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   China Economics                                                                                               

   9 November 2010


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.

    China Economics                                                                                              

    9 November 2010

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.

   China Economics                                                                                        

   9 November 2010

China to shrink surplus, but                               Completing the on/offshore
not the Geithner way                                  4    RMB circle                                               26
                                                           Onshore RMB bond market opens up to offshore funds         26
Two big misconceptions                                7    Internationalisation of the RMB is maturing: from the first to
1. China must revalue to contain inflation             7   second of three stages                                     27
2. Rising trade surplus means RMB still undervalued    8   Why Beijing decided to open its interbank bond market first28

                                                           Implications for Hong Kong as an offshore RMB centre       28
From greenbacks to
                                                           Snapshot: China’s interbank bond market                    32
‘redbacks’                                            10
Crisis and internationalisation of the renminbi       10

Matching China’s rising economic power                11
                                                           RMB trade settlement takes a
                                                           breather                                                 33
The latest moves                                      14   What has happened?                                         33
The roadmap                                           15   FX takeaways                                               34
The implications                                      16   Macro takeaways                                            35

Ready, steady, go!                                    20   From trade to investment                                 37
Renminbi trade settlement goes global                 20

Potential lies in non-G3 countries                    21   Connecting the dots for RMB
Where to park the renminbi?                           21
                                                           internationalisation                                     39
                                                           A long march                                               40
Increased flexibility encourages use of renminbi      22
                                                           Where it’s heading…                                        41

                                                           Market-driven bank interest rates                          42
Offshore renminbi products
take off                                              23   Reserve currency: still decades away                       47
What’s new                                            23   Now is a good time…                                        48
A renminbi interbank market created                   23

New Hong Kong renminbi rules: the low-down            24   Disclosure appendix                                      50
New platform for renminbi product development         24
                                                           Disclaimer                                               51
Pre-empting future bottlenecks                        25

Revving up the engine                                 25

    China Economics                                                                                                

    9 November 2010

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

This is an updated extract from an article            1. Trade surplus and CA balance as % of GDP             Qu Hongbin
                                                                                                              Chief China Economist
originally published on 25 October 2010                     As % of GDP                                       The Hongkong and Shanghai
                                                      12                                                      Banking Corporation Limited
China and other countries have rejected US                                                                    +852 2822 2025
Treasury Secretary Geithner’s proposal of limiting     8
                                                                                                              Sun Junwei
the current account balance at 4% of GDP at the        6                                                      Economist
G20 finance ministers meeting. In fact, it was Yi      4
Gang, Vice Governor of the PBoC, who first said        2
China would lower the current account surplus to       0
GDP ratio from 5.8% in 2009 to 4% in three to            2000 2002 2004             2006 2008 2010f
                                                      Source: CEIC, HSBC
                                                            Trade balance           Current account balance
five years’ time at an IMF meeting in early Oct.
That said, China never likes being pushed into        Source: CEIC, HSBC

anything. While they both agree on the “what” (a
lower trade surplus), they disagree fundamentally    last three years amid faster recovery in Chinese
on the “how”. But there is a key difference here:    demand. Its current account surplus to GDP ratio
Geithner wants to see faster renminbi                almost halved to 5.9% in 2009 from a peak of
appreciation, but Beijing wants to see a broader     10.6% in 2007. Between 2007 and 2009, its trade
and better-staggered policy package that would       surplus to GDP ratio dropped from a peak of 7.5%
also boost domestic demand, push through             down to 4%, largely due to Beijing’s RMB4trn
structural reforms, accelerate wage growth, and      stimulus package which substantially boosted
liberalise resource prices.                          imports of raw materials and machinery
                                                     equipment. In stark contrast to the negative
China’s current account (and trade) surplus as a     growth rates seen across the developed world in
percentage of GDP has been shrinking over the        2009, China’s economy staged a sharp V-shaped

   China Economics                                                                                             

   9 November 2010

recovery last year to expand 9.1% y-o-y (real           target. This complements China’s ongoing
terms). The second-round impact of the stimulus         transition towards a more sustainable and balanced
package continues to ripple through the economy,        growth path. We anticipate domestic demand
both fuelling job creation and domestic                 growth to average 8-9% for the next few years.
consumption. For the first nine months of 2010,
                                                        Policy making is set to revolve around “inclusive
China’s import growth rate continued to outstrip
                                                        growth” for the next five years. Wage growth is
that of exports, averaging 42.4% y-o-y versus
                                                        already on the rise, and should continue upwards
34% y-o-y for the latter. By the end of 3Q,
                                                        as the government seeks a more equitable
China’s total trade surplus had narrowed to
                                                        distribution of the benefits of economic growth.
USD120.6bn, or 10.5% less than the same period
                                                        As labour compensation is pushed up via income
last year.
                                                        distribution reforms and faster wage growth, so
We expect China’s domestic demand to stay strong        consumption’s contribution to growth should rise.
in the coming years, maintaining a substantial
                                                        Wages form the dominant income source for urban
growth differential with its major trading partners
                                                        households and hold the key to spurring private
to further narrow its trade surplus (via robust
                                                        consumption. But wage income growth has lagged
import growth). As Premier Wen said at the World
                                                        productivity growth in recent decades, something
Economic Forum in January 2009, China’s steady
                                                        which allowed unit labour costs to fall for so long.
and fast growth itself is an important contribution
                                                        Through various measures including minimum
to global financial stability and world economic
                                                        wage growth and labour union consultations,
growth. Indeed, in view of the sluggish recovery of
                                                        Beijing’s plan is for wage growth to catch up with
Western countries, China’s growth matters a lot for
                                                        productivity growth by 2015. This, plus expected
the global economy. Stronger Chinese domestic
                                                        improvement in social security provisions, should
demand will likely lower the current account to
                                                        increase the share of labour compensation to GDP,
GDP ratio to around 4% by 2011.
                                                        so lifting private consumption.
China’s domestic demand growth engine should
                                                        Inflationary pressures should alleviate as the pace
support a growth rate of around 9% next year,
                                                        of GDP growth slows to below its full potential
despite slower global economic growth and thus
                                                        (estimated at 10%), giving Beijing more room to
cooler external demand. Regardless of recent credit
                                                        continue its liberalization of resource price
tightening measures on new infrastructure projects,
                                                        controls – an important structural adjustment.
we expect continued investment into massive
                                                        Resource price reforms should help close the gap
ongoing infrastructure projects to provide a floor to
                                                        between domestic and international resource
fixed investment growth. This, plus improving
                                                        prices, minimize inefficient manufacturing
labour market conditions, should underpin solid
                                                        capacity and ultimately help slow down exports in
domestic demand growth through 2011.
                                                        related sectors.
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

      China Economics                                       

      9 November 2010

    2. Real effective exchange rates for China and others

    140                       REER Jan 2005=100



          00 01 02 03 04 05 06 07 08 09 10
             China       Australia   India
             Japan       Korea
    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.

   China Economics                                                                                                                

   9 November 2010

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

This is an updated extract from an article                Chart 1. PPI partial pass-through to CPI                           Qu Hongbin
                                                                                                                             Chief China Economist
originally published on 6 May 2010                        10    (% yr)                                        (% yr) 15      The Hongkong and Shanghai
                                                                                                                             Banking Corporation Limited
1. China must revalue to                                   8
                                                                                                                             +852 2822 2025
contain inflation                                          6
                                                                                                                             Sun Junwei
                                                           4                                                           5
There’s no doubt that rising global prices for             2                                                           0
commodities and resources have been a key driver           0
behind the strong rebound in producer price levels                                                                     -5
                                                          -2 97 98 99 00 01 02 03 04 05 06 07 08 09 10
during 1H. Chart 1 shows how PPI increases have           -4                                                           -10
historically been passed-through in part to
                                                                                CPI (Lhs)        PPI (Rhs)
consumer price inflation.
                                                          Source: CEIC, HSBC

This leads many analysts to believe that a
meaningful appreciation in the RMB is necessary for       Chart 2. PPI aligned with international commodities prices

China to control inflation. However, this argument        500                                                (%yr)     20
overlooks a simple fact – China is already a price        450
setter in global commodity and resource markets,          400

which means RMB appreciation alone won’t be               350                                                          0
enough to contain imported inflation in China.                                                                         -10
China is the world’s largest consumer of                  200                                                          -20

commodities and resources. Over the last five years             97 98 99 00 01 02 03 04 05 06 07 08 09 10

it has accounted for over 55% of global incremental
                                                                               CRB index (Lhs)        PPI (Rhs)
demand for crude oil, and almost 150% of global
incremental demand for iron ore. Hence, any change        Source: CEIC, HSBC

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.

     China Economics                                                                                                                                    

     9 November 2010

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

2. China vs. global incremental demand for commodities                                      restrictions, loan growth has slowed from over
2009                                            China                       Global          32% at the end of last year to 21.8% as at the end
Crude oil (000’ barrel/day)                        512                         445          of March. More needs to be done to achieve the
Iron Ore* (kt)                                     170                          14
Aluminium (kt)                                   1,319                      -2,668          target of slowing loan growth to 17% y-o-y by the
Copper (kt)                                      1,259                      -1,150          end of the year.
Steel (mt)                                         106                         -48
Source: BP, IEA, WMBS, EIA, Ministry of Commerce, Ministry of Land Resources, HSBC          We expect the PBoC to continue to lift reserve ratios
                                                                                            by another 50-100bps in the coming quarters, while
However, as a price setter, China does have a                                               restrictions on new lending will stay in place.
unique policy option to check imported inflation –                                          Meanwhile, following the State Council’s latest
unwind its infrastructure boom to cool demand for                                           measures to curb property speculation, we expect
commodities and energy. In doing so, China can                                              local authorities to introduce more detailed rules to
also take some heat out of the overheated                                                   dampen the investment demand for property and
economy to ease pressure on the domestic supply                                             increase the supply of affordable housing in the
of electricity, food and other resources.                                                   coming quarters.
Beijing has already announced plans to slow                                                 2. Rising trade surplus means
growth in the central government’s total spending                                           RMB still undervalued
to 6.3% for this year from 24% last year, with
infrastructure leading the slowdown. Meanwhile,                                             First, let’s get the facts straight. No, China’s trade
the central authorities are also checking the pace                                          surplus is not on the rise. On the contrary, it has
of new infrastructure projects by provincial and                                            been shrinking for the last five months in absolute
municipal governments by curbing bank lending                                               terms. As a share of GDP, the trade surplus has
and re-regulating local government investment                                               been falling fast, from about 7.5% in 2007 to 4%
corporations. All these measures, once                                                      last year. And we expect it to drop further to less
implemented, are likely to slow growth in                                                   than 3% in 2011.
infrastructure investment and, in turn, growth in                                           The bigger issue is whether this trade surplus should
Chinese demand for commodities and energy in                                                taken as hard evidence that the RMB is seriously
the coming quarters.                                                                        undervalued. Though possible, the nature of China’s
Chief among other policy tools for fighting                                                 trade surplus is quite different from that in most
inflation is quantitative tightening on credit and                                          other countries.
property (see Asian Economics Quarterly 2Q                                                  First, over 80% of China’s total trade surplus is
2010: Time to cool off, published 19 April 2010).                                           created by processing trade, a sector dominated by
After 100bps in reserve ratio hikes and lending                                             Mainland-based foreign companies. This implies

   China Economics                                                                                                            

   9 November 2010

that China’s own domestic companies generate only    3. Trade surplus as % of GDP

a fraction of the total trade surplus.                       (USD bn)                                             (%)
                                                     300                                                                  8
Second, global manufacturers have been shifting                                                                           6
their labour-intensive stage of productions into
                                                     150                                                                  4
China to capitalise on China’s massive labour        100
pool. These foreign-owned factories import parts,     50
components and materials to assemble them into         0                                                                  0

finished products before final shipment to global          1995 1997 1999 2001 2003 2005 2007 2009 2011f
                                                                            Trade balance (Lhs)
markets. Their value of the final assembled
exported goods often exceeds the sum of its                                 Trade balance as % of GDP (Rhs)

imported components and materials; with the          Source: CEIC, HSBC

difference being the value added in China (aka
profit margins, rentals and wages). But under the    4. Trade surplus dominated by processing trade

existing international system of trade statistics,   350     (USD bn)
this value added portion is recorded as a trade
surplus for China.                                   200
Hence, instead of being a key indicator for the      100
undervaluation of its currency, China’s trade         50
surplus is perhaps more a by-product of vertical     -50
                                                             2000         2002       2004         2006        2008
integration in global manufacturing activities.
                                                                    Processing trade by foreign joint v entures
Or more specifically, the migration of
                                                                    Ordinary trade by domestic companies
manufacturing assembly lines from more
expensive (labour cost wise) developed               Source: CEIC, HSBC

economies into China. Of course, this vertical
                                                     5. Key reasons for doing business in China
integration in turn has spurred the development of
China’s massive and well-disciplined labour pool,              Grow th of market
substantial infrastructure improvements and the
                                                            Size of local market
associated economies of scale.
                                                                    Cheap labour

