1

Offshore RMB development in Hong Kong: A look into the Eurocurrency experience

Ricky ChoiSenior Research AnalystEABFU

The views and analysis expressed in this paper are those of the author, and do not necessarily represent the views of the Economic Analysis and Business Facilitation Unit.

2

Outline

Eurocurrency market development

Eurodollar’s ‘success’ and USD’s strong international status

Other factors driving Eurodollar and Euroyen marketdevelopment

RMB’s potential as an international currency and theassociated costs and benefits

RMB business in Hong Kong and Hong Kong’s role in RMBinternationalisation

3

Eurocurrency (Eurodollar and Euroyen) market development

4

Defining the Eurocurrency marketBank loans to/deposits from

Residents Non-residents

A B

C D

A: Domestic banking: Residents in domestic currency

B: Traditional foreign banking: Non-residents in domestic currency

C+D: Eurocurrency banking: Both residents and non-residents in foreign currency

B+D: International banking: Non-residents in both domestic and foreign currencies,but do not include all Eurocurrency transactions

Domesticcurrency

Foreigncurrency

5

Estimating Eurocurrency market size: Using BIS data

Bank loans to/deposits from Residents Non-residents

A B

C D

Domesticcurrency

Foreigncurrency

In early years, BIS estimated the net size of Eurocurrency market(EC) which had been adjusted for interbank activities (e.g.redeposit by banks) to prevent overestimation

However, it is no longer available after 1980. The external andlocal positions in foreign currency are used to estimate theEurocurrency market size

1964-66, 1968:

1967, 1969-80: EC

Starting from 1981:

EC: Net size of Eurocurrency market (C+D), Local(FC): Local positions in foreign currency (C), Ext(FC): External positions in foreign currency (D)

( )19801977)()(

)()(_.−

⎟⎟⎠

⎞⎜⎜⎝

⎛

+×+=

FCFCFCFC LocalExt

ECLocalExtECEst

196720101977)(

)()()(

20101977)(

)()()(_.

⎟⎟⎟⎟⎟⎟

⎠

⎞

⎜⎜⎜⎜⎜⎜

⎝

⎛

⎟⎟⎠

⎞⎜⎜⎝

⎛×+

×⎟⎟

⎠

⎞

⎜⎜

⎝

⎛⎟⎟⎠

⎞⎜⎜⎝

⎛×+=

−

−

FC

FCFCFC

FC

FCFCFC

ExtLocal

ExtExt

ECExt

LocalExtExtECEst

Similarly, the Eurodollar and Euroyen market size are also estimated based on the above method

6

Eurocurrency, Eurodollar and Euroyen market size

- Eurodollar accountedfor over 80% of theEurocurrency marketin the early days

- Declined to around60% after mid 1990s

- Euroyen accountedfor just 7.5% at itspeak in 1999

*The data coverage of Eurocurrency/Eurodollar markets expanded significantly in 1983 to include a number of financial centres, suchas Hong Kong, Singapore, and Cayman Islands etc

Eurocurrency and Eurodollar markets*

0

2,000

4,000

6,000

8,000

10,000

12,000

1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 20080%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%US$ billion

Eurodollar's share ofEurocurrency market (RHS)

Other Eurocurrencies (LHS)Euroyen (LHS)Eurodollar (LHS)

Euroyen's share of Eurocurrencymarket (RHS)

Source: Bank for International Settlements (BIS)

7

Eurodollar market reached around 50% of domestic market size

- Eurodollar wasonly 1/10 of USdomestic market inthe early 1970s

- Expanded rapidlyto around 50%over the pastdecades

*Interbank activities were included in US banking sector liabilities before 1973. The data coverage of Eurodollar market expandedsignificantly in 1983 to include a number of financial centres, such as Hong Kong, Singapore, and Cayman Islands etc

Eurodollar market and US banking sector size*

0

2,000

4,000

6,000

8,000

10,000

12,000

1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 20080%

10%

20%

30%

40%

50%

60%

70%

80%US$ billion

Eurodollar market size (LHS)

US banking sector liabilities(ex-interbank) (LHS)

