SCB Research on CNH

8/7/2019 SCB Research on CNH

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| Special Report |

Important disclosures can be found in the Disclosures Appendix

All rights reserved. Standard Chartered Bank 2010 http://research.standardchartered.com

Delphine Arrighi, +852 3983 8568Standard Chartered Bank (Hong Kong) LimitedSenior Rates [email protected]

Kelvin Lau, +852 3983 8565Standard Chartered Bank (Hong Kong) LimitedRegional [email protected]

Nicholas Kwan, +852 2821 1013Standard Chartered Bank (Hong Kong) LimitedHead of Research, [email protected]

Robert Minikin, +852 3983 8567Standard Chartered Bank (Hong Kong) LimitedSenior FX [email protected]

Stephen Green, +86 21 3851 5018Standard Chartered Bank (China) limitedHead of Research, Greater [email protected]

Thomas Harr, +65 6530 3617Standard Chartered Bank, SingaporeHead, Asian FX [email protected]

Will Oswald, +65 6307 1527Standard Chartered Bank, SingaporeHead of Fixed Income [email protected]

The new CNH market15:15 GMT 27 August 2010

Contents:

I. The new CNH market............ p.2

II. How the CNH market was

built ...........................................p.3

III. The CNH market today....... p.6

IV. How quickly can CNH liquidity

be built?.................................. p.10

V. Important similarities and

differences with the Eurodollar

market ..................................... p.12

VI. Frequently asked questions

................................................. p.14

Highlights

• The offshore CNY market in Hong Kong (CNH) has sprung to life.

• Comparisons with the Eurodollar market are inevitable, but there areimportant differences.

• We expect significant CNH liquidity growth as a result of CNY tradesettlement, tourist receipts and other CNY flows.

• New spot FX and deposit markets have developed as new rules limitCNY fungibility.

• CNH bond issuance could grow quickly, if the transfer of funds tomainland China is relaxed further.

• Rapid product innovation could mean the sophistication of the CNHmarket quickly runs ahead of the onshore market.

• Standard Chartered, as one of the leading CNY trade settlementbanks, is in the midst of these CNY/CNH flows and is active in buildingthese markets.

• We include an FAQ section on technical issues in the CNH market.



Special Report | 27 August 2010

I. The new CNH market

2

China’s move on 16 August to allow qualified financial institutions to repatriate offshore Chinese yuan (CNY) into the

domestic bond market was a very important piece of the puzzle for the development of a significant offshore CNY market

in Hong Kong. (Throughout this report, ‘offshore’ denotes outside of mainland China and includes Hong Kong.) Although

there will still be restrictions on capital account fund flows across the border, this was an exciting, significant and

unexpectedly early step. It means the birth of a new market: the offshore CNY market in Hong Kong, a market now

known as CNH. This market appears to have strong backing from the People’s Bank of China (PBoC) as a core plank of

its ambitions to internationalise the CNY.

Until a few months ago, Hong Kong banks with CNY could only deposit the funds at the designated clearing bank, at a

very low, stable yield (0.865%). As a result, the offshore CNY market was inactive. In recent months, alternatives have

developed: one can now invest in a CNH bond issued in Hong Kong, or lend the funds to a corporate that needs the

funds to settle trade in CNY.

However, while these new channels will grow quickly, we believe their scale will be outpaced by the demand for CNH

liquidity and assets in the early days – and they are, of course, a bit separated from the onshore mainland markets.

Therefore, granting selected banks access to the onshore market (subject to a quota, and possibly only for some types of

funds) is a very important move, since it opens up a whole new universe of higher-yielding and more liquid investment

opportunities.

Two other pieces of the puzzle were put into place earlier this year. First, the PBoC and the Hong Kong Monetary

Authority (HKMA) relaxed restrictions on how to develop the CNH market, giving the HKMA a great deal of autonomy in

developing it. More recently, the HKMA relaxed its rules on moving CNH around Hong Kong. This, among other things,

makes it possible for banks to offer CNH retail products and to develop risk-management tools like CNH interest rate

swaps.

Given limited fungibility between the onshore and offshore CNY markets, there are still marked pricing divergences

between CNO (onshore) and CNH (in Hong Kong). This is true not only spot but also in the forward markets. While the

CNH financial markets are not yet as well developed as those on the mainland, the pace of innovation is rapid, and at

some point, the Hong Kong market may offer a broader range of products than that available on the mainland.

Standard Chartered, as one of the leading CNY trade settlement banks, is right in the midst of these flows and is active

in building these markets. For instance, the Bank successfully managed the first issuance of a CNY-denominated bond

by an overseas non-financial corporation in Hong Kong on 19 August.