                                                           Presence of suppliers

                                                     Access to regional market

                                                                                    0       5     10     15    20        25

                                                     Source: UNTCAD, HSBC

     China Economics                                                                                                  

     9 November 2010

From greenbacks to
 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

This is an updated extract from an article              country rapidly accumulated export earnings in           Qu Hongbin
                                                                                                                 Chief China Economist
originally published on 6 July 2009                     dollars. Meanwhile, government controls on outward       The Hongkong and Shanghai
                                                        investment by domestic corporations and households       Banking Corporation Limited
Crisis and internationalisation                                                                                  +852 2822 2025
                                                        meant that most of the dollar receipts can be  
of the renminbi                                         recycled out of the country through just one channel     Sun Junwei
Aside from the slowdown, the global economic            – the central bank’s FX reserve accumulation. To
crisis has also led to unprecedented risks to China’s   find an ultimate solution to this issue, apart from
more than USD1.8trn of USD assets. The Fed’s            gradually loosening controls on capital outflows
remedy of quantitative monetary easing is causing       (please refer to our reports From People’s Banks to
concerns about inflationary risk and is weighing on     people’s hands, 8 March 2006, and Recycling
the value of the greenback. This has prompted           China’s trade dollars, 7 May 2007), Beijing realises
Chinese policymakers to rethink the root causes of      it is time to push forward the internationalisation of
the ‘dollar trap’. There is a growing consensus in      the renminbi.
Beijing that one of the fundamental reasons the
                                                        As in many emerging market countries, the US
country has fallen into the trap is that its own
                                                        dollar is still the dominant currency for settling
currency – the renminbi – is not yet an international
                                                        cross-border trade flows in China. The global
currency, which means Chinese exporters and
                                                        crisis and unconventional policy responses by the
importers have to rely on the dollar for invoicing
                                                        world’s major central banks will likely lead to
their foreign trade. We estimate that over 70% of
                                                        greater uncertainty over the exchange rates of the
China’s USD2.6trn annual trade flows (2008) are
                                                        major currencies, especially the dollar.
settled in the US dollars, with the balance being
                                                        Meanwhile, with global demand contracting,
settled in the euro, yen and other currencies. With
                                                        exporters and importers in China and in counter-
China’s exports surging nearly 30% annually in the
                                                        party countries are finding it much tougher to
previous boom cycle of global demand (2002-7), the

    China Economics                                                                                                         

    9 November 2010

remain profitable. They are likely to do whatever                     currency goes hand in hand with the rise and fall
they can to expand revenue and control costs,                         of a country’s economic power. In the 19th
including lowering the transaction costs of settling                  century, 60-90% of international trade was priced
trade. This is likely to prompt corporations in both                  in British pounds. After eclipsing Britain’s
China and its major trade partners to use a local                     economy in the late 19th century, the US rose in
currency rather than the US dollar for settling                       economic power and turned into a net creditor
cross-border trade.                                                   from a net debtor. Meanwhile, the dynamics of
                                                                      economic power were reflected in the strength of
Matching China’s rising
                                                                      the US dollar, which overtook sterling as the
economic power                                                        international reserve currency after World War II.
What does the internationalisation of the renminbi                    The dominant role of the US dollar continues to
really mean? Simply put, the internationalisation                     hold despite the rise of potential future
of a currency is the process of promoting its use                     alternatives such as the euro and now the
outside of the home country.                                          renminbi. Although the recent financial crisis
                                                                      undermines investors’ faith in the US dollar to
The international uses of a currency can be
                                                                      some extent, the primacy of this currency across
categorized in three key areas: 1) international trade,
                                                                      international markets means that it should retain
as a pricing and invoicing currency; 2) international
                                                                      its standing as the world’s top international
debt markets, loan and deposit business, as a
                                                                      currency for the foreseeable future.
financing and investment tool; and 3) foreign
exchange markets, as a payment vehicle. An                            The internationalisation of the deutschemark,
internationalised currency implies a currency that is                 which was the second-largest international
widely accepted for investment, as a financing and                    currency after the US dollar before the circulation
payment vehicle and as a reserve, intervention and                    of the euro, can be attributed to 1) Germany’s
anchor currency in all countries across the world.                    economic power and 2) the stability of the
                                                                      deutschemark. Germany became the third-largest
Table 1. Measuring international currencies in terms of function
                                                                      economy after the US and Japan in 1968, due to
Currency use in global markets Currency use in other countries
                                                                      its post World War II growth spurt which saw its
International debt markets, loans & Official use (reserves,           competitiveness in machinery exports shoot up.
deposits (financing & investment) intervention, anchor)
                                                                      Germany’s robust trade record helped the
Foreign exchange market             Private use (investment &
(payment vehicle)                   financing, payment vehicle)
                                                                      deutschemark appreciate against the US dollar
                                                                      and British pound, as the liberalisation of trade
International trade (pricing &                                        and capital paved the way for internationalisation
                                                                      of the deutschemark. More importantly, the
Source: HSBC
                                                                      Bundesbank, known as the most independent
                                                                      central bank in the world, pursued a stable
What are the key criteria to fulfil if a currency is
                                                                      currency as one of its most important objectives,
to internationalise? Past empirical studies1
                                                                      for fear of inflation. By limiting the growth of
conclude that the international acceptance of a
                                                                      money supply, the Bundesbank backed a strong
1 Bergsten, C. Fred., 1975, “The Dilemmas of the Dollar: the          and stable currency that foreign investors and
Economics and Politics of United States International Monetary
Policy”, published for the Council on Foreign Relations by New York
                                                                      central banks chose to hold to minimize exchange
University Press, and Eichengreen, Barry, 1994, “History and Reform   rate losses. In this way, the deutschemark
of the International Monetary System”, Center for International and
Development Economics Research (CIDER) Working Papers C94 -041        accounted for up to 18% of the world’s foreign
, University of California at Berkeley.
                                                                      exchange reserves by the early 1990s.

     China Economics                                                                                                                

     9 November 2010

The internationalisation of the yen began in the                  economies; the value of its foreign trade has risen
1970s, when Japan became the world’s second-                      at a pace of 23% annually for the last decade, more
largest economy after two decades of around 10%                   than double the average growth rate of global trade
growth. However, fearing the potential negative                   in the same period. China surpassed Germany as
impact of the yen’s internationalisation on                       the world’s second-largest trading country in 2009.
domestic financial markets, Japanese
                                                                  There is a common misconception that China’s
policymakers did not actively push for yen
                                                                  cross-border capital inflows are still insignificant
internationalisation until the Asian financial crisis
                                                                  owing to strict Chinese capital controls. But these
and launch of the euro. Thus, the international use
                                                                  controls are both carefully calibrated and targeted.
of the yen is not as wide as it perhaps could be.
                                                                  Despite the global financial crisis, China was the
This reflects the 1) initial passive attitude of the
                                                                  largest developing world foreign direct investment
Japanese authorities towards internationalising the
                                                                  (FDI) recipient and among the top five global FDI
yen; 2) less open nature of Japan’s domestic
                                                                  recipient in 2009 (USD92bn in 2008 and USD94bn
financial markets which hindered efficient yen
                                                                  in 2009). At the same time, six years after Beijing
internationalisation; and 3) big swings in the
                                                                  first started to ease outward capital controls,
JPY/USD exchange rate which effectively
                                                                  Chinese outward direct investment (ODI) hit a
undermined the international use of the yen in
                                                                  record USD56.5bn in 2009. With the country’s
global trade and investment flows.
                                                                  growing appetite for natural resources, technology
Long overdue                                                      and brand names in the global markets, this uptrend
If history is a guide, the internationalisation of the            in China’s ODI will likely continue, possibly
renminbi is long overdue given China’s rising                     reaching USD100-150bn per annum by 2012. In
global economic presence versus the limited use of                the light of the global financial crisis, China should
its currency overseas. China’s nominal GDP topped                 and will likely maintain the gradual pace of its
USD4.9trn in market exchange rates (2009 year                     capital market liberalisation. An anticipated surge
average of USD1=RMB6.83) last year and is set to                  in ODI and FDI out/inflows will keep China’s
reach USD5.6trn this year, which means China                      cross-border capital flows widening in the coming
may finally take over Japan as the world’s second-                years, but policy makers will likely stay cautious
largest economy in 2010. Moreover, China is also                  on the speed of the current.
probably the most globalised of all major

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

 5000      (USD bnr)                                          8    10     (%)                                            (%)   25
 4000                                                         6     8                                                          20
 3000                                                               6                                                          15
 2000                                                               4                                                          10
 1000                                                         2
                                                                    2                                                          5
      0                                                       0
                                                                    0                                                          0
          1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
                                                                        1992 1994 1996 1998 2000 2002 2004 2006 2008
                     China GDP at current price(Lhs)
                                                                                       Trade (Lhs)          FDI (Rhs)l
                       China as % of world GDP

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

     China Economics                                                                                                                                         

     9 November 2010

Supportive factors in place                                                      armed with their overseas renminbi-denominated
China’s rapid integration with neighbouring                                      shopping budgets. These trends ultimately pave
economies and rising outbound tourism provided                                   the way for the renminbi’s evolution into a
an effective kick-start to the use of the renminbi                               regional hard currency.
overseas. Border trade has been on the rise for a                                More importantly, the Chinese government
number of years, with reserve-short neighbouring                                 continues to reform the foreign exchange system
countries generally favouring the renminbi for                                   and deregulate the capital account. Since the sharp
trade settlement given its relative stability. At the                            exchange rate reform move of July 2005, China
same time, rising income levels are sending                                      has allowed the renminbi to float flexibly with
increasingly more Mainland tourists abroad,

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   individuals             outward
                          to foreign countries
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    corporate               outward
May 2005                  Amend the operative procedures of foreign exchange administration in overseas futures hedging              corporate               outward
                          business of SOEs

Oct 2005                  Improve foreign debts administration                                                                       corporate               inward
Oct 2005                  Engage in financing and in return investment via overseas special purpose companies for domestic           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       corporate               outward
                          of clients
Jun 2007                  Further strengthening and regulating the examination, approval and supervision of foreign direct           corporate/individuals   inward
                          investment in real estate industry
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               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

     China Economics                                                                                                                            

     9 November 2010

reference to a basket of currencies, which               and 100 in Shanghai were selected to participate
enhanced the flexibility and credibility of the          in the programme. Companies in Hong Kong or
renminbi. In addition to the full convertibility of      Macau were given the green-light to settle trade in
current account, Beijing has gradually loosened          renminbi with selected enterprises in China, with
capital account controls. Via the qualified foreign      no upper limit.
institutional investor (QFII) and qualified
                                                         …and swap deals to provide seed
domestic institutional investors (QDII) schemes,
cross-border capital flows have found another
outflow channel via the capital account. For             To provide seed money for its trading partners, as of
individuals, the limit on renminbi that can be           end-3Q, the PBoC has also signed a total of
carried by Chinese citizens going abroad or              RMB803.5bn bilateral currency swap agreements
foreigners entering China was in 2005 raised to          with six central banks (Republic of Korea, Hong
RMB20,000 from RMB6,000.                                 Kong SAR, Malaysia, Indonesia, Belarus and
                                                         Argentina). Moreover, the PBoC is still in talks with
These factors demonstrate that favourable                other central banks to form more bilateral currency
conditions for the wider usage and acceptance of         swap agreements. We believe they are likely to
the renminbi already exist. The question is              include China’s major neighbouring countries such
whether and to what extent Beijing accelerates the       as Thailand, Vietnam and the Philippines.
pace of renminbi internationalisation. Recent
moves indicate that the pace was intentionally           The start of the global financial crisis created an
sped up amidst the global financial crisis.              opportunity for China to sign currency swap
                                                         agreements, as shrinking capital flows and exports
The latest moves                                         evacuated foreign funding initially cut into the
It is in this context that the internationalisation of   foreign exchange reserves of most emerging
the renminbi has become a leading item on                market countries. These currency swap lines
China’s policy agenda, as illustrated by the recent      garnered additional foreign exchange reserves for
announcements of a series of policy measures             counter-party countries, shoring up their defences
designed to jumpstart the international use of           against near-term financial risks and lending their
the renminbi.                                            domestic importers PBoC loans to pay for imports
                                                         from China.
Kick-starting a pilot programme…
                                                         Table 3. Bilateral currency swap agreements between the PBoC
Following the announcement of renminbi                   and other central banks
settlement on cross-border trades between 1)             RMBbn                            Bilateral currency              Total trade with
Hong Kong/Macau and the Pearl River                                                                    swap                  China (2009)