Eurodollar market as a percentageof US banking sector (RHS)

Source: BIS

8

Euroyen market reached nearly 8% of domestic market size at its peak

- Euroyen was smallwhen comparedwith Japandomestic bankingsector

- Peaked at 7.6% in2007

*The data coverage of Euroyen market expanded significantly in 1983 to include a number of financial centres, such as HongKong, Singapore, and Cayman Islands etc

Euroyen market and Japan banking sector size*

0

2,000

4,000

6,000

8,000

10,000

12,000

1977 1981 1985 1989 1993 1997 2001 2005 20090%

1%

2%

3%

4%

5%

6%

7%

8%US$ billion

Euroyen market as apercentage of Japanbanking sector (RHS)

Euroyen market size (LHS)

Japan banking sector liabilities(ex-interbank) (LHS)

Source: BIS

9

Eurodollar market is disproportionately large when compare to US economic size

*The data coverage of Eurodollar/Euroyen markets expanded significantly in 1983 to include a number of financial centres, such asHong Kong, Singapore, and Cayman Islands etc

- In addition to GDP,results were similarfor other economicparameters, such astrade and ODI stocketc

Source: BIS, World Bank

Eurodollar/Euroyen market size ratio and US/Japan GDP ratio*

0

20

40

60

80

100

120

140

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

US /Japan GDP ratio

Eurodollar/Euroyen market sizeratio

15.4

2.7

10

Eurodollar’s ‘success’ and USD’s strong international status

11

What is an international currency?

An international currency should serve several functionsMedium of exchange

By private sector: used directly or as a vehicle currency in foreigncurrency exchanges between two other currenciesBy official sector: as a vehicle for currency market intervention

Unit of accountBy private sector: invoice merchandise trade and denominate financialtransactionsBy official sector: define exchange rate parities

Store of valueBy both private and official sectors: hold the international currency andinvest in financial assets denominated by the international currency(reserve assets)

JPY13.5%

Others41.5%

USD45.0%

CNY0.0%

Others45.8%

USD43.4%

JPY10.9%

EUR19.6%

JPY9.5%

CNY0.5%

USD42.4%

Others28.0%

12

USD and JPY’s share in world foreign exchange turnover

1989 1998 2010

USD is the most actively traded currency in the world. JPY is also anactively traded currency

Source: BIS

USD56.1%

Others41.8%

JPY2.1%

Others43.3% USD

52.0%

JPY4.7%

13

USD and JPY as a unit of account:% of world trade

USD is the dominant trade denomination currency in the world

1980 1995

Source: Currency competition and foreign exchange markets: the dollar, the yen and the euro by Philipp Hartman (1998) and Theimplications of the introduction of the Euro for non-EU countries by Peter Bekx (1998)

14

USD has long been a unit of account to define exchange rate parity

- Under the BrettonWoods system, allcurrencies werefixed to USD

- USD still definedthe exchange rateparity for 50% of allcurrencies afterBretton Woods

- This ratio hasgradually declined to8% recently

- However, JPY hasnever been a unit ofaccount to defineexchange rate parity

*Only includes economies without a separate legal tender or adopt a currency boardarrangement due to lack of data. Data on anchor currencies of various pegs (including theabove two) became available in 2008, out of which the proportion of currencies using USD asanchor was at 30%Projected based on data from IMF (1979, 1981, 1989, 1999, 2002 and 2008) and EuropeanCommission's paper no. 26: The implications of the Introduction of the Euro for non-EUcountries (1975 and 1993)

Share of currencies pegged to USD*

0%

10%

20%

30%

40%

50%

60%

1975 1980 1985 1990 1995 2000 2005

8%

15

USD and JPY as a store of value:% of world official foreign reserves

- Given US economicpower and its large anddeep financial market,USD assets have alwaysbeen a majorcomponent of officialforeign reserves

- USD accounted forover 60% of foreignexchange reserves inthe world over theyears and peaked at85% in 1970s

*Excluding foreign currency reserve without a specific currency

Distribution of currencies as foreign currency reserves*

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

USD

JPYEUR

% of world

61.4%

26.3%

3.8%

Source: International Monetary Fund (IMF)