In this Special Report, we explain how we think the CNH market will develop over the next few months, and the

consequences for offshore corporates and institutions.




II. How the CNH market was built

3

First, we tell the story of how this market came into being. In the next sections, we explain how the market operates

today and how we think it will develop in the future.

The development of the CNH market has progressed as follows:

• After the HKMA announced the beginning of CNY business on a trial basis in Hong Kong in December 2003,

development of the offshore market was extremely limited. It was basically confined to the build-up of CNY in

low-yielding retail bank deposits and the provision of restricted personal CNY services.

• Starting in 2007, mainland financial institutions, subject to approval, were allowed to issue CNY bonds in Hong

Kong. This was the first step towards creating more uses for CNY funds sitting in Hong Kong. The scope of

eligible issuers has been further expanded in 2009 and 2010, as we explain further below.

• In January 2009, the PBoC and the HKMA signed a currency swap agreement to provide CNY liquidity of up to

CNY 200bn with a renewable term of three years. Like other CNY swaps signed with central banks around the

region, this has not been exercised (more on this below).

• In June 2009, the PBoC launched the pilot scheme for CNY settlement of cross-border trade between Shanghai

and four cities in Guangdong province on the one hand, and Hong Kong on the other. This scheme allowed

CNY conversion within selected cities between the onshore and offshore markets for trade-related transactions.

Promoting the use of the CNY as a trade invoicing and settlement currency is clearly a big priority for China’s

central bank. One reason for this is to reduce the FX risk faced by importers and exporters – which would also,

down the line, allow for more CNY flexibility, another PBoC priority. As Chart 1 shows, CNY trade settlement

flows have increased rapidly. The Bank has been closely involved in this scheme, and we on the research side

have closely followed it (see On the Ground, 20 July 2010, ‘China – Another step offshore for the CNY’).

Chart 1: An increasingly important source of CNH deposits

Cumulative CNY settlement trade volumes since the launch of the scheme, CNY bn

0

10

20

30

40

50

60

70

80

Dec-09

Jan-10

Feb-10

Mar-10

Apr-10

May-10

Jun-10

Total CNY trade settlement volume

Sources: PBoC, Standard Chartered Research

• However, a number of challenges needed to be resolved before offshore corporates accepted the CNY as a

trade currency. How would an offshore corporate hedge CNY? Where would the company park its funds andearn a decent return? And where would it source offshore CNY? These challenges have limited the

development of the CNY as a trade currency, but are becoming easier to overcome with the development of the

CNH market.




II. How the CNH market was built (cont)

4

• Notably, non-bank financial institutions and non-trade corporates have not been involved in the CNY scheme.

As such, the scheme has had little impact on the capital account.

Events in recent months have accelerated the pace of CNH market development:

• In February 2010, the HKMA stipulated that participating banks could “develop [CNY] business based on the

regulatory requirements and market conditions in Hong Kong, as long as these businesses do not entail the flow

of [CNY] funds back to the mainland”. The HKMA went so far as to state that participating banks “can conduct

[CNY] businesses in accordance with the prevailing banking practices applicable to the businesses conducted

in other foreign currencies.” This helped to set the stage for freer CNH circulation in Hong Kong.

• On 19 July 2010, the PBoC and the HKMA signed the Supplementary Memorandum of Co-operation. These

rules helped build the foundation for the CNH market, as they substantially broadened the pool of potential CNY

holders and the type of CNY-denominated financial products which could be offered (see On the Ground, 20

July 2010, ‘Another step offshore for the CNY).

• The memorandum lifted restrictions on the offshore CNY market and allowed non-bank financial institutions

(such as securities brokerages and insurance companies), as well as corporates not directly involved in trade

with the mainland, to open CNY accounts and enjoy unrestricted CNY services (i.e., non-trade-related CNY

conversion), including loans and payments. Banks acting as counterparties to non-trade-related conversions are

not allowed to automatically net out their positions with the clearing bank, Bank of China HK (but are permitted

to do so with other participating banks). In contrast, the clearing bank can be freely used as a counterparty for

trade-related CNY conversion. This limitation means the agreement does not imply a significant opening up of

the mainland’s capital account.

• On 16 August 2010, the PBoC made a small step towards further opening up its own capital account, but a

huge leap for CNH development, when it opened a channel for offshore CNY liquidity to flow into the onshore

interbank bond market. Under the new regulations, foreign central banks, CNY clearing banks in Hong Kong

and Macau, and cross-border CNY trade settlement participating banks – including Standard Chartered Bank

(Hong Kong) Limited – are allowed to invest CNY liquidity in onshore bonds. These investments have to be

conducted through a special account and are subject to a PBoC quota (see FX Alert, 18 August 2010, ‘CNY –

Implications of new bond-market access’).