Delta/Yangtze River Delta, and 2) ASEAN and              Korea                                               180                         1067
                                                         HK                                                  200                        *2521
Guangxi/Yunnan in December 2008, the State               Malaysia                                             80                          354
                                                         Belarus                                              20                          5.5
Council selected five major trading cities in            Indonesia                                           100                          193
mainland China to kick off the pilot programme in        Argentina                                            70                           53
                                                         Singapore                                           150                         327
June 2009. These cities included Guangzhou,
                                                         Iceland                                              3.5                         0.6
Shenzhen, Dongguan and Zhuhai in the
                                                         Source: PBoC, CEIC (* total exports and imports between China and Hong Kong,
Guangdong province and Shanghai, which                   including re-exports)

accounted for 45% of China’s total trade in 2008.
Initially, 300 enterprises in Guangdong province

   China Economics                                                                                                               

   9 November 2010

The roadmap                                                renminbi trade settlement scheme kicked off,
                                                           direct investment by mainland enterprises
How can China achieve the ultimate goal of making
                                                           overseas almost doubled in 2008. Renminbi trade
the renminbi an international currency? The strategy
                                                           settlement should expand the currency’s
is best summarised as a double-layered three-step
                                                           circulation and acceptance in overseas markets,
process. The geographical expansion plan extends
                                                           thereby supporting its wider use in outward
the use of the renminbi first to neighbouring and
                                                           investment. Foreign enterprises ultimately need to
regional countries, then to other emerging market
                                                           invest the renminbi they accrue in trade
countries, and finally to all countries globally. In
                                                           settlement, which necessitates the development of
parallel to this geographical dimension, there is
                                                           more sophisticated capital markets either in
another a three-stage process that sees the use of the
                                                           offshore renminbi centres or the mainland. The
renminbi seeping first into global cross-border
                                                           evolution of Hong Kong as an offshore renminbi
trade, then global investment flows, and ultimately
                                                           centre, as well as domestic capital market reforms,
reserve holdings.
                                                           should offer foreign investors the renminbi-
The 2009 pilot programme to expand the                     denominated financial tools or hedge foreign
renminbi’s role in trade settlement was a crucial          exchange risks they need as an incentive to
milestone in the process of RMB                            engage (further) in renminbi trade settlement.
internationalisation. We foresee more than half of
                                                           More importantly, the strong growth potential of
China’s total trade flows, primarily bilateral trade
                                                           China’s economy points to the renminbi’s rise as a
with emerging market countries, being settled in
                                                           reserve currency. Empirical research2 has suggested
RMB within the next three to five years, from less
                                                           that every one percentage point increase of GDP as a
than 3% currently. If we are right, then it means
                                                           share the world total (measured at actual exchange
that nearly USD2trn worth of cross-border trade
                                                           rate) leads to 0.55ppt of central bank reserve
flows would be settled in renminbi, making it one
                                                           holdings in the corresponding currency. Assuming
of the top three currencies used in global trade.
                                                           the share of Chinese GDP to world GDP (at current
 Chart 3. China’s top five trading partners (2009)         prices and actual exchange rates) rises by 10ppt
                                             EU            (taking into account the likely appreciation of the
                                            17%            renminbi) over the next ten years, this would suggest
      others                                               at least a 5.5ppt increase in central banks’ renminbi
       43%                                           US
                                                           holdings. Therefore, as long as China’s GDP growth
                                                           stays above global growth, the renminbi should
                                                  Japan    increase its share in central banks’ reserves,
                                                  11%      eventually making it one of the most important
                      South                                reserve currencies.
                                         Hong Kong
 Source: CEIC, HSBC

Once the renminbi is widely accepted for
international trade settlement, it can be used in          2 Eichengreen, Barry and Jeffrey Frankel, 1996, “The SDR, Reserve
                                                           Currencies, and the Future of the International Monetary System” in
cross-border investment. Chinese enterprises have          The Future of the SDR in Light of Changes in the International
                                                           Financial System, edited by Michael Mussa, James Boughton and Peter
been accelerating the pace at which they invest            Isard, International Monetary Fund, 1996.

overseas for over a decade. Even before the

     China Economics                                                                                                                                

     9 November 2010

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

Does the internationalisation of the                                       The implications
renminbi require full convertibility?
                                                                           The internationalisation of the renminbi will have
The short answer to this question is: no, at least not                     significant implications for China and the global
initially. It is worth noting that the renminbi                            economy over the long term. In our view, even the
officially became convertible under the current                            initial phase of expanding the currency’s role in
account (for all trade and profit repatriation                             trade settlement is likely to lead to nearly USD2trn
purposes) over 10 years ago. So the current rules                          worth of annual cross-border renminbi flows in
place few restrictions on converting the renminbi                          three to five years. This, in turn, will have a
into other currencies for trade purposes, leaving                          significant impact on global markets by 2013.
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.

   China Economics                                                                                                              

   9 November 2010

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






            World        AR     BZ        ME         IR          SAR      UAE        KU     EG        SAF       RU     TU
                                                          2002                2007

Lifting trade flows                                                    Boosting China’s trade with other EM
Settling cross-border trade in renminbi rather than                    countries
the dollar helps Chinese exporters and importers                       Moreover, renminbi trade settlement should
cut transaction costs and minimize foreign                             increase trade flows between China and other major
exchange rate risk. Given the uncertain outlook                        emerging market countries. Compared with still-
for the US dollar in the coming years, this benefit                    struggling developed economies, China’s earlier
will likely be substantial. Although the worst of                      and faster recovery – led by infrastructure
the global trade contraction seems to be over, the                     investment – looks set to generate massive demand
recovery will likely be gradual, which implies                         for raw materials and commodities. For commodity
fierce competition for all exporters. As a result,                     exporting nations, the gain will not just come from
anything that enables Chinese exporters to control                     China’s rising imports, but recovering commodity
costs will be important for gaining market share.                      prices will also improve their terms of trade. This in
Despite a 14% contraction in China’s total trade                       turn will help those economies cope with the
value in 2009, Chinese exporters continued to                          financial crisis and enable them to buy more
expand their market share as other countries saw                       Chinese manufactured products. (See Riding on
even deeper contractions. Renminbi trade                               China’s recovery, 27 May 2009). Going forward,
settlement will ultimately make Chinese exporters                      Beijing will likely include more commodity
and importers more competitive, helping them                           exporting nations in Latin America, the Middle East
expand their market share in the coming years.                         and Asia in the trial scheme for renminbi trade
We consequently expect China’s total trade flows                       settlement. This will likely reinforce trade cycling
to continue to grow by around 15% annually in                          between China and commodity exporting nations in
the next three years.                                                  coming years, setting the stage for changes in global
                                                                       trade patterns.

     China Economics                                                                                                     

     9 November 2010

 Chart 5. China’s rising imports of crude oil and iron ore (in   Hong Kong to become the offshore
 volume terms) benefited from stimulus plan
                                                                 centre for renminbi trading
  80      (% yr, 3mma)
                                                                 The potential USD2trn worth of cross-border
  60                                                             RMB clearing/settlement each year not only
  40                                                             means enormous transaction banking business,
                                                                 but it also paves the way for Hong Kong to
                                                                 become the “go to” renminbi offshore centre.
     0                                                           Hong Kong’s policymakers are committed to
         01   02      03   04    05     06   07     08    09     strengthening the SAR’s status as a regional
                            Crude oil        Iron ore            financial centre.

 Source: CEIC, HSBC
                                                                 Under the latest administrative rules of the pilot
                                                                 renminbi-trade settlement scheme, banks across
Slowing China’s dollar accumulation                              the world can now settle renminbi-denominated
China has been piling up its foreign reserves at a               trade either through designed offshore clearing
pace of USD334bn per year since 2005, with the                   banks such as Bank of China (Hong Kong) or
trade surplus and net capital inflows contributing               through agent banks in China.
63% and 25% to the increase, respectively.                       In addition to the above, as we argued in our
Expanding the renminbi’s role in trade settlement                previous note (Expanding the renminbi’s role in
will effectively reduce China’s export earnings in               foreign trade, 18 March 2009), allowing renminbi
dollars. So even if the trade surplus continues,                 trade settlement is likely to further attract capital
growth in China’s dollar receipts should slow as the             inflows to Hong Kong in the medium term
scheme expands in coming years. Given that the                   because those companies whose home countries
pilot programme already covers regions that account              do not have a renminbi clearing bank will have to
for over 40% of China’s total exports, the impact on             settle their trade with China through a third
trade income in dollars is likely to be substantial in           county. Hong Kong serves as an ideal choice as a
coming years, though renminbi settlement in imports              major international finance centre free of capital
may offset some of this impact.                                  and exchange controls.
Meanwhile, China is also introducing policy                      The above will likely help drive the expansion of
initiatives that allow foreign companies to issue                Hong Kong’s renminbi deposit base to over
renminbi bonds and shares in the domestic stock                  RMB400bn (from the current RMB150bn) within
markets. This should reduce their need for                       three years as companies here increasingly settle
bringing in dollar funds to finance their                        trade in renminbi rather than US dollars.
investments in China. This will only reinforce the
slowdown in China’s dollar accumulation in                       This will also likely lead to more renminbi-
coming years. Combined with growing outward                      denominated capital market products issued and
direct investment, growth in China’s purchasing                  traded in Hong Kong. To encourage companies to
of dollar assets is likely to slow even more                     use the renminbi in trade, there must be
substantially in the next three years.                           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

   China Economics                                     

   9 November 2010

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.

     China Economics                                                                                                                        

     9 November 2010

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

This is an updated extract from an article                            The rising demand for renminbi trade settlement                  Qu Hongbin
                                                                                                                                       Chief China Economist
originally published on 25 June 2010                                  is reflected in the recent surge in volume. Monthly              The Hongkong and Shanghai
                                                                      renminbi settlement volume jumped to more than                   Banking Corporation Limited
Renminbi trade settlement                                             RMB50bn in August/September from less than
                                                                                                                                       +852 2822 2025
goes global                                                           RMB2bn in 2H09, according to the PBoC’s 3Q                       Sun Junwei
In June the PBoC expanded renminbi cross-border                                                                                        Economist
                                                                      monetary policy report (see chart 1). A total
trade settlement from Hong Kong, Macau and                            settlement value of RMB197bn was recorded by
ASEAN to all countries and domestically from                          end-September. The use of renminbi in imports
five cities (Shanghai, Guangzhou, Shenzhen,                           settlement topped RMB18bn, or 83% of the total
Dongguan, and Zhuhai) to 20 provinces. Since the                      settlement value, while exports settlement
pilot programme in July last year (see our report                     represented only 9%, due partly to impeded
of 6 July 2009, From greenbacks to ‘redbacks’:
                                                                      facilitation of export tax rebates. That said, as
China kick-starts plan to internationalise the
                                                                      procedures become more streamlined and trade
renminbi), the operation of renminbi settlement
                                                                      rebounds strongly, we expect the surge in renminbi
and clearance has been smooth, export tax rebate
                                                                      trade settlement to continue in the coming months.
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).