16

US specific non-economic factors drive USD to be an international currency

The dummy would reflect the effect of simply being the US whileholding the economic condition constantResults indicate that the US dummy variable was significant for allcombinations, suggesting that there are US specific non-economic factorsthat drive USD to be an international currency

where Y is an international currency indicator, D is the defined dummy variable and X is a matrix of economic variablesincluding GDP, GDP per capita, export, import, trade, ODI stock, IDI stock and these variables expressed as share of the world

tttttt XDY εββ +++= 21c

Bearing in mind the disproportionate size of the Eurodollar market tothe US’s economic status, indicators for an international currency(currency’s share of foreign exchange turnover, foreign exchange reservesand invoicing in world trade) were tested against a dummy variable forthe US and combinations of economic variables of countries includingChina, Japan, the UK, Germany and the US :

17

What drove the USD to be an international currency?

18

Bretton Woods system favoured the use of USD as a unit of account

The international monetary system used after WWII until 1971

A gold dollar systemUSD pegged to goldAll other currencies fixed to USD with 1% fluctuation marginsUSD became the unit of account to define the parities

USD position relatively unchanged after Bretton WoodsHigh switching costNo other alternative to fully replace USD

19

US has relatively lax exchange controls

Absence of restrictions on international financial transactions using thecurrency

The US had no exchange controls for most of the past few decadesexcept for some partial controls in mid 1960s-early 1970sOther major economies, such as the UK and Japan, still maintainedcontrol over cross-border investment and capital transfer

20

US has the world’s largest and deepest financial markets

The US has the world’s largest and deepest financial markets in the worldBroad (with wide variety of financial instruments) and deep (having well-developed secondary markets)Can satisfy the investment preference of different global investors’ (officialand private)

Source: Wilshire Associates (Wilshire 5000 is used for US in 1970-85), CEIC (Japan figures in 1970-85, UK figures in 1972-85)

0

500

1,000

1,500

2,000

2,500

1970 1975 1980 1985

USJapanUK

US$ billionStock market capitalisation

21

Given USD and JPY’s international position, what other factors drive the Eurodollar and Euroyen development?

22

Some political factors favoured offshore market development

Factor favourable to the Eurodollar market onlyCommunist and Arab countries (1950s-1960s) were reluctant to placetheir assets in the US after WWII and Suez War respectively

Factor favourable to both the Eurodollar and the Euroyen marketsThe two oil shocks (1973 and 1979) led to the massive accumulation ofoil dollars which fostered international fund flows and Eurocurrencymarket development

23

Regulatory factors: Liberalisation of exchange control may foster offshore market development

Generally, exchange controls impede the development of offshorefinancial activities

But given the international currency status of USD, partial exchangecontrol measures did not fully restrict offshore market development

Empirical evidence suggest that certain US onshore regulatory controlsin the domestic financial market has a positive effect on the growth ofthe offshore market

The liberalisation of exchange controls and the financial system in Japanhad once fostered the development of Euroyen market

24

Partial exchange controls did not restrict offshore market development given USD’s position

Notes: - Interest Equalization Tax was a tax specifically targeted on foreign stocks and bonds so as to equalize the US and Europeanyields on stocks and bonds at that time

- Voluntary Foreign Credit Restraint Program was a virtually mandatory measure which prevented American banks fromincreasing their loans to European and Japanese companies

- Mandatory Foreign Investment Program forbade domestic financing of foreign investment by the US multinationals

- US had no exchangecontrols except IET,VFCRP and MFIPin 1960s

- The Eurodollarmarket stilldeveloped rapidlyamid partialexchange control

% growth

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

Eurodollar market growth

Interest Equalization Tax (IET) (1963-1973)Voluntary Foreign Credit Restraint Program (VFCRP) (1965-1973)Mandatory Foreign Investment Program (MFIP) (1968-1973)

Statistical distortion due toexpansion of data coverage

Source: BIS

25

Reserve requirements and deposit insurance reduced the efficiency of financial intermediation in the US