• This August move facilitated the expansion of the CNH-denominated market in two ways. First, qualified

institutions can acquire higher-yielding CNY-denominated assets (rather than low-yielding deposits held at the

clearing bank) and can thus offer higher CNH-denominated deposit rates. Secondly, the move allows them to

build a more diversified range of counterparties (rather just the clearing bank) as they extend their CNY asset

portfolio to match their expanding CNH-denominated deposit liabilities.

CNH deposits

As a result of these moves, CNH deposits have been growing. Currently, CNH deposits in the Hong Kong banking

system total about USD 12.5bn, a little more than 0.1% of China’s USD 10trn onshore CNY deposit base. We show the

build-up over time in Chart 2. Similarly, daily offshore spot FX transactions in CNY are estimated at only about 0.2% (or

USD 30-50mn) of the USD 20bn onshore spot market. At USD 4bn, the size of the offshore CNY bond market is only

about 0.1% of the onshore market (USD 2.9trn).




II. How the CNH market was built (con’d)

5

Chart 2: Set to rise

CNH deposits in Hong Kong vs. onshore deposit base

0

20

40

60

80

100

Feb-04

Jun-04

Oct-04

Feb-05

Jun-05

Oct-05

Feb-06

Jun-06

Oct-06

Feb-07

Jun-07

Oct-07

Feb-08

Jun-08

Oct-08

Feb-09

Jun-09

Oct-09

Feb-10

Jun-10

0.00%

0.05%

0.10%

0.15%

0.20%

CNH deposit in HK (CNY bn, LHS) as a % of total onshore CNY deposit in China

Sources: Bloomberg, Standard Chartered Research

The huge difference in size between the offshore and onshore markets probably makes Beijing confident that it can allow

more rapid development of the CNH market without a significant negative impact on the onshore system. But this gap

also underlines the huge potential for offshore market development, provided that the right incentives and systems are

put in place.

For instance, if offshore CNY deposits were to grow from the current 0.1% of China’s onshore deposit base to 4%, this

would double Hong Kong’s local-currency deposits. If the ratio were to rise to 8%, Hong Kong’s total deposits (both local-

and foreign-currency) would double. In the early 1960s, when the Eurodollar market started to emerge, the ratio of

offshore to onshore USD deposit bases grew by about one percentage point per year. If the same speed were to be

repeated in the CNH market, Hong Kong’s bank deposit base could double within five to 10 years, depending on whether

you are comparing it with the HKD-only or the total (HKD plus foreign-currency) base.




III. The CNH market today

6

Things are moving fast at the moment in terms of CNH liquidity and product development. Here, we lay out the state of

the market today. In the next section, we take a look at how things could develop in the future.

The HKMA is taking a supportive approach to the development of CNH-denominated financial instruments. There is no

general prohibition on new products, although trading requires prior approval from the HKMA, and authorized institutions

need to submit product and risk management plans. This raises the prospect that the Hong Kong offshore market could

become substantially more sophisticated than the mainland onshore financial markets.

Permission has already been granted for principal-protected structured investments and deliverable forwards, while the

application process for additional products is ongoing. So far, only fully funded structured products denominated in CNH

have been brought to the market.

We summarise the products currently available in Table 1. Below, we provide product-by-product detail.

Table 1: Snapshot of CNH-denominated product availability

CNH product Availability Remarks

Spot Yes USD 30-40mn interbank volumes

Forward Yes There are now CNY DF, CNY NDF and CNH DF curves

FRA/CCS No Trading may be imminent

Money market Yes Interbank trading relatively thin amid CNH ‘pooling’ in small number of institutions

CDs/structured notes Yes for CDs CDs launched; structured notes may be seen soon

FX options No Lack of transparency/fix in CNH spot is currently stalling development

Structured products Not all Fully funded structures so far

Bonds Yes Hong Kong CNH bond market continues to build

Mutual funds Yes First offshore renminbi mutual fund launched in August 2010

Source: Standard Chartered Research

CNH money market

Initially, trading in the CNH money market has been relatively thin, in sharp contrast to the steady improvement seen in

CNH spot and forward liquidity. Indeed, following an initial flurry of deals shortly after the 16 August liberalisation

announcement (deals grew from USD 10mn to USD 50mn in size and from one-week to one-month maturity), activity

has died down. The CNH market has split into two distinct tiers, and a very limited number of banks with access to

substantial trade flows or deposits hold healthy CNH balances. Elsewhere, there is a general absence of CNH liquidity.