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, Shanghai, Guangzhou, Shenzhen, Dongguan
                            Jilin, Heilongjiang, Jiangsu, Zhejiang, Fujian, Shandong, Hubei, and Zhuhai
                            Guangxi, Hainan, Chongqing, Sichuan, Yunnan, Tibet, Xinjiang
Source: PBoC, HSBC

   China Economics                                                                                                        

   9 November 2010

 Chart 1. Monthly renminbi trade settlement surging        Chart 2. Strong potential for renminbi trade settlement with
                                                           emerging markets
 60     (RMB bn)
                                                           70    (%)
 20                                                        50
  0                                                        40

      Oct-09          Jan-10     Apr-10        Jul-10           95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
                                                                                EM countries' share in China's imports
               Value of renminbi trade settlement (Rhs)
                                                                                EM countries' share in China's ex ports
 Source: PBoC, HSBC
                                                           Source: CEIC, HSBC

Potential lies in non-G3
                                                          Secondly, as the emerging markets supply key
countries                                                 commodities or intermediate goods for assembly
As everything is ready to roll out to all countries,      before final shipment to the developed world, we
(versus only Hong Kong, Macau and ASEAN in                expect imports from these economies to account
the pilot scheme), we expect a further leap in            for an increasing share of renminbi trade settlement.
renminbi trade settlement. We see much potential
in the emerging economies (non-G3).                       Where to park the renminbi?
                                                          It is crucial to develop offshore renminbi products
Firstly, China has seen substantial growth in trade
                                                          and expanded channels by which foreign investors
with the emerging markets (chart 2). The imports
                                                          and enterprises may park their renminbi. Otherwise,
from these represent c70% of China’s total imports,
                                                          there is less incentive for the offshore investors
compared with 52% in the 1990s, while China’s
                                                          and enterprises to hold and trade in renminbi,
exports to these account for 55% of total exports,
                                                          especially when the trading volume becomes
higher than less than 50% in 1990s. The likelihood
                                                          sizeable. More importantly, to become an
of rapid growth in emerging markets in the coming
                                                          international currency, the renminbi must be used
years implies increased demand for China-made
                                                          widely for investment as well as for payment.
products. We expect more than half of China’s
total trade flows, primarily bilateral trade with         Therefore, we believe more measures are needed
emerging markets, to be settled in renminbi in the        in the coming quarters to facilitate offshore
next three to five years.                                 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

     China Economics                                                                                                 

     9 November 2010

local capital market in US dollars, the mini-QFII         Chart 3. A more flexible renminbi after de-pegging
scheme should be a separate renminbi-version of           6.85
the QFII that allows foreign investors to invest in
mainland capital markets through Hong Kong. It
is reported that technical obstacles have been
                                                           6.7         Announcement of de-
resolved in Hong Kong, and the scheme awaits
                                                                       pegging on 19 June
corresponding policies and measures from the              6.65
central bank and other regulators.

In addition, we expect further liberalisation and                Jun         Jul      Aug       Sep    Oct     Nov

opening up of the domestic market to give wider                                              USDCNY

access to foreign investors using renminbi. In theory,    Source: Reuters, HSBC

the areas opened to foreign investors should also
be accessible for overseas renminbi capital.             Moreover, the resumption of the renminbi exchange
                                                         rate reform should also fuel expectations of renminbi
Increased flexibility                                    appreciation, though the magnitude is likely to be
encourages use of renminbi                               much smaller than in the pre-crisis era. This should
Flexibility is the watchword after the resumption        give more incentive to the foreign trade partners
of renminbi exchange rate reform. Unlike its             to choose renminbi as the settlement currency.
handling of the previous crawling peg against the
                                                         In the long run, liberalisation of the renminbi
US dollar, the PBoC’s emphasis will now be on
                                                         exchange rate is a prerequisite for achieving the
referencing to a basket of currencies. Although
                                                         ultimate goal of making renminbi an international
the renminbi is likely to gradually appreciate
                                                         currency. The expansion of the renminbi trade
against many currencies, in the post-crisis era we
                                                         settlement programme comes right after the
are likely to see more volatility in renminbi, or
                                                         renminbi de-peg, implying the authorities’ resolve to
even temporary depreciation against the US dollar
                                                         speed up the renminbi’s internationalisation process.
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.

   China Economics                                                                                                   

   9 November 2010

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

This is an updated extract from an article originally   Ready, steady, go! Renminbi trade settlement goes       Donna Kwok
published on 22 July 2010                               global, 25 June 2010).                                  The Hongkong and Shanghai
                                                                                                                Banking Corporation Limited
What’s new                                              A renminbi interbank market created                     +852 2996 6621
Global roll-out of renminbi trade                       On 19 July, the PBoC and Bank of China (Hong            Qu Hongbin
settlement                                              Kong) Limited (BOCHK), the Renminbi Clearing            Chief China Economist
                                                                                                                The Hongkong and Shanghai
Geographical boundaries for the clearing of cross-      Bank, inked an agreement lifting the last               Banking Corporation Limited
                                                                                                                +852 2822 2025
border renminbi trade settlement transactions           restrictions on Hong Kong’s renminbi interbank
were significantly widened on 13 June 2010. This        market. This gave the green light to non-bank
came shortly after the People’s Bank of China           financial institutions to open renminbi accounts
(PBoC) and Hong Kong Monetary Authorities               without limits, enabling corporate, institutional
(HKMA) extended a scheme allowing companies             and individual retail investors to transfer funds
to settle trade contracts in renminbi with their        between renminbi accounts held in different Hong
counterparts in China from just those in Hong           Kong banks, for any purpose. But note: Beijing
Kong, Macau and ASEAN to companies in all               hasn’t thrown away all control – clearing with
countries, and domestically from five cities            mainland banks must still pass through BOCHK,
originally (Shanghai, Guangzhou, Shenzhen,              and can only take place for settlement of trade
Dongguan, and Zhuhai) to 20 provinces. In the           specific transactions.
first year of the original scheme total volume of       By allowing banks to circulate renminbi amongst
renminbi trade transactions jumped to more than         themselves on behalf of both retail and corporate
RMB10bn in March 2010 from less than RMB2bn             clients, a new platform has been created for renminbi
in 2H09. The success of the scheme has clearly          financial product development. Not only does this
spurred China’s timetable for speeding up               consolidate Hong Kong’s role as a renminbi
internationalisation of its currency. (See our note,

     China Economics                                                                                                      

     9 November 2010

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

          (RMB bn)






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

                                                   Value of renminbi trade settlement

  Source: PBoC, HSBC

offshore centre, but more importantly it also opens                  Key limitation: authorised institutions’
up new ways in which foreign investors can hold –                     ability to cater to demand will be capped
and thus invest in – the renminbi offshore.                           by their capacity to square their position in
                                                                      Hong Kong’s renminbi interbank market.
New Hong Kong renminbi
                                                                      BOCHK retains key control of renminbi
rules: the low-down                                                   supply flowing into the interbank market.
 All restrictions and caps lifted on the                             Renminbi supply (on a smaller scale) can also
  transfer of renminbi funds between different                        be deposited in the interbank system via
  renminbi accounts held within the same, or by                       renminbi trade settlement transactions and
  different, authorised financial institution(s).                     conversions made by personal and designated
                                                                      business customers within the
 Conversion limits unchanged for personal
                                                                      RMB20,000/day limit.
  and designated business customers at
  RMB20,000/day for renminbi deposit                                New platform for renminbi
  accounts for personal customers; up to                            product development
  RMB20,000 per transaction per person in
                                                                    The agreement signed by the PBoC and BOCHK
  banknotes for walk-in personal customers and
                                                                    revised the Settlement Agreement on the Clearing
  one-way conversion from renminbi to other
                                                                    of Renminbi Businesses in Hong Kong, an act that
  currencies for designated business customers.
                                                                    had previously forced all participant banks to
 Renminbi-denominated investment products,                         clear/settle any renminbi transactions for retail
  except for renminbi loans to personal customers                   accounts via BOCHK. Under the new rules,
  and designated business customers, can now be                     participant banks can now clear and settle
  offered by all financial institutions.                            transactions among themselves (subject to
                                                                    availability in the interbank market) – so creating
 Restrictions on opening of renminbi
                                                                    the first offshore renminbi interbank market.
  corporate accounts by non-bank financial
  institutions scrapped.                                            More critically, the lifting of this barrier means
                                                                    that the trading of renminbi investment products

   China Economics                                                                                                 

   9 November 2010

such as fund and life insurance offerings in Hong        number of offshore investors and enterprises
Kong is now possible.                                    willing to settle trades in renminbi will simply not
                                                         keep pace with the growth in numbers of willing
Banks in Hong Kong wasted no time in launching
                                                         and approved onshore enterprises – especially
a new renminbi structured products the day after
                                                         once trading volumes become sizeable.
the signing – which sold out within the first day.
Moreover, in a sign of things to come, banks have        To date, demand for renminbi settlement has been
also started offering more competitive preferential      heavily skewed towards imports settlement. Such
time deposit rates for customers who placed new          deals formed a large majority (83%, RMB18bn) of
renminbi funds with them. Fiercer competition for        total renminbi settlement value by the end of
renminbi deposits should spur faster accumulation        March 2010; exports settlement made up only 9%.
of renminbi in the local banking system. This new        Hiccups in the facilitation of export tax rebates are
pool of renminbi retail funds is also likely to          likely to have dampened onshore renminbi exports
intensify demand for pre-existing renminbi-              transaction demand, but stronger foreign trader
denominated products (e.g., renminbi bonds) and          appetite for the scheme would no doubt have
catalyze the introduction of other instruments           helped. As procedures become more streamlined,
such as renminbi-denominated QFIIs, which we             the export tax rebate issue should eventually be
expect to take off in the coming quarters.               ironed out. But for offshore demand to truly take
                                                         off, a system of attractive offshore investment
Pre-empting future
                                                         channels for China’s currency is critical.
The introduction of renminbi-denominated
                                                         Revving up the engine
investment instruments may be construed by some          Looking ahead, the frequency and size of Beijing’s
as an attempt by Beijing to attract offshore funds       steps towards renminbi internationalisation look set
back into Chinese equity markets. But such a view        to increase. China is currently the world’s largest
is misplaced – with 18% y-o-y growth in money            exporter and second-largest trader, seeing
supply in 1H10, the country is hardly strapped for       USD2.45trn worth of goods (88%) and services
cash. Given the recent resumption of renminbi            (12%) traded across its borders in 2009. The biggest
exchange rate reform (see It is all about flexibility,   potential for renminbi settlement lies in China’s
20 June 2010; From the Horse’s Mouth: PBoC               trade with non-G3 economies, most of which is
advisers on the renminbi de-peg, 22 June 2010),          settled in a third party currency – USD – rather than
China has more reasons to keep capital out, not in.      their own currencies. Based on our forecast that half
                                                         of China’s total foreign trade with those countries
Instead, we see Beijing’s efforts to support and
                                                         will be settled in renminbi within three to five years,
facilitate the introduction of renminbi-
                                                         even if we assume a modest average annual rate of
denominated products by Hong Kong financial
                                                         growth of 15% to 20% for trade (from 2003 to
institutions as an attempt to pre-empt a potential
                                                         2007, China’s annual trade growth rate averaged
bottleneck in the renminbi trade settlement
                                                         almost 30%), that would translate into annual
scheme. The development of offshore renminbi
                                                         renminbi-denominated trade flows of nearly
products expands the number of vehicles in which
                                                         USD2trn per year. This would make the renminbi
foreign investors and enterprises can park
                                                         one of the top three currencies in global trade.
renminbi earnings and funds. Without an
incentive to hold and trade in renminbi, the

     China Economics                                                                                             

     9 November 2010

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

This is an updated extract from an article           clearing banks and central banks, can participate.     Donna Kwok
originally published on 18 August 2010               Moreover, the PBoC will be holding on to its           The Hongkong and Shanghai
                                                     reins of control over such investments via quotas,     Banking Corporation Limited
Onshore RMB bond market                              though the exact details have yet to be clarified.
                                                                                                            +852 2996 6621
opens up to offshore funds                                                                                  Zhi Ming Zhang
                                                     We expect this move to accelerate the take up rate     Analyst
The People’s Bank of China on 17 August gave
                                                     of the RMB trade settlement scheme, which              The Hongkong and Shanghai
the green light for foreign central banks and all                                                           Banking Corporation Limited
                                                     picked up noticeably over 2Q and 3Q. Although          +852 2822 4523
RMB clearing banks participating in the RMB                                                       
                                                     the size of such flows will unlikely move markets
trade settlement scheme to enter its RMB20trn                                                               Yi Hu
                                                     just yet (from August to September, over               Analyst
onshore interbank bond market with immediate
                                                     RMB100bn of trade was settled in RMB, versus           The Hongkong and Shanghai
effect. This is the fourth move in less than two                                                            Banking Corporation Limited
                                                     the total of RMB 1.7trn of goods exported), the        +852 2996 6539
months by Beijing towards the eventual                                                            
                                                     closer these flows move towards critical mass, the
internationalisation of the RMB, and comes just a                                                           Daniel Hui
                                                     closer the RMB will move along the road to
month after the liberalisation of RMB transactions                                                          Currency Strategist
                                                     eventual reserve currency status.                      The Hongkong and Shanghai
in Hong Kong. Similar to last month’s move, this                                                            Banking Corporation Limited
change does not alter the existing capital account                                                          +852 2822 4340
                                                     Even with the accelerated schedule we pencilled in
regime, but is a critical (even incremental) step    for this process (See our note, Offshore renminbi      Qu Hongbin
towards full internationalisation of the RMB.        products take off, 22 July 2010), the move was more    Chief China Economist
                                                                                                            The Hongkong and Shanghai
                                                     aggressive than expected. This is because it opens     Banking Corporation Limited
An initial read of the rules indicate that only
                                                     up China’s onshore interbank market which              +852 2822 2025
offshore RMB obtained through existing primary                                                    
                                                     accounts for over 99% of all trading activities,
channels – trade settlement and central bank                                                                Sun Junwei
                                                     rather than the much smaller stock exchanges in        Economist
swaps – will be eligible, and only direct
                                                     which QFII investors can already invest in bonds, or
counterparties of such channels, namely RMB
                                                     in offshore RMB bond markets such as Hong Kong.