- Reserve requirementand FDIC insuranceadded to domesticfunding costs

- This would widenthe bid/ask spreadof domestic funding

- The wider thespread the morefavourable it is forEurodollar marketdevelopment

% growth

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

Eurodollar market growth

Domestic - Eurodollar reserve requirement

Statistical distortion due toexpansion of data coverage

Favourable to Eurodollar development

Source: BIS

26

Interest rate control in the US made it profitable to go offshore

- US market interestrates were abovecontrolled interestrates before 1978

- The interest ratedifferentialencouragedEurodollar activities;empiricallyrelaxation of suchcontrols impededoffshore activities

- No precise data onthe interest rateceiling in Japan wasavailable forcomparison

12%

15%

18%% growth

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010-6%

-3%

0%

3%

6%

9%Saving deposit ceiling for UScommercial banks (RHS)

Gradually phasing outthe interest rate ceiling

Abolition of interest rate ceilingEurodollar market growth (LHS)

Domestic certificateof deposit rate (RHS)

Favourable to Eurodollar development

Statistical distortion due toexpansion of data coverage

Source: BIS

27

Liberalisation after 1984^ led to rapid development of the Euroyen market in the following years

^Liberalisation measures include but not limited to1984 June:-Short-term Euroyen loans to residents and non-residents liberalized

　 -Issuing of Euroyen bonds by foreign private corporations, state and local governments, and government agenciesauthorized

1985 Apr: -Medium-term and long-term Euroyen lending to non-residents liberalized-20% withholding tax payable by non-residents on Japanese Euroyen bonds abolished

1986 June:-Foreign banks allowed to issue Euroyen bonds

- US continuouslypressured Japan torelax its exchangecontrol in the early1980s

- This led to theliberalisation ofJapan’s financialsystem andencouraged Euroyenmarket development-60%

-30%

0%

30%

60%

90%

120%

150%

180%

1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008

US-JapanAccord in 1984

New foreign exchangelaw implemented in1998

Euroyen market growth

New foreign exchangelaw implemented in1980

Relaxation of outflows in 1977,Relaxation of inflows in 1979

Distortion due to theearly stage ofdevelopment

% growth

Source: BIS

28

Reserve requirements and deposit insurance in Japan affected the efficiency of financial intermediation by less

- Low reserverequirements anddeposit insurancepremiums in Japan hadlittle discernable impacton the bid/ask spreadof domestic funding

- The benefits of goingoffshore were limited

- However, the Bank ofJapan implementedquantitative restraintsbefore 1991 whichempirically encouragedEuroyen growth

% growth

-60%

-30%

0%

30%

60%

90%

120%

150%

180%

1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008

Euroyen market growth

Domestic reserve requirement

Too low to have effect on Euroyenmarket development

Abolition of window guidanceContinuous implementation of window guidance

Source: BIS

29

RMB’s potential as an international currency and the associated costs and benefits

30

No Chinese equivalent of “Bretton Woods” and RMB is not yet a commonly used unit of account

Unlike USD, RMB was never a major denominating currency and the unitof account to define exchange paritiesRMB became a trade denominating currency in July 2009 and developedrapidly from negligible to representing around 1.0% of world’s totalmerchandise trade in Q3 2011

*Cross-border trade settlement in RMB includes both merchandise and service tradeSource: People’s Bank of China (PBoC), China Customs, World Trade Organization

China's RMB cross-border trade settlement amount*

0.1 3.5 18.4 48.7126.5

341.3 360.3

597.3 583.4

0

100

200

300

400

500

600

700

Q32009

Q42009

Q12010

Q22010

Q32010

Q42010

Q12011

Q22011

Q32011

RMB billion

Share of RMB cross-border trade settlement in Chinaand total world trade

0%

2%

4%

6%

8%

10%

12%

Q3 2009 Q4 2009 Q1 2010 Q2 2010 Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011

As % of Mainland'smerchandise trade

As % of world'smerchandise trade

9.2%

1.0%

31

But there is a rising demand for another international currency after the financial crisis

