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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
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
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.
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Macro China Economics 9 November 2010
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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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Macro China Economics 9 November 2010
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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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Macro China Economics 9 November 2010
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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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This is an updated extract from an article
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
Qu Hongbin Chief China Economist The Hongkong and Shanghai Banking Corporation Limited +852 2822 2025 [email protected]
Sun Junwei Economist
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Macro China Economics 9 November 2010
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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
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Macro China Economics 9 November 2010
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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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Macro China Economics 9 November 2010
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This is an updated extract from an article
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
Qu Hongbin Chief China Economist The Hongkong and Shanghai Banking Corporation Limited +852 2822 2025 [email protected]
Sun Junwei Economist
11
Macro China Economics 9 November 2010
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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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Macro China Economics 9 November 2010
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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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Macro China Economics 9 November 2010
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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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Macro China Economics 9 November 2010
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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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Macro China Economics 9 November 2010
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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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This is an updated extract from an article
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
Qu Hongbin Chief China Economist The Hongkong and Shanghai Banking Corporation Limited +852 2822 2025 [email protected]
Sun Junwei Economist
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
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Macro China Economics 9 November 2010
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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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Macro China Economics 9 November 2010
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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]
Qu Hongbin Chief China Economist The Hongkong and Shanghai Banking Corporation Limited +852 2822 2025 [email protected]
24
Macro China Economics 9 November 2010
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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
25
Macro China Economics 9 November 2010
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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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Macro China Economics 9 November 2010
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This is an updated extract from an article
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
Donna Kwok Economist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6621 [email protected]
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]
Qu Hongbin Chief China Economist The Hongkong and Shanghai Banking Corporation Limited +852 2822 2025 [email protected]
Sun Junwei Economist
27
Macro China Economics 9 November 2010
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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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Macro China Economics 9 November 2010
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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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Macro China Economics 9 November 2010
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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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Macro China Economics 9 November 2010
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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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Macro China Economics 9 November 2010
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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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Macro China Economics 9 November 2010
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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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Macro China Economics 9 November 2010
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This is an updated extract from an article
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
Qu Hongbin Chief China Economist The Hongkong and Shanghai Banking Corporation Limited +852 2822 2025 [email protected]
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]
Donna Kwok Economist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6621 [email protected]
34
Macro China Economics 9 November 2010
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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
Macro China Economics 9 November 2010
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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
36
Macro China Economics 9 November 2010
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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
Macro China Economics 9 November 2010
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This is an updated extract from an article
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
Qu Hongbin Chief China Economist The Hongkong and Shanghai Banking Corporation Limited +852 2822 2025 [email protected]
Sun Junwei Economist
38
Macro China Economics 9 November 2010
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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.
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Macro China Economics 9 November 2010
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This is an updated extract from an article
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
Macro China Economics 9 November 2010
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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
41
Macro China Economics 9 November 2010
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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
42
Macro China Economics 9 November 2010
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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
43
Macro China Economics 9 November 2010
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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
44
Macro China Economics 9 November 2010
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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
45
Macro China Economics 9 November 2010
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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
46
Macro China Economics 9 November 2010
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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
47
Macro China Economics 9 November 2010
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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
48
Macro China Economics 9 November 2010
abc
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
Macro China Economics 9 November 2010
abc
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.
50
Macro China Economics 9 November 2010
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Global Economics Research Team
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
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
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.