   China Economics                                                                                             

   9 November 2010

As such, we expect the pace at which new RMB-          to offer RMB-denominated products, barring certain
investment channels are being opened up to foreign     types of loans. Barriers to the free flow of RMB
RMB holders to further steepen.                        (between same/ different corporate/ institutional/
                                                       individual accounts) inside Hong Kong were also
Internationalisation of the
                                                       lifted, creating the first true offshore RMB products
RMB is maturing: from the first                        platform for foreign RMB holders.
to second of three stages
                                                       Then, in August 2010, stage two was pushed along
Beijing’s game plan for accelerating RMB
                                                       a second dimension in the on- as opposed to off-
internationalisation can be broadly defined in
                                                       shore direction. The PBoC opened the door to its
three stages. The first is to make the RMB a
                                                       RMB20trn onshore interbank bond market to
global trade settlement currency; the second an
                                                       foreign central banks, RMB-clearing banks in Hong
international investment/debt currency; and the
                                                       Kong and Macau as well as offshore institutions
third an international reserve currency. The world
                                                       with RMB accounts through participant banks of
is currently being coaxed along from stage one to
                                                       the RMB-trade settlement scheme. The opening of
stage two. Stage three, however nationalistically
                                                       this door provided a channel (albeit narrow) for
enticing, is still more symbolic than material at
                                                       foreign investors to a new world of onshore RMB
present. It will take many years before the RMB
                                                       investment options. Within weeks, Malaysia’s
attains the required characteristics of a reserve
                                                       central bank had put in an order for an undisclosed
currency. But the acceleration and contours of the
                                                       amount to fold into their foreign reserves. Since
process towards this goal will continue to surprise
                                                       then, official entry passes have also been granted to
markets, in our view.
                                                       local Hong Kong banks seeking entry into China’s
Stage one (turning the RMB into a global trade         interbank bond market.
currency) kicked off in June 2009 with the launch
                                                       In the end, all such moves are designed to step up
of the RMB trade settlement pilot scheme. But it hit
                                                       the pace of circulation of offshore, and ultimately
teething problems early on, with foreign traders
                                                       onshore, RMB held by foreign investors – with
reluctant to switch into RMB cash flows when
                                                       both circuits linked up via a channel tightly
buying from China for lack of attractive vehicles in
                                                       supervised by the PBoC. In closing this link, the
which to park RMB funds accumulated from/for
                                                       progress of each stage is heavily interdependent.
trade deals. To date, the growth in the number of
offshore enterprises willing to purchase mainland      With regard to the third stage of promoting the
exports in RMB significantly lags that of approved     RMB as an international reserve currency, this
onshore enterprises using RMB to settle import         move should be considered as more symbolic than
transactions. Year-to-date, Chinese importers make     material. The RMB still lacks (and will lack, for
up for 80-90% of RMB-denominated settled deals.        many years to come) many of the required
To address this imbalance, Beijing did two things:     characteristics of a reserve currency. Nonetheless,
1) loosen the geographical limits on the scheme by     the push and acceleration of the process towards
rolling it out to 20 mainland provinces/cities and     this goal will likely make forecasters pull in
the rest of the world in June 2010; and 2) kicking     projected timelines as to when markets might
off stage two a month later.                           expect the RMB to be a serious alternative as a
                                                       global reserve currency.
In July 2010, all Hong Kong financial institutions
received the green light to open RMB accounts and

     China Economics                                                                                                                 

     9 November 2010

From an FX perspective, it is important to                          Two key reasons drive Beijing’s preference for
recognise that the announcement does not change                     opening up its interbank bond market to offshore
the existing capital account regime in China. As                    RMB capital, in our view:
such, it will have little to no implication for the
                                                                    First is the need to close the widening US
supply and demand of USD-RMB and spot FX.
                                                                    Treasury and RMB government yield gap. After
China’s progress towards RMB
                                                                    crossing with the RMB government rate at around
internationalisation should be interpreted as
                                                                    3.6% (10-year) in April, the US Treasury
distinctly separate from capital account
                                                                    government rate continued to drop towards 2.6%,
liberalisation. As long as a consensus view of the
                                                                    in contrast to the long-end of RMB rates which
RMB being undervalued holds in Beijing, and
                                                                    edged down only slightly. Based on our forecast
policymakers continue to worry about the
                                                                    for low inflationary pressures and no rate hikes
potential for speculative capital inflows, we
                                                                    until 2012 at the earliest, demand needs to go up
emphasise that any move to further liberalise
                                                                    in China’s interbank bond market if the RMB
cross-border FX channels will be limited
                                                                    government yield is to be driven down further.
primarily to outflows.
                                                                    Second is Beijing’s agenda to push through the
One notable detail in the announcement was the
                                                                    recapitalisation of its banks. To supplement their
fact that central banks holding RMB obtained
                                                                    IPO fund raising activities (RMB300bn of which
through various FX swap agreements
                                                                    are still pending), the PBoC has also reversed its
(RMB803.5bn outstanding) signed in recent years
                                                                    drainage of liquidity from the interbank bond
have now also been granted access to China’s
                                                                    market into positive injections. Introducing more
onshore bond market.
                                                                    buyers into China’s interbank bond market should
Why Beijing decided to open                                         further boost these efforts.
its interbank bond market first                                     Implications for Hong Kong as
Compared to China’s smaller exchange or Hong                        an offshore RMB centre
Kong’s offshore market for RMB bonds, China’s
                                                                    Hong Kong’s role in the internationalisation of the
interbank bond market is more opaque. More
                                                                    RMB is not to function as the final stop for where
importantly, it is large enough to allow investors
                                                                    all RMB funds will be parked, but as a key inter-
to put on relatively bigger interest rate positions.

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

 60        RMB bn                                                     Hong Kong                                             58
 50                                                                   Singapore                    21

 40                                                                  Sw itzerland             12
 30                                                                    Indonesia          3
 20                                                                       Macau           2
 10                                                                        Japan          2
     0                                                                    Others          2                                 %
         Sep-09       Dec-09      Mar-10        Jun-10     Sep-10
                  Value of renminbi trade settlement (Rhs)                          0         15        30        45            60

 Source: PBoC, HSBC                                                  Source: PBoC, HSBC

   China Economics                                                                                                       

   9 November 2010

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

                                            Exchange                             Over 10yrs                  Less than
                                             market                                   15%                      1yr
                                               1%                                                              30%
    Interbank                                                            7yr - 10yr
                                                       Over the
     market                                                                 14%

                                              Others                         5yr - 7yr

                                               6%                               9%
                                                                                                          1yr - 3yr
                                                                                      3yr - 5yr

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

stop in Beijing’s wider game plan for                             debut sovereign RMB6bn bond at a yield higher
internationalising the RMB. The long-term goal is                 than its onshore borrowing cost last October.
for foreign holders of RMB to have the capacity
                                                                  Hong Kong received a unique first-mover
and desire to retain and invest their RMB funds
                                                                  advantage when the first offshore RMB-interbank
both in and out of the mainland, not to accumulate
                                                                  market was created there in July. The opportunity
it on one side of the border. Closing the on/offshore
                                                                  to position itself as a unique offshore launch-pad
RMB loop and keeping it flowing is key.
                                                                  for RMB products has effectively given Hong
But by opening up the onshore interbank RMB                       Kong’s financial services-driven economy a new
bond market to foreign buyers, is the PBoC                        lease on life. We estimate that about half of the
diverting demand away from Hong Kong’s own                        trade that China settles in RMB with emerging
nascent RMB bond market? Not really. First,                       countries (or USD1trn) could be transacted in
Hong Kong’s RMB bond market is also too small                     Hong Kong in the next three to five years.
to absorb bond flows on an institutional scale. As
                                                                  Hong Kong was the obvious choice in Beijing’s
of 30 September 2010, total RMB deposits in
                                                                  selection of its first offshore RMB centre for many
Hong Kong amounted to just under RMB150bn,
                                                                  reasons, including geographical proximity,
accounting for little more than 3% of total deposits
                                                                  economic ties, political/language/cultural
in Hong Kong. Second, Hong Kong’s RMB bond
                                                                  similarities, and internationally reputable and
market (ranging from bullet bonds to bank-issued
                                                                  competitive financial/legal/institutional systems.
certificates of deposit (CDs)) is still valued at only
                                                                  The last point is especially important from a
RMB40bn, barely a drop in the bucket versus the
                                                                  logistical standpoint as it lessens the amount of
potential pool of approximately RMB800bn that
                                                                  preparation that needs to be done in upgrading
foreign central banks can theoretically tap into
                                                                  existing financial/regulatory systems before each
from outstanding FX swap contracts. Third, Hong
                                                                  regulatory change or pilot programme is announced.
Kong’s RMB bond market tends to be
predominantly driven by retail investors, who                     For example, the Hong Kong Stock Exchange has
typically have a very limited appetite for bonds. In              yet to see its first RMB-denominated IPO but is
sum, liquidity is too low, and retail demand too                  reportedly ready for the first deal as soon as the
satiated in the territory’s RMB bond market.                      go-ahead is given. Offshore RMB bonds can also
Recall the Ministry of Finance had to issue its                   already be settled via Euroclear (as of

     China Economics                                                                                       

     9 November 2010

13 September), although the first such transaction    Ultimately, markets need more depth and scale if
has yet to take place.                                participants are to stop talking and start acting.
                                                      For the whole thing to take off in Hong Kong, we
The key impediment where speed is concerned
                                                      need to get sizeable flows going and institutional
traces back to regulatory hurdles. Access to the
                                                      investors moving. Although the retail demand for
onshore RMB bond market, for example, still
                                                      RMB products is there, the scale of institutional
requires a QFII (Qualified Foreign Institutional
                                                      demand and supply of RMB products remains
Investor) quota to be approved by the CSRC
                                                      negligible for two key reasons: a lack of
(China Securities Regulatory Commission), as
                                                      transparent and predictable channels to re-invest
does the remittance of RMB funds raised by
                                                      RMB funds back into the Chinese market and the
offshore bond issuances back into China. One of
                                                      limited ability of Hong Kong-based product
the reasons Beijing wants to retain an onshore
                                                      sellers to square their positions with BOCHK (the
market is to exert control over developments in a
                                                      clearing bank) as per their needs. Only once these
hands-on manner, but it looks like Beijing is
                                                      two criteria are addressed can a much larger-scale
doing a good job keeping a tight lid on activities
                                                      and more varied range of RMB product offerings
in offshore markets too. The expiration of the
                                                      be turned into reality.
Bank of China (HK)’s RMB conversion quota in
late October is a prime example. The imposition       RMB offshore products now on offer in Hong
of quotas, a necessity for case-by-case approvals     Kong can be broadly classified into the groups
for the remittance of RMB funds raised offshore,      below:
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.