We expect money market liquidity to improve as CNY-denominated assets become more plentiful.

Institutions that are long CNH are able to deposit with the clearing bank (subject to internal limits), and the current

interbank CNH money market bid builds on the 0.865% offer by the clearing bank. Note that this is not an absolute floor

for very short CNH rates, as the trade settlement banks have a limited ability to deposit CNH. The CNH offer side

remains low at the short end, at 0.90-0.95%, and edges gradually higher as tenors extend. In general, the offshore CNH

curve appears to be at least 50bps lower than onshore SHIBOR. Standard Chartered and a few other banks do publish

daily levels for CNH HIBOR on Reuters – see SCBHK04.




III. The CNH market today (cont)

7

CNH FX spot and forwards

Spot-market liquidity for ‘non-trade-related’ CNH has improved markedly in recent weeks. We estimate that daily

interbank market volume may now be USD 30-50mn; including internally cleared trades by Hong Kong trade settlement

banks, overall CNH volumes may already be around USD 150mn per day. Individual trade sizes have also picked up

markedly – and while quotations for USD 50-70mn trades in USD-CNH are not yet standard, they are not uncommon.

Typical indicative interbank market quotes for non-trade-related CNH are 100 pips wide.

All of the market focus is on the ‘new’ currency – non-trade-related CNH. However, it is noteworthy that there are two

CNH markets. As a result, Standard Chartered Bank (Hong Kong) Limited quotes both trade-related and non-trade

related USD-CNH. Trade-related CNH is fungible with CNO, given the automatic access of Hong Kong trade settlement

banks to the clearing bank. However, this is not true of non-trade-related CNH. So an offshore branch, e.g. Standard

Chartered Bank New York, can buy CNH from the Hong Kong branch on behalf of its clients; but whether this is trade-

related or non-trade-related will determine how the Hong Kong branch squares the position. This in turn determines how

favourable a rate the customer receives in selling USD and buying CNH (the rate is currently less favourable for non-

trade-related transactions). When liquidity is poor, FX trading desks may simply work on an order basis for customers

seeking non-trade-related transactions.

There are quotes in CNH-HKD and USD-CNH for up to two years forward, but liquidity in the forward market remains far

short of that in the onshore DF or offshore NDF markets. As we expected, three very distinct forward curves have now

formed. 1Y forward prices in USD-CNH are generally good for around USD 3-5mn, but trade settlement banks will

typically also have an (internal) limit on their overall exposure to the CNH forward market, which may constrain market

access in some circumstances.

There is no readily accessible cross currency swap (CCS) market for now, although physically deliverable CCS (such as

USD-CNH) will likely be created soon, subject to HKMA approval.

CNH bonds

Investment in China’s interbank bond market is allowed only for central banks and trade settlement banks. As a result,

the recent liberalisation steps do not create a direct competitor to the Hong Kong CNY-denominated bond market for

retail CNY-denominated deposits.

However, any customer that maintains a CNY deposit account with a participating authorised institution can invest in

CNY bonds issued in Hong Kong (which means the pool of investors is now essentially global). The current outstanding

volume of CNH bonds is CNY 28.6bn (USD 4bn); we show the issues in Table 2. And we expect the pool of available

CNH bonds to grow quickly. Standard Chartered managed the first issuance of a CNY-denominated bond in Hong Kong

by an overseas non-financial corporation on 19 August. The success of this issue is likely to foster the rapid development

of this market.




III. The CNH market today (cont)

8

Table 2: Outstanding CNY-denominated bonds issued in Hong Kong

Issuer Maturing Amount outstanding, coupon

Bank of China Sept 2010 CNY 1bn. 3.25%

China Construction Bank Sept 2010 CNY 3bn, 3.24%

Bank of China Sept 2010 CNY 2bn, 3.25%

Bank of East Asia July 2011 CNY 4bn, 2.8%

HKCB Financial Services July 2011 CNY 2bn,

HSBC float July 2011 CNY 1bn, 3M SHIBOR +38bps

China Development Bank float Aug 2011 CNY 1bn, 3M SHIBOR +38bps

China Development Bank Aug 2011 CNY 1bn, 2.77%

Export Import Bank of China Sept 2011 CNY 3bn, 3.4%

HSBC China Sept 2011 CNY 2bn, 2.6%

Bank of China Sept 2011 CNY 1bn, 3.4%

China Government Bond Sept 2011, Sept 2012, Sept 2014 CNY 6bn, 2.25%, 2.7%, 3.3%

Hopewell Highway Infrastructure July 2012 CNY 1.38bn, 2.98%

McDonald’s Sept 2013 CNY 200mn, 3%


In contrast to the relatively tight controls on the domestic market, any entity (local or foreign) can issue CNY bonds in

Hong Kong – as long as it meets general criteria for participation in the Hong Kong bond market. There are no

constraints on the conversion of CNY proceeds into other currencies, and the remittance of the proceeds back onshore is

unlikely to be too challenging.