The global financial crisis in 2007 exposed the weakness of advancedeconomies and eroded international confidence in USD and EUR

As reserve-rich countries, such as China and other Asian countries, sufferfrom the continuous depreciation of USD, there is rising demand foranother international currency

32

However, China is still far from relaxing all exchange controls

The US had lax exchange controls in 1960s while Japan also relaxed itsexchange controls since early 1980s

China still adopts a foreign exchange management system similar to theone in Japan before 1980; cross-border fund flows are prohibited unlessallowed rather than allowed unless prohibited

China also requires pre-event regulation, examination and approval forcapital account transactions. Since RMB is not yet freely convertible,residents and non-residents are not free to own their desired amount offoreign currencies and RMB

Cross-border fund flows are still restricted, albeit being gradually relaxed

33

RMB financial assets are not widely available to foreign investors

Thus, foreign investors are not able to invest widely in RMB assetsexcept:

QFIIs and RQFIIs are allowed to participate in the securities marketsin the Mainland in foreign currency and RMB respectivelyEligible institutions (including several foreign central banks) arepermitted to participate in the domestic interbank bond marketPBoC established bilateral currency swap agreements with 12economies amounted to over RMB 1.2 trillion

Hong Kong has developed the first RMB bond, equity and commodity(gold) market outside China

China’s financial markets are still developing

Financial market development in China still lags other economiesWithout a well developed financial market, relaxing exchange controls can beriskyDevelopment of RMB to the status of an international currency will be alengthy process due to high switching cost

34

0

5,000

10,000

15,000

20,000

25,000

1970 1975 1980 1985 1990 1995 2000 2005 2010

USJapanUKChina

US$ billion

Source: Wilshire Associates (Wilshire 5000 is used for US in 1970-89), World Federation of Exchanges (US, Japan and UK figuressince 1990 and China figures since 2002), CEIC (Japan figures in 1970-89, UK figures in 1972-89), Shanghai and ShenzhenStock Exchanges (China figures in 1991-2001)

Stock market capitalisation

35

China has the potential, given its rising international status

- The economicpower of China hasbeen increasingrapidly over thepast few years

- Continuous rapidgrowth will furtherstrengthen itseconomic power inthe world

Share of World’s GDP

Source: World Bank

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Japan

US

China

36

Origin from:

US Japan France Germany UK

China Japan China US China US Japan China US Japan China US Japan

1980 36 2 8 1 36 4 13 35 4 8 36 1 10

1990 8 2 4 1 16 4 8 14 6 7 28 2 5

2000 4 2 2 1 9 3 8 10 2 6 13 1 5

2010 1 4 1 2 2 6 11 1 4 14 3 2 13

Ranking of import trade

Ranking of export tradeDestination

to:US Japan France Germany UK

China Japan China US China US Japan China US Japan China US Japan

1980 17 2 5 1 52 7 19 33 6 17 42 2 18

1990 18 2 13 1 20 6 9 27 6 11 32 2 10

2000 11 3 4 1 14 5 9 16 2 12 24 1 10

2010 3 4 1 2 9 6 13 7 2 18 9 1 14

China’s strengthening ties with other major economies

In 2010, China already ranked top three by import origin in majoreconomies (even higher than the US), while its position as the top exportdestination also rose rapidly

Source: Organisation for Economic Co-operation and Development (OECD), China Customs

37

China’s strengthening ties with other major economies (Cont.)

US Japan France Germany UK

To: China Japan China US China US Japan China US Japan China US Japan

1990 34 9 19 1 N.A. 1 30 41* 1 14 31* 16 8

2000 18 9 5 2 21 2 9 17 1 7 15 2 8

2009 8^ 12 4 2 17 10 35 7 12 12^ 26 2 14

*Data for 1989, ^Data for 2008

US Japan France Germany UK

From: China Japan China US China US Japan China US Japan China US Japan

1990 24 1 N.A. 2 46 2 3 19* 11 3 21* 1 2

2000 N.A. 8 24 2 31 3 22 25 7 14 28 2 4

2009 28^ 11 23^ 3 31 3^ 9 21 6 7^ 18 2 10^

Ranking of outward direct investment (ODI) flows (from major economies to China)

