shanghai-Hong Kong Connect is, by design, limited in scope. The initiative allows northbound investors, those based in Hong Kong, to buy constituent stocks of the SSE 180 and SSE 380 indices. Southbound flows can been used to buy the Hang Seng Composite LargeCap and Hang Seng Composite MidCap indices. It also means that more than 100 dual-listed shares are in play. Giving investors in Hong Kong direct access to Shenzhen-listed shares in the future may also be easier to implement than the current Shanghai access, according to the China equities head. “Shenzhen has the advantage of being very close to Hong Kong. That proximity could be an advantage for many firms and [my firm] is quite excited about the possibility,” he said. If the scheme is implemented as planned, the additional trading volume may have a major impact on the Chinese market. “If the stock-connect quota is actually all used up and, combined with the QFII quota, which hasn’t been used up, both quotas used to capacity would be meaningful for Chinese market,” he said. “That’s what the regulator is after: increasing international participation in the Chinese market. The stock programme is one way they are doing this.” However, brokers, investors and regulators in Shanghai and Hong Kong still have a lot of work to do before trades can be made. So, the benefits of the scheme for both cities will not be immediately obvious once it launches. As such, portfolio managers looking to get a first crack at PRC stock markets will have to invest with longer-term horizons in mind. “The A shares have pretty much always been a closed market for international investors,” said Steven Sun, head of China equity strategy at HSBC. “Transparency and disclosure are pretty lacking in the mainland stock market, but expected to improve over time. So, for longer-term investors

Helping hand Source: REUTERS/Kim Kyung-Hoon Members of an honour guard have their boots clean as they get ready for a welcoming ceremony. China’s structured finance market has made a great leap forward this year, with more domestic securitisations in the first six months than in the previous nine years combined. Sales of asset-backed securities reached Rmb81.3bn (US$13bn) in the first half of this year, more than the total of Rmb74.7bn issued before the end of 2013. This year’s uptick has more than quadrupled outstanding volumes, with just Rmb17.1bn in circulation at the end of 2013. China allowed the first ABS pilot issues in 2005, but most domestic securitisations have come in the form of collateralised loan obligations from the country’s major banks. Over the past two months, auto-loan financiers have entered the market, with foreign-owned originators involved for the first time. “The opening up of auto-loan ABS market is good news to both auto financing companies for better funding costs and customers for better borrowing rates,” said Patrick Steinemann, co-head of Asia industrials investment banking at Bank of America Merrill Lynch. “Auto financing companies will be in a stronger position to compete with banks.” A deeper structured finance market will substantially reduce the reliance of auto-financing companies on bank loans – something that China’s regulators have been working hard to achieve. This February, the China Banking Regulatory Commission granted quotas totalling Rmb5bn (US$826m) to six non-bank financial institutions to issue auto-loan securitisations. “The opening up of auto-loan ABS market is good news to both auto financing companies for better funding costs and customers for better borrowing rates. Auto financing companies will be in a stronger position to compete with banks.” Among others, foreign-owned auto-loan lenders, including the local units of BMW, Volkswagen, Ford, Nissan and Toyota, were allowed to sell ABS, in a sign that the domestic markets are opening up to overseas issuers. As global auto lenders enter the ABS arena in China, they are also helping to shape and develop the new market. Volkswagen Finance’s inaugural Rmb796m (US$130m) Driver China One securitisation, priced on July 21, is the first securitisation of Chinese auto-loan receivables to receive international credit ratings. The structure closely follows VW’s global Driver standard. The issue will settle on August 1 in the domestic interbank bond market. “International ratings help to expand the investor base of a domestic securitisation as many foreign investors have rating requirements to meet. The ratings help in evaluating the transaction and facilitating purchases,” said Jerome Cheng, senior credit manager at Moody’s. “As the investor base grows, the pricing may be improved.” The new ABS was made available to international investors allocated qualified financial institutional investor or renminbi qualified financial institutional Investor quotas, as well as foreign banks in China and regular domestic investors. “Having international ratings, knowing the management practice of the foreign firms and seeing the familiar ABS format will all give more comfort to foreign investors,” said one banker. In fact, pricing of Triple A rated tranches of foreign auto-loan ABS has been falling. Ford Motor paid 5.5% for a tenor of 0.68 years in late May, but BMW paid only 4.8% for a tenor of 0.55 year with same rating in mid-June. That reflected a better understanding and growing acceptance of the format among a growing investor base. Almost every auto-financing major in the world has its own ABS platform as an important source of funding, and foreign players are happy to extend that practice to the largest global auto market. In the VW structure, there is an overcollateralisation equivalent to 0.5% of the issue size – a departure from traditional PRC transactions. That provides an extra level of credit support to the issue.