    China Economics                                                                                                                                       

    9 November 2010

5. Offshore RMB products available in Hong Kong as of November 2010
Type                                 Date of Example                                                     Comments
                                   first deal
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.
Bonds            Corporate – FIs      Jul-07 China Development Bank Corporation. Coupon: 3.0%            Relevant rules currently only exist for financial institutions (FI)
                 incorporated in             p.a. Maturity: 2 years.                                     issuers incorporated in mainland China issuing in the CNH
                 mainland China                                                                          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 –          Jul-10 (1) Hopewell Infrastructure issued RMB 1.38bn. coupon:      No approval needed from either HK or China regulators for
                 foreign issuer              2.98%. Maturity: 2 years. (2) McDonalds issued RMB          issuing CNH bonds in HK, unless repatriation of proceeds into
                                             200mn. Coupon: 3.0% p.a. Maturity: 3 years.                 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
                 Sovereign           Oct-09 Ministry of Finance issued a total RMB 6bn in 3 tranches     Symbolically significant as it signalled the priority the Beijing
                                            on 2, 3, and 5yrs and coupon 2.25%, 2.7% and 3.3%            government is giving to the offshore development of RMB bonds.
                                            respectively                                                 The MOF issuance also established the first RMB sovereign yield
                                                                                                         curve outside China.
Structured                            Jul-10 BOCHK RMB leveraged structured deposit; HSBC equity         Typically linked to an underlying index that ranges from currency,
deposits                                     linked note. Various maturities and coupons.                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                          Late 2009 RMB insurance policies from Bank of China Group             Full potential has thus far been limited because insurers are
products                                     (BOCG) Life and China Life Insurance (Overseas).            restricted in their ability to locate assets with long-enough tenors
                                             Maturity: mostly 5-10 years, some for life. Premium         to match those of the policies they are offering. The ADB RMB
                                             payments for RMB-denominated savings insurance plans        bond’s 10-year tenor helps to alleviate this by setting the first long
                                             could be settled in RMB as of July 2010.                    term benchmark yield for future issuances of longer-termed
Investment                           Aug-10 Hai Tong Asset Management’s launched the “Haitong Global     Limited by the channels for re-investment into the mainland. The
funds                                       RMB Fund” with a RMB 5bn ceiling, to be sunk into overseas   introduction of rules allowing “RMB denominated mini QFII”,
                                            fixed income RMB products including notes and bonds.         possibly by year-end, could help catalyze the speed and depth of
                                            Actual sales to date have yet to reach the limit.            development for such funds.
Source: HSBC, Bloomberg

     China Economics                                                                                                           

     9 November 2010

Snapshot: China’s interbank                                       Central government and commercial banks are the
bond market                                                       two major issuers in the interbank bond market,
                                                                  followed by the PBoC. Their issuances account
China’s interbank bond market is the largest
                                                                  for 32%, 30% and 23% of total outstanding
onshore market for RMB bond issuance and
                                                                  bonds respectively.
trading. Of the total outstanding RMB20trn of
RMB bonds, around 92% stays in the interbank                      However, bank bonds and corporate bonds are
market. Bonds in China’s exchanges and OTC                        more active in the secondary market, making up
markets each accounted for 2% of the total as of                  37% and 25% of total trading activities in the first
end-July 2010.                                                    eight months of this year, with a turnover rate of
                                                                  2.3x and 3.6x respectively, compared to 1.8x and
By trading volumes, the interbank bond market
                                                                  0.6x for central bank bills and government bonds.
accounts for over 99% of total trading activities.
Year to date, total transaction volume stands at

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.

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

   China Economics                                                                                                

   9 November 2010

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

This is an updated extract from an article           swapline with China. It plans to draw RMB10bn           Qu Hongbin
                                                                                                             Chief China Economist
originally published on 29 October 2010              from it to help any AIs that need to settle RMB         The Hongkong and Shanghai
                                                     trade transactions immediately. This is to alleviate    Banking Corporation Limited
What has happened?                                   demand pressure for immediate transactions only,
                                                                                                             +852 2822 2025
Bank of China Hong Kong (BoCHK), the CNY             but does not necessarily represent a sustained source   Richard Yetsenga
                                                                                                             Global Head of EM FX Strategy
(aka RMB) designated trade settlement clearing       of RMB supply. Barring further changes, the trade       The Hongkong and Shanghai
bank, recently stated that its annual RMB8bn         settlement process in Hong Kong may slow in the         Banking Corporation Limited
                                                                                                             +852 2996 6565
settlement quota has been reached and that further   short term, although RMB can still be sourced from
trade settlement services to Participating           the CNH market.                                         Perry Kojodjojo
Authorised Institutions (AIs) cannot be provided.                                                            Asian FX Strategist
                                                     From a macro perspective, there seems to be a           The Hongkong and Shanghai
As far as RMB trade settlements goes, BoCHK is                                                               Banking Corporation Limited
                                                     widening gap between institutional demand for           +852 2996 6568
the only settlement agent between the banks in                                                     
                                                     the RMB and actual RMB trade settlement
Hong Kong and the PBoC, i.e. the only designated                                                             Donna Kwok
                                                     volumes, fuelled by rising expectations for the         Economist
clearing bank in Hong Kong. As such, it is one of
                                                     RMB’s appreciation. The immediate impact on             The Hongkong and Shanghai
the most significant channels for RMB to move                                                                Banking Corporation Limited
                                                     RMB trade business will likely be limited as the        +852 2996 6621
from the mainland to Hong Kong.                                                                    
                                                     HKMA has triggered its RMB200bn currency
According to the Deputy Chief Executive of the       swap agreement with the PBoC, offering
HKMA, since the trade settlement scheme started in   unlimited support to all RMB trade deals due for
July 2009 until the end of September 2010, BoCHK     immediate settlement. But supply constraints will
bought RMB4bn. This suggests that, interestingly,    set in for any non-trade related institutional
the remaining RMB4bn was bought in October           demand. Recent conversations with the PBoC
alone. To limit the short-term impact, the HKMA      indicates that it has no intention of slowing down
has announced that it has activated its RMB200bn     RMB cross-border trade. Moreover, the RMB

      China Economics                                                                                                    

      9 November 2010

 Chart 1. Record reserve accumulation in 3Q

 120,000                  USDm





            Jan-06              Jan-07                    Jan-08               Jan-09             Jan-10
                                              Reserves C hg                 Int'n

 Source: CEIC, HSBC

conversion quota under the scheme will likely be                   Broader considerations
increased, but before that happens, agency banks                   BoCHK’s quota exhaustion could simply be an
will need to tighten the process through which                     administrative speed bump on the road to RMB
institutional purchases of the RMB for non-trade                   internationalisation. Once addressed, the
purposes are filtered out. If the quota shortage                   explosive growth in the CNH market that had
proves to be entirely trade-driven, we expect                      been underway should return. It is also possible
Beijing to widen the quota. If not, once                           that there are broader forces at play – that the
unqualified use of the RMB trade settlement                        explosive growth in the CNH market has
system has been identified and stamped out, we                     prompted an intentional pause in the process of
expect Beijing to forge ahead with its longer term                 RMB internationalisation.
strategy for internationalisation of the RMB.
                                                                   Consider this: RMB internationalisation
FX takeaways                                                       presumably had some broader geopolitical
What this means in the short term                                  objectives, but is also designed ultimately to take
                                                                   some pressure off China’s balance of payments.
Given trade settlement was the key source of
                                                                   By creating a global pool of RMB, the intention
RMB flows into the CNH market, the current
                                                                   seems to have been to make domestic monetary
‘roadblock’ will result in USD-CNH moving
                                                                   management less exchange rate-sensitive. The rub
significantly lower. As stated in the HKMA press
                                                                   here, of course, is that in the market build-up
release, the daily RMB20,000 per day conversion
                                                                   phase, the RMB needs to come from China. There
by individuals remains unaffected since it runs via
                                                                   is no other source. Since the 19 July
a separate mechanism. In concert, the NDF curve
                                                                   announcement creating the CNH market, the
should also trade lower given the shift in the CNH
                                                                   volume and nature of trade settlement flows
market and the perception that parity pricing
                                                                   between the mainland and Hong Kong have
between the onshore and offshore curves will be
                                                                   changed fundamentally. Refer here to the
less forceful.
                                                                   suggestion that more than half of BoCHK’s trade
                                                                   settlement quota has been used in October alone.

   China Economics                                                                                                     

   9 November 2010

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

  6.9                                                                                                          6.85
 6.85                                                                                                          6.8
  6.8                                                                                                          6.75
 6.75                                                                                                          6.7
 6.55                                                                                                          6.55
  6.5                                                                                                          6.5
 6.45                                                                                                          6.45
  6.4                                                                                                          6.4
    Aug-10                                         Sep-10                                        Oct-10
                                                CNY         CNH

 Source: Bloomberg, HSBC

Previously, because the RMB was non-                         going forward. The narrow differential between the
transferable between entities outside China, the             RMB and CNH rates (Chart 2) in evidence through
take-up of trade settlement was tiny. This also              the latter stages of October is unlikely to return
meant that RMB flowed both out of China and                  anytime soon, therefore, and the NDFs are likely to
back in, through the trade settlement route.                 trade at a larger discount going forward.
Following 19 July, however, the volume of trade
                                                             Macro takeaways
settlement transactions increased sharply – now
you could actually do something with RMB                     Immediate impact on trade settlement
received. Moreover, rather than there being two-             limited
way trade settlement flows with the mainland,                If the HKMA’s pledge to support RMB trade
now there was only RMB coming out. With the                  transactions needing “immediate” settlement
CNH rate stronger than the onshore RMB rate,                 extends through year end, we expect limited
there is a natural incentive for RMB that comes              immediate impact on RMB trade settlement
out of China for trade settlement to remain in               business. However, supply constraints will kick in
Hong Kong. In addition, the 19 June de facto de-             for any institutional demand for the RMB that is
peg of the RMB has resulted in a return of                   not explicitly and clearly trade-related. If this
heightened RMB appreciation speculation. All of              shortage proves to be trade-driven, we expect the
these forces have resulted in sharply higher                 annual RMB conversion quota to be widened to
demand for RMB trade.                                        further facilitate development of the RMB as a
                                                             global trade settlement currency. If not, once any
Settlement, and consequently much stronger RMB
                                                             unqualified use of the RMB trade settlement
demand from the mainland. Notice here the record
                                                             system has been identified and stamped out in the
rate of reserve accumulation in 3Q in China
                                                             short run, we expect Beijing to continue with its
(Chart 1).
                                                             longer term strategy for RMB internationalisation.
On this basis, the latest step is likely to be an            After all, this not the first, nor will it be the last,
intentional effort to temper the recent exponential          time that the Chinese authorities have dealt with
pace of market growth. It is certainly not a total halt,     upward pressure on the currency. To date, it has
but we expect this to proceed much more cautiously

     China Economics                                                                                           

     9 November 2010

never derailed a national strategic priority on the     Post-QE2, the PBoC will likely raise the vigilance
scale of the RMB internationalisation process.          with which it filters out institutional purchases of
                                                        the RMB for non-trade purposes under the RMB
RMB trade settlement to remain a
                                                        trade settlement scheme. That said, the PBoC has
long-term strategic priority for Beijing
                                                        no intention of slowing down RMB cross-border
Institutional demand for RMB has been surging at        trade, which means that once the filtering process
a pace well beyond the initial expectations of both     is refined, the annual RMB conversion quota
the Chinese authorities and financial markets in        system will likely be renewed and the RMB
recent months, fuelled by the global roll-out of the    internationalisation process set back on course.
trade settlement scheme in June, the launch of the
CNH market in Hong Kong in August, and rising           If the bulk of institutional demand for the RMB
expectations for RMB appreciation.                      under the trade settlement scheme proves to be
                                                        legitimately trade-related, we think it will be seen
We define Beijing’s game plan for accelerating          by Beijing as a green light to step harder on the
internationalisation of the RMB in three stages.        accelerator in its drive to internationalise the
The first is to make the RMB a global trade             RMB. But if non-trade pressures were the primary
settlement currency; the second to make it an           reason for the earlier than expected quota expiry,
international investment/debt currency; and the         then Beijing will use this as a means to impose
third to make it an international reserve currency.     supply constraints on institutional demand for the
The world is today being coaxed along from stage        RMB that do not conform with its longer-term
one to stage two.                                       plans for internationalising the currency.
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.