Ranking of inward direct investment (IDI) flows (to major economies from China)

China is already ranked as a major ODI destinations (in terms of flows) inthe world, though it is not yet an important source of IDI flows to the restof the world amid exchange control

Source: OECD, Ministry of Commerce, People’s Republic of China

Costs of currency internationalisationBroadening the scope for residents and non-residents to buy and sellRMB instruments might limit the ability to influence domestic interestrates and money supply (unless foreign holdings are relatively small)

Currency internationalisation requires capital account liberalisationwhich may entail certain risks:

RMB may face sharp depreciation pressure if foreign holders sell theirdomestic currency instruments in large amounts. It might become a risk ifChina has a large foreign currency debtIncreased issuance of foreign debt in China or Chinese corporate debt inforeign markets, may make China more vulnerable to external financialshocks

The associated risks of capital account liberalisation will require prudentmanagement as well as the facilitation of a productive real sector and anefficient financial sector

38

Granger causality of onshore and offshoreinterest rate and liquidity measures

In order to test the interaction between onshore and offshore activities,Granger causality tests under a vector error correction model havebeen carried out between onshore and offshore interest rates andliquidity measures for the US and Japan, while exchange rates couldnot be tested since there is only one available rate:

⎩⎨⎧

+++=+++=

−−

−−

tttt

tttt

ECTycECTxcy

21212

11111

x εβεβ

39

y refers to the first difference of offshore interest rates or liquidity measures, x refers to the first difference of onshoreinterest rates or liquidity measures and ECT is the error correction term

This is also referred to as the VEC Granger causality/block exogeneity Wald test

Granger causality of onshore and offshoreinterest rate and liquidity measures

40

No Granger causality between onshore and offshore liquidity measureswere found for JPY; In addition, only weekly JPY interest rates wereavailable with which meaningful results were unobtainable

- Empirical evidencesuggest that USonshore interest ratesGranger caused USoffshore interest ratesbetween January 1982and June 2007inclusive, while noGranger causality wasfound betweenonshore and offshoreUSD liquiditymeasures

Onshore and offshore USD interest rates

0

5

10

15

20

25

30

1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

Offshore USDinterest rates(blue line)

Onshore USD interest rates (red line)

Percent per annum

Break in 1981

Break in 2007Break in 1990

Two-way Granger causality Onshore Granger causes offshoreJun 1973 - Dec 1980 Jan 1982 - Jun 2007 Jan 2009 -

June 2011

No Grangercausality

Onshore Granger causes offshore

41

Benefits of currency internationalisation

Seigniorage, deriving from the issuing of non-interest bearing claims

Internationalisation of a currency will expose the onshore financial sectorto competition from the offshore financial sector which will enhance theonshore market’s efficiency

Lower exchange rate risk in conducting international trade or lower therisk of currency mismatch in financing activities

Availability of a wider funding source in RMB from overseas investors

42

RMB business in Hong Kong

Scope of business in Hong Kong

2004 2007 2009 2010 2011

Retail

Financing

Trade settlement

Wealth management

Investment

• Personal RMB business

• RMB bonds • RMB trade settlement pilot scheme

• Changed Clearing Arrangement• Expanded trade pilot scheme • RMB wealth mgmt. products,

e.g. investment funds• Access to onshore bond market • Case approval of RMB FDI

• Inward and outward FDI in RMB

• Expanded trade settlement• RQFII • RMB bonds expanded to

Mainland corporations

43

Rapid growth in deposit size

44

- RMB depositbegan in Feb 2004

- Grew rapidlyafter the launch ofRMB cross-bordersettlementbusiness in 2H2009

- RMB 618.5 bn inOct 2011, 10.1%of Hong Kongtotal deposits,0.8% of theMainlandSource: Hong Kong Monetary Authority (HKMA)

RMB deposits in Hong Kong

0

100

200

300

400

500

600

700

Dec 2003 Dec 2004 Dec 2005 Dec 2006 Dec 2007 Dec 2008 Dec 2009 Dec 20100%

2%

4%

6%

8%

10%

12%

As a percentage oftotal deposits inHong Kong (RHS)