The 2Y-3Y tenor looks set to remain the ‘sweet spot’ for both institutional and retail tranches. Some issues in the past

have included a 5Y tranche, but only as a relatively small proportion of total deal size given the low demand. Historically,

CNY issues in Hong Kong have been priced on a fixed-rate basis, and that appears likely to be the case going forward.

The development of CNY-denominated bonds in Hong Kong will provide a larger pool of assets for banks to match their

current CNH liabilities. This, in turn, will facilitate the creation of a credible interbank market – an essential step in the

development of hedging products and interest rate swaps in particular, which will require a reliable fixing.

CNH investment products

Hong Kong-domiciled banks are revamping their funding programmes to include CNH-denominated certificates of

deposit (CDs), while CNH-denominated structured notes may be seen before too long (subject to HKMA approval). It

seems likely that new structured products will be focused on the FX, commodity and rates areas, with credit and equity-linked products potentially being introduced later on.

The onshore CNY bond market

As explained above, the PBoC is now taking applications from central banks and CNY trade settlement banks, including

Standard Chartered Bank (Hong Kong) Limited, for quotas to access to the onshore interbank bond market (IBM).

The National Association of Financial Market Institutional Investors (NAFMII) operates under the direct supervision of the

PBoC to manage the IBM, a market which accounts for 98% of all domestic debt issuance and trading (another bond

market is hosted by the stock exchange system, but it is smaller and less liquid). There are 1,076 market participants.

Bond spot trading volume in 2009 was CNY 48trn, and repo trading was CNY 72trn – both up from close to nothing five

years ago – while bond trading on the stock exchange platform has not grown in recent years.




III. The CNH market today (con’d)

9

As of end-July, the IBM hosted CNY 587bn in commercial paper, CNY 1.169trn in medium-term notes and CNY 5.566trn

in financial bonds. The bulk of issuance, however, is PBoC paper (CNY 4.80trn outstanding) and Ministry of Finance

treasury bonds (CNY 6.11trn outstanding).

The Qualified Foreign Institutional Investor (QFII) system is only open to investors accessing securities on the stock

exchanges, so it has never been used by offshore financial institutions to access the IBM. The Asia Bond Fund II

launched by EMEAP is the only initiative that has gained offshore access to the IBM.

The liberalisation announced on 16 August marks the first move to open up access to domestic bonds to offshore

investors. Of course, there will be limits. It is clear that the PBoC will restrict participants to central banks and CNY trade

settlement banks. It will also govern their quotas, based largely on the underlying CNY trade needs of trade settlement

banks. The exact rules regarding the quota remain to be seen. In other words, this is the bond-market equivalent of the

QFII scheme, but with a much narrower range of potential players, at least for now.

Central banks can apply for a quota and gain exposure to CNY debt, both sovereign and corporate. It is unclear how they

will gain the required CNY – but there are options. They might buy CNY from trading firms receiving CNY from mainland

importers, although the quantities outside Hong Kong will be limited in the short term. They might exercise their swap

lines with the PBoC, of which some CNY 800bn have been agreed but not exercised. Or in a special arrangement, the

PBoC could offer to simply sell CNY to them.

Other products

While the current rules allow access to the onshore interbank bond market, it is also possible that the Beijing authorities

will open up a similar route into the domestic stock exchange-based equity market. Expectations are running high that a

quota system allowing offshore CNY to be invested back into mainland bond and stock markets will be launched before

the end of this year. This could be done within a framework similar to the QFII scheme – a ‘mini-QFII’, as the market has

coined it.




IV. How quickly can CNH liquidity be built?

10

There are currently at least two ways for onshore CNY liquidity to develop in Hong Kong:

1. Mainland importers paying CNY via settling a trade transaction in CNY (as explained above).

2. Mainland tourists and other visitors spending CNY in Hong Kong. Arrivals from the mainland to Hong Kong rose

by 54.5% y/y in June 2010; their spending, excluding airfares, was estimated at around USD 10bn in 2009.

