Chinese Financial Review: Onshore and Offshore
CNY/CNH: Chinese Financial Review
On April 18, S&P cut its credit outlook for US Treasuries from stable to negative. This was seen as a clear warning that if the US politicos cannot agree on a sustainable fiscal adjustment plan, the US triple-A rating was at risk. This shot across the bow, on the heels of President Obama’s proposed alternative to the Ryan plan, was widely discussed. With the US dollar being driven down by the continued easing of US monetary policy, the fiscal pressures were broadly seen as evidence the US was headed in the wrong direction.
Almost a week before S&P’s move, Fitch cut the outlook for China’s yuan debt to negative from stable. Media coverage was almost non-existent and there has hardly been any commentary. Frankly, most observers don’t even seem to know it took place.
It seems almost surrealistic that one of the world’s fastest growing economies, enjoying a substantial current account surplus and having amassed more than $3 trillion in reserves is not a triple-A credit in the first place, would also have its outlook cut, and that it would receive such little attention as well.
Fitch expressed concern about a number of factors, contingent sovereign liabilities, the pace of bank lending, rising real estate valuation and inflation. The PBOC is tightening policy and attempting to slow bank lending. This provides additional spur to growth in the yuan bond market in Hong Kong, affectionately called “dim sum”.
Chinese companies, and indeed the Chinese government itself, can raise funds more cheaply in Hong Kong than they can in Shanghai. In late April, a three-year government bond was yielding about 3.25% on the mainland, while in Hong Kong the same maturity was paying almost 100 bp less.
The Dim Sum market has continued to grow rapidly. There have already been more deals this year than all of last year, with China’s ICBC, the largest bank in the world by market value, the largest issuer thus far this year. Unilever recently issued a 3-year yuan bond in Hong Kong paying a record low 1.15%.
Dim Sum—Small Servings
Nevertheless, the Dim Sum market remains relatively small. The largest underwriter expects issuance this year to be between CNY120-CNY150 bln (~$18-$22 bln). The market is also not very deep. Most issuance is for three years and less. There are several reasons for this, which are instructive to investors trying to understand the potential significance of the Dim Sum market.
First, the Dim Sum market may be emblematic of a transition phase for China. As we shall see, the Dim Sum market exists in part because the yuan is not fully convertible. Eventually the yuan will be convertible, even if the precise timeframe is not clear and even if not a clear goal of the new five year plan.
Second, the Dim Sum market is also in part predicated on the fact that the on-shore market is highly restricted and non-Chinese borrowers are largely prohibited from issuing bonds on the mainland. Two supranationals (Asian Development Bank and International Finance Corp) seem to have won Chinese favor, but even they were both required to use the proceeds within China. The Dim Sum market may be considered an experiment by Chinese officials in granting foreign investors greater access. If this remains successful, China may try to introduce it on the mainland.
Third, there are some operational limits. For example, there is no liquid cross currency swap market beyond a year. Cross currency swaps allow investors to hedge the currency and interest rate risk simultaneously. This serves to limit the range of issuers to largely companies that have revenues in yuan and service yuan-denominated obligations.
Now that we have reviewed some characteristics influencing the supply of Dim Sum bonds, let’s turn out attention to demand. To appreciate this is to recognize the rise of the CNH market, which is yuan in Hong Kong.
The most recent data, through the end of March, shows that yuan deposits in Hong Kong have risen to CNY451.5 bln from CNY370.5 bln at the end of January and 217 bln at the end of October 2010.
The yuan accounts for about 7.6% of total deposits in Hong Kong, twice their share at the end of October. At the current pace of growth, yuan deposits in Hong Kong could reach around CNY900 bln by the end of the year. Periodically there is speculation that Hong Kong will drop its dollar peg and re-peg to the yuan. Most recently it has been based on ideas of the growing importance of the yuan in China. This data suggests conditions are still far from the yuan crowding out HKD in Hong Kong.
Hong Kong Deposits March ’11 Jan ’11 Oct ‘10
Yuan (blns) 451.4 370.6 217.1
% of total deposits 7.6% 6.3% 3.6%
Source: Hong Kong Monetary Authority
It is these growing yuan deposits in Hong Kong (CNH) that are the pool of funds available to invest in Dim Sum bonds. In turn, a key source of the yuan deposits is the growing settlement of trade in yuan.