(solid line)

RMB billion

Outstanding amount ofRMB deposits inHong Kong(LHS) (bars)

Personal RMB business (Feb 2004)

Expansion of RMB business (Oct 2005)

Mainland financial institutions toissue RMB bonds (Jan 2007)

PBOC and HKMAsigned currency swapagreement (Jan 2009)

Pilot scheme of cross-bordertrade settlement (July 2009)

Expanded tradesettlement(June 2010)

Revised clearingarrangement (July2010)

Pilot scheme to invest in Mainland'sinterbank bond market (Aug 2010)

List of eligible firms under trade settlementscheme expanded (Dec 2010)

Pilot scheme for ODI in RMB (Jan 2011)

Further expansion of RMB trade settlement scheme, RQFII, RMB FDIby Hong Kong enterprises, RMB bonds issuance by Mainland'scorporation (Aug 2011)

Bond market still at early stage of development

- First RMB bondissued in July 2007and grewsignificantly

- RMB 137.8 bn inNov 2011,equivalent to 0.7%of China’s bondmarket

- Equivalent to 9.4%of HKD bondmarket at end June2011

45

Source: HKMA

Outstanding amount of RMB bonds in Hong Kong

0

20

40

60

80

100

120

140

160

Jul 2007 Jan 2008 Jul 2008 Jan 2009 Jul 2009 Jan 2010 Jul 2010 Jan 2011 Jul 20110.0%

0.1%

0.2%

0.3%

0.4%

0.5%

0.6%

0.7%

% of outstanding bondsin China (RHS)(solid line)

RMB billion

Outstanding amount ofRMB bonds in HongKong (LHS) (bars)

First RMB bond (by Mainland's financialinstitution) in July 2007 (China DevelopmentBank)

First issuance by foreign bankin July 2009 (HSBC (China))

First China sovereign bondin Oct 2009

More Chinese sovereignbond in Dec 2010 andAug 2011

First issuance by foreigncorporation in July 2010(Hopewell HighwayInfrastucture)

First issuance by Mainland'scorporation in Nov 2011

Cross-border settlement drives market growth

- Growth driver forRMB deposits in HongKong

- 8.6% of China’s totaltrade in Oct 2011

- Hong Kong’s shareamounted to 90% inQ3 2011

46

Source: HKMA

RMB cross-border settlement in Hong Kong

0

40

80

120

160

200

240

Jul 2009 Jan 2010 Jul 2010 Jan 2011 Jul 20110%

2%

4%

6%

8%

10%

12%RMB billion

RMB cross-bordersettlement amount inHong Kong (LHS) (bars)

% of China's total trade(RHS) (solid line)

Program started in July 2009 formerchandise trade between 4 Guangdongcities plus Shanghai and Hong Kong, Macauand ASEAN countries

Program expanded in June 2010 to cover bothmerchandise and service trade and 20 provincesand cities with the world. The list of eligible firmswere expanded in Dec 2010

Program further expanded in August 2011 to coverthe entire country with the world

CNH and CNY exist in two separate spot markets

- Two separate spotmarkets without freefund flows

- CNH normally tradesat a premium to CNY,but obvious deviationsalso occur duringtimes of financialvolatility

- Empirical evidencesuggest that the tworates do not have aGranger causalityrelationship

47

CNH and CNY spot rates

6.1

6.2

6.3

6.4

6.5

6.6

6.7

6.8

6.9

Aug2010

Sep2010

Oct2010

Nov2010

Dec2010

Jan2011

Feb2011

Mar2011

Apr2011

May2011

Jun2011

Jul2011

Aug2011

Sep2011

Oct2011

Nov2011

CNH (blue)

CNY (red)

RMB per USD

Pilot scheme to invest in Mainland'sinterbank bond market (Aug 2010)

HKMA issued guideline on net open position forAIs. List of eligible firms under cross-border tradesettlement scheme expanded (Dec 2010)

Pilot scheme for ODI settlement inRMB (Jan 2011)