In Table 3, we lay out some basic assumptions about how we see CNH deposits developing. For one, we stick with the

two above-mentioned main sources of CNH. For the CNY trade settlement route, we assume that the share of annual

mainland imports settled in CNY will gradually rise to around 15% of the total by 2015, from less than 1% now. The pace

of invoicing conversion is also assumed to be faster between China and emerging markets (Asia, Africa and Latin

America) than with developed markets. The emergence of the post-crisis New World Order, in our view, should cement

the development of intra-regional trade and South-South trade corridors in the coming decades, if not years, as emerging

markets tap demand outside of the traditional consumption powerhouses in the West. Emerging markets which are used

to using a third country’s currency to settle trade among themselves should also be more receptive to the idea of

changing their invoicing behaviour. Another assumption we have made here is that half of the annual gross CNY inflows

from both channels will stay in CNH deposit accounts.

The result is that CNH deposits will expand at a five-year CAGR of over 100%, reaching USD 475bn by 2015 (from USD

13bn currently). By the same calculation, Hong Kong’s total bank deposit base should almost double over the next five

years, with CNH accounting for close to one-third of the total. Bear in mind that we are already working on the

conservative assumption that current regulations will not change materially over the period; we merely assume that the

CNY will continue to reach out at a fast pace, and that Hong Kong will be effective at pooling this money headed offshore.

Table 3: Projecting CNY deposit migration from mainland to Hong Kong

China's

total

imports of

goods

Growth in

imports of

goods

% of

imports of

goods

settled in

CNY

CNY trade

settlement

annual

flows,

from

imports of

goods

CNY trade

settlement

annual

flows,

from

imports of

goods +

services

Hong

Kong

annual

tourism

receipts

(excl.

airfares),

total

Growth in

tourism

receipts

Hong

Kong's

annual

CNY

tourism

receipts

from

mainland

(excl.

airfares)

CNH

deposits,

annual

gross

inflows

CNH

deposits,

annual net

inflows

CNH

deposits,

cumulative

net inflows

Total

deposits

CNH

deposits,

% of total

USD bn

(1) (2), (3)

USD bn USD bn

(4)

USD bn

(1), (8)

USD bn

(5)

USD bn USD bn

(6)

USD bn USD bn

(7)

Current 1,247 19 13

2011 1,409 13% 1.5% 21 24 22 14% 13 38 19 32 903 3.5%

2012 1,592 13% 3.1% 49 56 25 14% 15 71 36 67 1,000 6.7%

2013 1,799 13% 6.3% 114 130 28 14% 17 147 73 141 1,138 12.4%2014 2,033 13% 10.5% 212 242 32 14% 19 262 131 272 1,339 20.3%

2015 2,297 13% 14.7% 338 385 37 14% 22 407 204 475 1,617 29.4%

(A) (B)

(C) =

(A) + (B)

(D) =

(C) x 50% (E)

Deposits in Hong KongFrom trade settlement From tourism receipts

Footnotes: 1. Current = 2010 full-year estimate 2. Assuming that China’s imports from Asia, Africa and Latam (accounting for a combined 70% of total projected imports) will

have 2%, 4%, 8%, 13% and 18% of their trade settled in CNY, respectively, during the 2011-15 period 3. Assuming imports from the rest of the world (accounting for 30% of projected total imports) will have 0.4%, 1.0%, 2.4%, 4.5%

and 7.0% of their trade settled in CNY, respectively, during the 2011-15 respectively 4. Assuming that annual CNY trade settlement flows from services trade remain a constant fraction (14%) vs. flows from goods

imports (based on Jul-09 to June-10 performance)5. Assuming 60% of receipts are from mainland visitors, all in CNY 6. Assuming 50% of annual CNH inflows generated by the trade settlement scheme and tourism will not stay in CNH deposits

7. (E) + 7% annual growth in non-CNH deposits 8. Mainland tourists’ spending in CNY elsewhere which could be channeled into Hong Kong is not included in this analysis





IV. How quickly can CNH liquidity be built? (con’d)

11

Given fast-growing demand for CNH liquidity, especially at this early stage of market development, we believe it is worth

exploring other possible routes for CNY deposits currently sitting in China to migrate over to the CNH market:

1. Foreign companies with sizeable CNY profits remit a portion out of China in CNY and sell in the CNH market. Even

assuming approval will be given on a case-by-case basis to begin with, demand for this should be high. As long as

profits have been paid, there are currently no restrictions on dividending out profits in foreign currencies, but

remitting dividends out in CNY is still prohibited.

2. One could also see CNY coming out of China if the Qualified Domestic Institutional Investor (QDII) scheme is

allowed to expand. This scheme allows institutions to raise funds onshore and take them offshore to manage them.

Demand for QDII products has been limited since the global financial crisis, but that is likely to change.