Chinese officials have been actively encouraging the use of the yuan for trade settlement over the last couple of years. This has been largely confined to Hong Kong, and to a lesser extent Taiwan. As we noted in our last Special FX on China (The Internationalization of the Yuan or the Sino-ification of Hong Kong), much of the yuan’s sphere, if such is developing, is primarily concentrated in Greater China and especially Hong Kong.
It is not just limited externally but also within China, as yuan trade settlement was treated like a bit of an experiment and confined to 20 provinces. Still, last year a little more than CNY505 bln of trade was settled in yuan. Some observers expect it to double this year.
At first, as one might expect, opportunistic importers were thought to have driven the growth of yuan trade settlement. More recently, exporters have begun settling more of their trade in yuan. Consider a mainland-based toy manufacturer that exported about $60 mln worth of product last year. It is now settling a fifth of those sales in yuan the rest in dollars, according to recent press reports. The dollar quote for the products, based on a 60 day payment period, assumed a 3.4% appreciation of the yuan.
Some reports estimate that around half of Hong Kong’s imports from the mainland are settled in yuan. The CNH stays in Hong Kong and outside of low yielding bank deposits, there is not a range of alternative financial products. Recently a Chinese-based real estate trust floated shares in CNH and there are reports of others following suit shortly.
There are several reasons why it was not been well received, but in general, we suspect many investors (and therefore issuers) will be particularly cautious because a CNH equity market is simply too reminiscent of the old “B-share” market of Chinese equities in Hong Kong. These shares were denominated in Hong Kong dollars in which foreigners could invest. To be listed did not require the kind of transparency that many foreign investors require, especially in light of the recent crisis, and China allowed that market to dry up.
There has been no new issuance, for example, in the past decade. Some of the same considerations that help explain why the Dim Sum bond market maturities are for three years and less helps explain why an “H-share market” is unlikely to flourish. China is thought to be moving toward convertibility, albeit slowly. China is also likely to eventually relax some controls on foreigners which restrict their ability to invest onshore.
However, the outlook for the Dim Sum bond market continues to look favorable. The amount of yuan deposits in Hong Kong far and away outstrips the supply of short-term financial instruments. Investors are willing to accept relatively low yields because it is better than on bank deposits, and they are also betting on currency appreciation.
The yuan has appreciated by just less than 3.4% against the US dollar over the past four quarters (Q2 10-Q1 11). The derivatives market implies that a 2.5 % appreciation is expected over the next 12-months. We suspect it will be faster than this, closer to 5%.
This will not be sufficient to appease those who argue that the low exchange rate is giving an unfair subsidy to Chinese exporters. However, the other side of the equation is that there are many foreign companies that use China as an export platform and benefit from the low yuan. This fact, and the political cycles in both China and the US, argue against a meaningful break through at this week’s Strategic Economic Dialogue meetings between the US and China.
The political considerations will likely push the US into a more confrontational stance ahead of the 2012 elections. It could lead to US companies being able to seek financial redress for losses that are incurred due to the yuan’s “unfair” exchange rate. The transition of power in China next year appears to have already begun. China’s preferred means of addressing inflation is not to let the currency rise sharply, but instead, to raise interest rates and required reserves and to use non-market mechanisms to convince some producers not to raise prices, or apparently even talk about raising prices.
Lastly, another milestone for the internationalization of the yuan appears to be passing. The beginning of the acceptance of the yuan as a reserve asset is at hand. South Korea appears to be the first country to indicate that it would put some of its reserves in yuan-denominated bonds. Our local contacts suggest that other East Asian countries, including Malaysia and Singapore, may not far behind South Korea in seeking to have reserves in yuan.
Given that South Korea applied for status as a Qualified Foreign Institutional Investor, which is the official empowerment to buy and sell securities on the mainland, we understand this to be CNY bonds not CNH. Korean officials confirmed that they were not reducing their dollar holdings, which is consistent with our long held view that central banks are diversifying their reserve flows, not their stock.
As of the end of last year, there were just shy of 100 Qualified Foreign Investors, who had a cumulative investment quota of almost $20 bln. It is the liberalization of access to the onshore market that is sought and expected by international investors, but not over the next several years.