Further expansion of RMB trade settlementscheme, RQFII, RMB FDI by Hong Kongenterprises, expansion of RMB bondsissuance by Mainland entities (Aug 2011)

No correlation between interest rates

- Similarly, SHIBORand CNH HIBORare two separatemarkets

- Divergentrelationship aftermonetary tighteningsince mid 2010

- CNH HIBORtrading remains thinbut is reportedly onthe rise

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Source: Bloomberg, National Interbank Funding Center Shanghai

3-month SHIBOR and CNH HIBOR

0%

1%

2%

3%

4%

5%

6%

7%

Mar 2010 Jun 2010 Sep 2010 Nov 2010 Feb 2011 May 2011 Jul 2011 Oct 2011

SHIBOR

CNH HIBOR

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Given RMB’s international position, what other factors drive Hong Kong to be an offshore RMB centre?

　

　　

50

Why Hong Kong?Tokyo London New

YorkSingapore Hong

Kong

Efficient and reliable financial infrastructure

Sound legal system

Free flow of capital and information

Strong pool of talent

International business customs and practices

Simple tax regime and low tax base

Long history of Mainland enterprises presence

Largest IDI and ODI investor of China

First mover advantage with RMB financial infrastructure

One country-two system with strong collaboration between our financial regulators, ensuring stronger financial security in China

Hong Kong is the most ready and experienced financial centre serving ChinaHong Kong is able to develop as an offshore RMB centre with the support ofMainland authorities

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Since China still has exchange controls, Hong Kong needs Mainland’s support to develop RMB business

Only Hong Kong and Macau have RMB clearing banks linked to PBoCRMB clearing bank and participating banks are allowed to participate in China’sinterbank bond market (subject to approval)China has committed to issue government bonds in Hong Kong on a regularbasis and allow its financial institutions and corporations (subject to quota) toissue RMB bonds in Hong Kong

RMB in Hong Kong, to a certain extent, is not subject to exchange control ordomestic regulations (such as interest rate set by PBoC)

China’s regulatory rules, business practices, financial infrastructure andinformation dissemination systems are different from international norms.Foreign investors are more inclined to carry out business offshore

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Hong Kong can bring a unique combination of potential benefits to the Mainland

Mainland financial institutions are poised to benefit from the developmentof Hong Kong’s RMB business with their strong Hong Kong presence andMainland networks

The liberalisation of China’s exchange controls can proceed at its own pacewhile any demand for sophisticated financial products of Mainlandenterprises can be satisfied in Hong Kong

RMB financial markets operating under international business practicescould be developed in Hong Kong ahead of Mainland’s liberalisation.China could manage its pace of development and reforms (through RMBre-circulation)

Foreign companies can issue RMB bonds in Hong Kong and insulate thedomestic market from the default risk of those companies

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Conclusion

The status of USD benefited from Bretton Woods, US’s lax exchangecontrol system and US’s large and deep financial markets, in turn allowingthe Eurodollar market to develop disproportionately larger than US’seconomic size

Political and regulatory factors (liberalisation of exchange control anddomestic credit controls) may have encouraged fund flow to the offshoremarket and encouraged its development

RMB is not yet an international currency, but has the potential, givenChina’s economic size and strengthening ties with the world

However, the lack of a Bretton Woods equivalent and deep financialmarkets while having exchange controls will hinder the RMB’s rise

Internationalisation of RMB has benefits as well as costs which needs to bemanaged prudently by the Mainland authorities

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Conclusion (Cont.)

Over the past few years, Hong Kong has already developed a sizeable RMBmarket, efficient financial infrastructure and accumulated valuableexperience

RMB re-circulation has been strictly controlled by China out of financialsecurity concerns, but has been gradually relaxed

Hong Kong may not be the only financial centre capable of developinginto an offshore RMB centre, but it is the most ready and experiencedfinancial centre serving China

Last but not the least, Hong Kong is a Special Administrative Region ofChina. Regulators can collaborate effectively at different stages of RMBinternationalisation and exchange control liberalisation, better ensuring thefinancial security of China

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Thank you