3. If offshore rates and bank services are attractive, it is possible that the CNY deposits of wealthy individuals could

quietly migrate across the border. At present, such capital account transactions are strictly controlled – but they are

possible, in theory. In recent years, there has been much speculation of ‘hot’ money entering China via massaged

(and therefore illegal) trade invoicing. It is conceivable that an onshore firm could exaggerate its import bill in order

to remit more CNY to a connected party in Hong Kong and to get CNY into the CNH market.

How do our projections change if we take into account more deposit migration via channels outside of trade and tourism?

Chart 3 shows two alternative scenarios. The first is a gradual migration of onshore deposits to Hong Kong via other

routes, with the size of these deposits reaching 1.0% of total onshore deposits by 2015. The second scenario assumes a

faster pace of migration, with these migrating deposits reaching 2.5% of total onshore deposits five years from now.

What immediately jumps out from the chart is how quickly the CNH liquidity situation (and hence the development of

CNH markets) in Hong Kong could change if the right incentives and regulations are put into place.

Chart 3: A need to open up further routes for CNY migration offshore

Projected CNH deposits in Hong Kong under three scenarios

0

200

400

600

800

1,000

1,200

2010

2011

2012

2013

2014

2015

Base case Alternative scenario 1 Alternative scenario 2

Notes: Alternative scenario 1: Gradual expansion of non-trade, non-tourism deposit migration channels, reaching 1.0% of onshore deposits by 2015; Alternative scenario 2: More rapid expansion of non-trade, non-tourism deposit migration channels, reaching 2.5% of onshore deposits by 2015





V. Important similarities and differences with theEurodollar market

12

Comparisons will inevitably be made between the CNH and the Eurodollar markets. The Eurodollar market grew rapidlyfrom the 1960s as a result of US capital account controls, as well as tax measures introduced by the US authorities. For

instance, in 1963, the US introduced an interest equalisation tax. Non-US banks were also not subject to US Fed’s

reserve requirements or to deposit insurance payments.

As a result, banks in Europe found that they could lend USD at a lower rate than banks in the US and offer deposits at a

higher rate. As a result, USD liquidity migrated to London, where non-US banks were not subject to regulation by the

Federal Reserve. Other factors helped, too. Middle East oil exporters preferred to keep their oil revenues out of the US,

for instance, as did the government of the Soviet Union and its allies, for political reasons.

Once the liquidity began to move, more and more corporates decided they wanted to borrow and raise US debt in

London. As we show in Table 4, non-residents continue to hold the majority of their USD offshore. And as Table 5 shows,there is still a large number of offshore holders of US corporate debt.

Table 4: US dollar deposits (USD bn, year-end 2008)

Location of bank

Non-bank depositor US Outside US Total

US resident 11,743 1,520 13,263

Non-US resident 809 2,580 3,389

Total 12,552 4,100 16,652

Sources: He and McCauley, Fed Reserve, BIS

Table 5: US bond market (USD bn, year-end 2008) Residence of holder

USD bond issuer US Outside US Total

US resident 18.117 5,656 23,773

Non-US resident 917 2,740 3,657

Total 19.034 8,396 27,430

Sources: He and McCauley, US Treasury, Fed Reserve, BIS

One of the keys to the Eurodollar market, as Dong He and Robert McCauley point out, was that the US government

never impeded settlement in the US. In other words, the market relied on the fact that offshore institutions could freely

clear their balances with onshore banks in the US. And once that happened, offshore banks could freely develop long

and short FX positions. (On this topic, we recommend He and McCauley’s paper, ‘Offshore markets for the domesticcurrency: monetary and financial stability issues’, March 2010).

During the late 1980s and 1990s, US capital controls and key taxes were eliminated, but by that time, the US offshore

market was so developed that it continued to be very important. To this day, LIBOR is the benchmark for US corporate

borrowing.

As the offshore CNY market develops, comparisons with the Eurodollar market will be inevitable. And there are important

similarities. There is strong global demand for CNY, as there was for USD, and China’s economy is clearly becoming

ever-more integrated with the global economy. In addition, China has capital controls which limit offshore access to

onshore markets, just as the US did. And like the US and the UK in the 1960s, China’s tax environment is very different

from that of Hong Kong.




V. Important similarities and differences with theEurodollar market (con’d)

13

However, the CNH market differs from the Eurodollar market in certain key respects:

1. The CNH is not a market-driven reaction to government-imposed capital controls and tax costs; in contrast, the

PBoC is developing the market as a core part of its strategy to facilitate the internationalisation of the CNY. If

companies are to invoice and settle in CNY offshore, then they need a place to borrow CNY, and they need to be

able to hedge and invest CNY. The CNH is therefore necessary. In other words, this is a controlled experiment.