   China Economics                                                                                                    

   9 November 2010

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

This is an updated extract from an article               first five cities allowed to participate in the pilot   Qu Hongbin
                                                                                                                 Chief China Economist
originally published on 6 September 2010                 programme of renminbi cross-border trade                The Hongkong and Shanghai
                                                         settlement launched in July 2009. Since then,           Banking Corporation Limited
The Shanghai municipal government has                                                                            +852 2822 2025
                                                         renminbi cross-border trade settlement in Shanghai
published a circular on promoting renminbi
                                                         accounts for nearly 50% of the national total.          Sun Junwei
settlement in the city. On top of more efforts to                                                                Economist
facilitate renminbi cross-border trade settlement,       More importantly, by allowing trial renminbi
Shanghai is also encouraging trial renminbi              settlement in overseas project financing and direct
settlement in capital accounts, including overseas       investment, Shanghai’s move will give a further
project financing in renminbi, direct overseas           boost to renminbi internationalisation. On the one
investment in renminbi and other trade-related           hand, there is a surging need for renminbi trade
renminbi settlement items within the capital             settlement in overseas markets, in particular after
account. This is a further step allowing outward         June’s expansion of renminbi cross-border trade
direct investment (ODI) in the renminbi after the        settlement to 20 provinces with all trading
green light was given to inward renminbi                 partners (see Ready, steady, go! Renminbi trade
investment in the domestic bond market for               settlement goes global, 25 June 2010). On the
foreign central banks and trade clearance banks          other hand, trial renminbi settlement for overseas
(see Hong Kong Economic Spotlight: Completing            project financing and direct overseas investment
the on/offshore RMB circle, 18 August 2010).             implies more renminbi supply offshore, matching
                                                         the rising demand for renminbi offshore. Note that
By encouraging wider renminbi settlement business,
                                                         there is big potential in emerging markets, as they
from cross-border trade to overseas renminbi direct
                                                         have been the main destination for China’s rapidly
investment and project financing, Shanghai wants to
                                                         rising overseas direct investment (USD48bn for
further sharpen its competitiveness to become an
                                                         non-financial overseas direct investment, or 48
international financial centre. Shanghai is one of the

     China Economics                                  

     9 November 2010

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.

   China Economics                                                                                               

   9 November 2010

Connecting the dots for
RMB internationalisation

This is an updated extract from an article                connects with and lays the foundation for the     Zhang Zhi Ming
originally published in The View, 6 August 2010           rest of the actions.                              The Hongkong and Shanghai
                                                                                                            Banking Corporation Limited
Summary                                                Moreover, the liberalisation of interest rates is   +852 2822 4523
 The campaign for the use of the renminbi              a relatively low risk initiative compared with
  (RMB) in cross-border trade settlement                the rapid expansion of exchange rate
  should be complemented by a similar drive             flexibility or the opening of the bond market.
  for a further and faster build-up of the RMB         We believe concerns over the potential
  bond market. The accumulation of RMB                  adverse consequences of liberalising loan
  offshore will create demand for safe and              rates are overblown, since the percentage of
  liquid RMB assets, while the build-up of such         loans extended at, below or above policy rates
  a liquid market will prompt wider adoption of         has remained stable throughout the recent
  the RMB in trade and beyond.                          credit easing and tightening cycles.
 The expansion of the offshore RMB bond               In the US, the liberalisation of bank deposit
  market in Hong Kong gives the mainland                rates in the 1970s and 80s did not squeeze
  market 3-4 years of build-up time while               bank interest margins either, but led to a
  absorbing initial offshore RMB holdings. The          much-desired and significant increase in non-
  issuance of sovereign RMB bonds will be               interest or fee earnings instead.
  critical in signifying Hong Kong’s status as
  the offshore RMB centre.                             We believe current controls on bank interest
                                                        rates choke bond market liquidity, as market
 However, the continued accumulation of                turnover peaked at less than 100% of market
  offshore RMB will bring pressure to open the          cap (vs. 20x in US), despite efforts to improve
  domestic RMB bond market, improve market              liquidity such as the launch of SHIBOR, the
  liquidity, liberalise the exchange rate and             regular auction of treasury benchmarks, and
    interest rates, and loosen capital controls – a       mark-to-market requirements.
    chain of interconnected actions essential for
    RMB internationalisation.                          Liberalising interest rates now has an added
                                                        benefit: since the latest rate action in
 Liberalising local interest rates or ending the       December 2008, bond yields have shot up 50-
  two-tier rate system (i.e., policy-driven bank        100+bps across the curve, suggesting that
  loan/deposit rates vs. market-driven bond               rates in the banking system have yet to catch
    yields) is at the heart of the build-up as it         up with the market. The further easing of

     China Economics                                                                                           

     9 November 2010

      administrative control over bank interest rates   condition for RMB internationalisation. Each of
      should be part of the “market-based tools” in     the more recent trio of initiatives – i.e.,
      fine-tuning the economy, in our view.             developing the offshore RMB bond market, the
                                                        signing of multiple RMB swap contracts with
A long march
                                                        China’s trading partners, and the launch of large-
In anticipation of its growing economic power in        scale use of the RMB in cross-border trade –
GDP terms and import-export trade volumes,              complement one other and could lift the offshore
China has initiated a series of carefully planned       circulation of the RMB to a new level, in our view.
initiatives to promote the RMB
                                                        Given the convenience and efficiency whereby
internationalisation in coming years and recently
                                                        much of the foreign exchange risk can be
has picked up the pace of this endeavour.
                                                        circumvented, plus the tax rebate incentives offered
An accelerating pace                                    by the government, up to USD2trn of trade led by
Figure 1 shows some key developments in the             Chinese firms could be settled in RMB within three
RMB internalisation endeavour since the 1990s.          years, according to an estimate by our Chief China
As early as 1993, the People’s Bank of China            Economist, Qu Hongbin. This would represent a
                                                        major milestone for the officials that promote the
(PBoC) signed agreements with the central banks
                                                        initiative. Unlike the RMB-USD de-peg in July
of eight neighbouring countries for the use of
                                                        2005, which invited controversy both inside and
RMB in bilateral trade settlement, although of
                                                        outside China, the use of the RMB as a trade
limited scale. The pace of the substantive
                                                        settlement currency has received nearly universal
promotion of the RMB for circulation outside the
                                                        endorsement, suggesting the trillion-dollar mark
mainland picked up in 2003 when individuals in
                                                        could be reached in a short period of time.
Hong Kong and Macau were allowed to freely
exchange and remit RMB (with daily limits).             RMB swap: not for emergency liquidity
                                                        With the exception of Hong Kong, recently signed
The de-pegging of the RMB from the USD in
                                                        RMB bilateral swap contracts between the PBoC
mid-2005, which resulted in a steady (or
                                                        and its counter-parties since December 2008 are
controlled) appreciation of 20% in the RMB value
                                                        very different from those signed from 2001 to 2003.
against the USD, was another major milestone in
                                                        Figure 2 provides a summary.
RMB internationalisation. It raised the profile of
the RMB as an attractive currency with steady           The average size of recent RMB swap contracts is
value and potential for appreciation – a necessary      about 10 times as large as the average size of the

 Figure 1. Development of the China bond market

 Source: HSBC

    China Economics                                                                                                                  

    9 November 2010

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

old ones. More importantly, the purpose of the                     years of extra time to build up the local market
contracts has been gradually shifted away from the                 that ultimately requires the full liberalisation of
provision of emergency liquidity to normal                         RMB interest rates and exchange rates.
operational use. In fact, only the use for trade
                                                                   Offshore bond market yet to grow
settlement is highlighted in the most recently
signed RMB swap contract with Argentina in April.                  The total size of the Hong Kong RMB bond
                                                                   market (the only offshore market developed since
Where it’s heading…                                                2007) was RMB40bn at the end of 3Q10. It is
RMB swap contracts will provide initial funding                    very small relative to Hong Kong’s RMB deposit
for the use of the RMB for cross-border trade                      base of RMB149bn and annual trade flows of
settlement. However, as offshore RMB holdings                      RMB3trn. Beijing is encouraging more issuance
increase over time, the pressure for places to park                of bonds, especially by mainland banks (including
them in liquid and safe RMB assets will build up.                  foreign-owned) subsidiaries in Hong Kong which
Figure 3 shows how we envisage the process                         might need RMB funding to provide trade
might unfold from here.                                            settlement and trade financing services.

The initial “parking lot” for offshore RMB in the                  In addition to quantity, sovereign issuance by the
coming 3-4 years will be the offshore RMB bond                     Ministry of Finance (MOF) will be critical for
market in Hong Kong. As the domestic bond                          establishing a genuine offshore benchmark and
market remains closed, the mainland gets 3-4                       signifying Hong Kong as the offshore RMB
                                                                   centre where offshore RMB accumulated

 Figure 3. Where it is heading...

 Source: HSBC

     China Economics                                                                                                        

     9 November 2010

elsewhere via trade could seek refuge before they         rate arbitrage, where onshore RMB yields are much
are allowed to invest in the onshore market.              higher than their offshore counterparts as the RMB
                                                          spot rate is still under government control and is
On the demand side, we should expect more
                                                          priced lower than what the offshore NDF markets
institutional buying, especially from non-bank
                                                          imply. This shows the inseparable interdependence
offshore companies engaged in RMB trade
                                                          of interest rates and exchange rates.
settlement who can now open RMB accounts and
buy bonds offshore.                                       The good news is that the use of the RMB in
                                                          cross-border trade settlement may kick-start a
We expect that the size of the RMB bond market
                                                          chain of events that could help expedite the
in Hong Kong could grow well above RMB100bn
                                                          structural reform process. Liberalising interest
over the next 3-4 years, by which time:
                                                          rates in the banking system, as highlighted in
 Cross-border RMB trade settlement should                Figure 3, is of relatively low risk and should take
  already have been extended to all direct                precedence over others, in our view.
  trading partners beyond those under the pilot
                                                          Market-driven bank interest
  programme, and may even draw interest from
  entities not trading directly with China, and
                                                          Domestic interest rate liberalisation is at the heart of
 Pressure to access the local RMB bond
                                                          the structural issue as it relates to the extent of
  market is likely to have built up, while the
                                                          flexibility in exchange rates (via on- and offshore
  domestic market should be more resilient as
                                                          interest rate differentials) and domestic credit
  controls over local interest and exchange rates
                                                          allocation, hence bond market liquidity, in our view.
  are likely to have eased further.
                                                          Slow and cautious…
Revisiting some difficult tasks
                                                          An overwhelming percentage of China’s domestic
Rising offshore accumulation of RMB as a result
                                                          credit allocation is still intermediated via the
of cross-border trade may trigger a chain of
                                                          banking system, as shown in Figure 4. Stripping
interconnected actions involving some difficult
                                                          away PBoC bills (used for mopping up onshore
structural issues in the local bond market’s
                                                          liquidity), bank loans account for more than 90%
development, in our view. These interconnected
                                                          of total credit lending.
and inevitable actions include: the opening of the
RMB bond market, the liberalisation of RMB                 Figure 4. Interest rates driven by policy vs markets

interest rates and foreign exchange rates and the                                Financial Corp bonds
loosening of capital controls, all of which are             Market-                                            Short-term
                                                                                     Bonds    4%
                                                            driven                                                loan
necessary for the internationalisation of the RMB.                                    9%
                                                            yields                                                29%
                                                                        Gov t bonds
At least at the technocrats’ level, we believe that                            11%
Beijing is fully aware of these structural deficiencies                                            Policy-
that must be resolved before the RMB can become                       PBOC bills
                                                                                                    rates     Medium
an international currency. For example, RMB funds                          8%
                                                                                                             -and long
obtained via the QFII (Qualified Foreign                                                                     term loan
Institutional Investors) programme are largely                                                                 39%
geared toward investing in the local A-share or            Source: CEIC, CDC

equity markets to prevent on- and offshore interest

   China Economics                                                                                                                                              

   9 November 2010

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

 Source: HSBC

As such, reforms to liberalise domestic interest                    Other than the recent drop in the minimum
rates in the banking system have been extremely                     mortgage rate for first-time homebuyers as part of
cautious and slow. Figure 5 summarises the key                      the government’s aggressive stimulus policy,
developments in interest rate liberalisation over                   there has been little progress in further liberalising
the last 26 years.                                                  interest rates in the banking system over the last
                                                                    five years. The lack of progress in easing interest
Overblown concerns
                                                                    rate controls clogs developments in bond market
The path to liberalising bank loan and deposit                      liquidity, the adoption of interbank interest rate
rates has been long and treacherous, with                           swap (SHIBOR) and FX forward markets, even
restrictions tightened up after easing in 1996 (see                 though the risk of interest margin squeezes has
Figure 5). The path is consistent with similar                      eased as banks become more risk conscious, in
experiences elsewhere. For example, Korea flip-                     our view.
flopped twice in the 1980s before full interest rate
liberalisation. In the case of China, it has taken                  Stability of actual loan rates
time for banks, which originally were all 100%                      Since 2004, banks have been allowed to apply a
state-owned policy vehicles, to develop a risk                      maximum 10% discount relative to policy loan
management culture. The extremely slow and                          rates while being free to float rates above policy
cautious approach stretching over two decades has                   rates at any level.
served that purpose, in our view.                                     Figure 6. Distribution of actual loan rates

Little progress since 2004                                                         %
By 2004, other than the maximum deposit rate                           80
and minimum loan rate across tenor, all other                          60
aspects of interest rates had been liberalised. The                    40
maximum deposit and minimum loan rates have                            20
been kept to insure bank interest earning margins                       0








during a sensitive period in which the majority of
the former state-owned banks were in the process
                                                                            As Benchmark                    10% below                        10% abov e
of initial public offerings.                                                10-30% abov e                   30-100% abov e

                                                                      Source: CEIC, HSBC

     China Economics                                                                                                                                          

     9 November 2010

 Figure 7. Policy loan rates during tightening and expansion     Figure 8. Loan quantity during tightening and expansion
 cycles                                                          cycles

   8                                                             2,000
   7                                                             1,500
 5.5                                                               500
 4.5                                                                  0








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

           6M       12M         1-3Y         3-5Y         5Y+                           China new bank loans (RMB bn)

 Source: PBoC                                                    Source: Bloomberg

Figure 6 shows the distribution (or percentage) of              How about deposit rates?
actual loan rates at (=1), below (<1, where rates               Deposit rates could be more vulnerable to
can be up to 10% lower than policy rates) or                    excessive competition among banks looking to
above (>1, where there is no upside limit) for all              increase their retail funding. As such, deposit rates
commercial banks in China since 1Q07.                           are usually the last leg in the full liberalisation of
                                                                interest rates. The experiences of the US, Japan
This time period captured a persistent credit
                                                                and Korea all share this feature. However, upon
tightening cycle, followed by a rapid easing cycle
                                                                fully liberalising bank deposit rates, there was
where both policy loan rates (see Figure 7) and
                                                                little evidence that bank interest margins were
loan quantity (see Figure 8) experienced large
                                                                squeezed materially.
fluctuations. Throughout the cycles, the
distribution of actual loan rates appeared to be                 Figure 10. Steady US interest margin

highly stable, suggesting that banks are largely                 15%
risk-conscious over the cycles.                                                        Interest-rate
                                                                 10%                 liberalization
For example, there is little evidence of a large                                             in the US
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
                                                                          34 39 44 49 54 59 64 69 74 79 84 89 94 99 04 09
an attempt to shore up interest earnings when loan                             Av erage lending rate    Av erage deposit rate
quantity declines.                                                             Differential

                                                                 Source: FDIC, HSBC
On the flipside, competition for loan business has
not resulted in a large increase in the proportion of           Figure 9 shows that in the case of the US, interest
loans offered at discount over policy rates in                  rate margins held steady at around 4% to 5%
either cycle. Although the effect of removing                   during the deposit rate liberalisation period over
minimum loan rates remains unknown, evidence                    the 1970s to 1986, and might have edged a bit
suggests that a further easing of downside                      higher overall since 1970.
restrictions on loan rates may not entail too much
systemic risk due to excessive price competition.

   China Economics                                                                                                                        

   9 November 2010

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

 40%                  Interest rate                                 40%        36%        35%                                       34%
                  liberalization                                                                            29%
                                                                                                                   26%       27%
 30%                    in the US                                   30%
 20%                                                                20%                                           14%
                                                                              11%       12%     12%     11%
 10%                                                                10%

  0%                                                                 0%

       34 39 44 49 54 59 64 69 74 79 84 89 94 99 04 09                        2003       2004   2005     2006     2007      2008   2009
          US commercial bank non-interest income as % of total                            China NII/OI        US NII/OI

 Source: FDIC, HSBC                                                 Source: FDIC, HSBC

Interestingly, there has been a steady increase in                 Bond market liquidity trapped…
the percentage of non-interest or fee earnings for                  Figure 12. RMB bond market size and annual turnover
US banks since 1970, suggesting a desirable                                         RMB bn
consequence of interest rate liberalisation:
competition has resulted in low-risk fee earnings                   15000

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),                          0
roughly in line with the ratio for US banks during                            98 99 00 01 02 03 04 05 06 07 08 09 10
the interest rate liberalisation process over the                                             Outstanding       Turnov er
1970s to early 1980s, but much lower than the                       Source: ADB, HSBC

post-liberalisation average of 20-36%. The
comparison gives a bit of comfort or at least eases                100%, of the market size throughout the last
some concern about the consequence of liberalising                 decade and is trending down after some
bank deposit rates in China: current fears might be                improvements since 2007.
overblown, and more deposit rate liberalisation,
                                                                   Turnover compares miserably with government
starting with large-denomination RMB deposits,
                                                                   bond market turnover in the UK and US, where
could be rolled out sooner rather than later.
                                                                   turnover ratios vary from around 5x to 25x (see
In search of a liquid asset                                        Figures 13 and 14), respectively.
Liquidity is another critical attribute much desired               Whether by design or by accident, the deep, open
by potential RMB holders. Neither the onshore                      and liquid US bond market serves as a magnet
nor the offshore RMB bond market is liquid yet                     that draws in huge investments and underpins the
by any measure.                                                    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.

      China Economics                                                                                                                

      9 November 2010

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

    50                                                             10

    40                                                              8
    30                                                              6

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

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

    Figure 15: Bid-offer spreads of government bonds (2009)    3        Encouraging more non-bank institutional
         6                                                              holdings of bonds
         5                                                     4        Efforts to reconnect the interbank vs.
         4                                                              exchanges bond trading platform

                                                               5        Improving the bond price quoting system, and
                                                               6        The launch of SHIBOR to facilitate hedging
                                                                        interest rate risk
                   US            Korea            HK   China   However, as shown in Figure 12, these initiatives
                                                               only lifted market turnover by a limited amount,
    Source: ADB, HSBC
                                                               peaking at less than 1x market size.
Bid-offer spreads also indicate extremely poor                 The main reason, in our view, is the dominance of
liquidity conditions in the RMB bond market as                 bank lending (see Figure 4) where interest rates
compared to its counterparts in Korea, Hong                    are still under administrative control. As such,
Kong and the US (see Figure 15). Moreover, bid-                rates in the secondary bond market only play a
offer spreads in the China bond market are highly              shadow role in credit allocation, therefore bond
unstable, which creates another level of                       trading and instruments such as SHIBOR only
uncertainty that reduces incentives to trade.                  serve to manage exposure to the shadow rates
Need market-driven rates to unlock…                            rather than the main rates that really affect the
                                                               majority of the lending.
The authorities in Beijing are fully aware of the
poor liquidity of China’s domestic bond market                 The limited growth over time in the volume of
and have made efforts to improve matters. The                  SHIBOR (designed to be the Chinese version of
recent efforts include:                                        LIBOR) contracts despite the government push is
                                                               another good example.
1        Regular issuance of key benchmark treasury
         (MOF) bills and bonds

2        Mandatory requirement for mark-to-market
         trading book using fair market value

   China Economics                                                                                                             

   9 November 2010

Reserve currency: still                                          Figure 17. Overseas holdings of Gilts

decades away                                                     40

The end-game for RMB internationalisation is for                 35

the RMB to become one of the international                       30
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
                                                                      1996 1997 1999 2000 2002 2003 2005 2006 2008
and liquid RMB asset markets, liberalising                                           Ov erseas holdings %
interest rates and the RMB exchange rate, and                    Source: UK Debt Management Office

removing foreign exchange and capital controls,
China needs to allow large foreign holdings of its               Large foreign holdings of domestic bonds also
domestic bonds while reducing its own holdings                  pose significant foreign exchange and interest rate
of foreign currency reserves in the long term.                  risk, reducing the effectiveness of domestic
                                                                monetary policy and the functioning of the real
While China has yet to allow any meaningful
                                                                economy. This is a price to pay for becoming an
holdings of domestic RMB bonds by foreign
                                                                international reserve currency and a deep and
countries, Figures 16 and 17 show that foreign
                                                                resilient domestic bond market is required to
ownership of US and UK bonds is rising and
                                                                buffer against any adverse shocks.
account for 30% and 35% of the total amount
outstanding, respectively. Although the recent                  It could take decades before offshore entities are
sharp rise may not be sustainable, there is no                  able to hold substantial amounts of domestic
question that significant foreign ownership of                  RMB bonds, and from that perspective it could
domestic bonds underpins the popularity and                     take a long time before the RMB can become a
reserve currency status for both the US dollar and              genuine international reserve currency.
the British pound.                                              On the flipside of the issue is domestic holdings
 Figure 16. Overseas holdings of US Treasuries                  of foreign reserves. Figure 18 shows the current
                                                                imbalance in levels of foreign reserve holdings by
                                                                China vs. the US, UK and eurozone.
 20%                                                             Figure 18. Domestic holdings of foreign reserves (May 2009)
                                                                  USD bn

       00       01   02   03    04    05   06    07   08   09
                     Foreign ow nership of UST (%)                         1000

 Source: CEIC                                                              500

                                                                                     US              UK   Eurozone   China

                                                                 Source: Bloomberg

     China Economics                                                                                                    

     9 November 2010

As a competing alternative reserve currency to the      Lastly, accelerating interest rate liberalisation now
USD and others, China must reduce its holdings          would have the added benefit of helping to fine-
of foreign reserves where, by default, outsized         tune the economy.
holdings of foreign reserves signifies the reserve
                                                        Out of touch
status of other currencies while weakening the
importance of the RMB in relative terms. To             Figure 19 shows bank rates vs. the government
narrow the gap, China needs to change the nature        bond yield curve as of 22 December 2008 (the last
of its real economic structure (i.e., shift away        time the PBoC cut policy rates) and now.
from being an export-driven economy), which               Figure 19. China deposit/loan rate vs government bond
may take decades to achieve.
                                                         7       %
Now is a good time…                                      6

Long-term issues aside, we think now is a good           5
time to expedite a further easing of interest rate
controls, which could eventually lead to the full        2
liberalisation of bank loan and deposit rates.           1
First, liberalising interest rates is at the heart of
                                                             0              6          13      19            25
the developing and strengthening of China’s                            Deposit                      Lending
financial system, including the internationalisation                   Yield (Nov -2010)            Yield (Dec-2009)
                                                          Source: Bloomberg, CDC
of the RMB as it connects with RMB exchange
rate and RMB bond market liquidity. From the
                                                         Bond yields have shot up 50-100+bps across the
perspective of policy consistency, one cannot
                                                        curve since the last rate cut, while bank loan and
have widespread adoption of the RMB as an
                                                        deposit rates remain identical and “out of touch”
international currency without having a relatively
                                                        with the bond market reality.
open and liquid bond market.
                                                        The market reality (outside the banking system) is:
Second, the further easing of interest rate controls
would be a relatively low risk initiative in             China’s MOF failed in three government debt
comparison with a rapid expansion of exchange                 auctions in a two-week period in early July
rate flexibility or opening up the local bond
                                                         The PBoC resumed the issuance of 1-year
market. Moreover, as we argued earlier, removing
                                                          bills on 9 July after an eight-month
restrictions on loan and deposit rates may not
                                                          suspension to help drain cash at banks, and
trigger an excessive bank interest margin squeeze,
and may even have the desirable consequence of           1-year RMB T-bill yields have hit 1.66%, the
inducing more fee-based earnings for banks.               highest in 2009 and 49bps higher than they
                                                          were immediately post the latest bank rate cut.
Third, the further easing of interest rate controls
could be a long process with many twists and            Rates in the banking system have yet to reflect
turns, and therefore should start as early as           market concerns that China’s RMB4trn stimulus
possible, at least before the internationalisation of   might be causing bubbles in stock and housing
the RMB hits a wall when offshore RMB holders           markets, forcing monetary policy down the road.
become frustrated by the lack of places to park         If bank rates are fully liberalised, they could have
their RMB holdings.

   China Economics                                     

   9 November 2010

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.

     China Economics                                                                                                 

     9 November 2010

Disclosure appendix
Analyst Certification
The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the
opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their
personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific
recommendation(s) or views contained in this research report: Hongbin Qu, Donna Kwok, Zhi Ming Zhang, Daniel Hui, Yi Hu,
Richard Yetsenga and Perry Kojodjojo

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   9 November 2010

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Qu Hongbin is Managing Director, Co-Head of Asian Economic Research, and Chief Economist for Greater China. He has been an
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Sun Junwei

Sun Junwei is an economist for China in the Asian Economics team. Prior to this, she worked as an economic analyst at a leading
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from Peking University.

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