2. At present at least, unlike the Eurodollar market, there are limits on the ability of Hong Kong banks to clear with

onshore banks. This means, as we explained above, that a connected but distinct CNH FX market will develop

offshore. In the short term, this may be an inevitable by-product of China’s reluctance to liberalise its capital account.

Further out, however, as steps are taken to gradually ease broader capital controls, the pace of CNH liquidity

expansion may accelerate markedly, and the divergence between the onshore and offshore USD-CNY rates will

naturally compress.

3. Sovereigns taking their USD out of the US were among the key first movers in the creation of the Eurodollar market.

However, in the case of China, foreign sovereigns do not currently hold CNY assets. It took some time for US

corporates to move USD offshore – and this is likely to be the case with China too, especially since the current

capital controls prevent China corporates from transferring funds offshore. In the Eurodollar case, US firms gradually

moved, and LIBOR (the London USD rate) became the corporate benchmark rate. Also, US retail depositors

basically remained onshore, and consumer loans in the US continued to be priced off the prime benchmark.

4. The PBoC will be very careful to ensure that the offshore market does not introduce unmanageable risks to the

onshore market. It will work closely with the HKMA to achieve this aim. As such, for instance, the liquidity reserverequirement of 25% on CNH deposits could potentially be adjusted in order to control credit growth. Having said that,

the CNH would have to gain considerable scale before having a macro-impact on the onshore market, so this is not

a significant risk in the foreseeable future. Moreover, the quota for access to the onshore bond market will be closely

managed – thus limiting offshore access to higher-yielding CNY assets.

5. The CNH interest rate environment will be affected by regulatory restrictions between the on- and offshore markets,

and by a number of other factors. These dynamics are very different to those in the Eurodollar market. CNH rates

have been much lower than onshore rates, given the limited investment options. However, as more debt is issued

and access to the onshore market expands (alongside an increase in the amount of Chinese trade denominated in

CNY), we expect CNH rates to move up. The degree of convergence with onshore rates will partly depend on the

size of the quotas granted to banks for access to the onshore market. Another dynamic is the strong desire of HongKong banks to accumulate CNY liquidity in order to better position themselves for the imminent increase in asset-

side CNH balance-sheet activity, and to participate in the CNH spot and deliverable forward markets (and eventually

the interbank, rates and derivatives markets). The absence of an onshore-like regulatory ceiling on deposit rates

(and a floor on lending rates) could also develop into a major advantage for the CNH market.

As a result, we guess that the CNH market will develop – but not as quickly as the spectacular expansion of the

Eurodollar market in the 1970s.




VI. Frequently asked questions

14

Definitions

So far, there is no standard market terminology for the offshore CNY market in Hong Kong. There is no specific Reuters

dealing code, although the ‘CNH’ currency identifier is now active on Bloomberg. The following identifiers may be used

by banks internally to identify specific types of cash flow:

CNO: Onshore deliverable Chinese yuan, accessible by China-registered entities in China and where the PBoC is

the clearinghouse

CNH: Offshore deliverable Chinese yuan, accessible by entities outside China

1. New account and transfer rules

What are the latest changes in corporates’ ability to open accounts and conduct CNY business?

All corporate customers, authorised institutions (bank or non-bank institutions under HKMA jurisdiction) and other

financial institutions (such as insurance companies, brokerage firms and asset management companies) are allowed to

open deliverable CNH accounts with Hong Kong-domiciled trade settlement banks, including Standard Chartered Bank

(Hong Kong) Limited.

Individuals and corporations can conduct CNH payments and transfers through banks inside Hong Kong. In general,

customers who have CNH accounts can freely buy and sell CNH via an authorised institution.

Authorised Institutions in Hong Kong are allowed to grant CNH loans to institutions and corporations, but not to personal

customers and what the HKMA refers to as ‘Designated Business Customers’ (DBCs, or Hong Kong-based non-financial

businesses with specific transaction requirements).

.Conversion limits of CNH 20,000 on retail accounts and one-way conversion restrictions on DBC accounts apply (please

refer to HKMA regulations for details).

While the HKMA has removed regulatory net open position limits for the CNH interbank market, it now requires banks in

Hong Kong to maintain a total CNY cash plus settlement account balance with the clearing bank of no less than 25% of

CNH deposits.

What transaction services can now be offered by branches and subsidiaries of trade settlement banks outside

Hong Kong and mainland China?

From a nostro account perspective, non-mainland and Hong Kong branches and subsidiaries are now allowed to open

CNH accounts in Hong Kong. In the specific case of Standard Chartered Bank, branches and subsidiaries can open

CNH accounts with Standard Chartered Bank (Hong Kong) Ltd. for ‘general purposes’, i.e. non-trade-related activities.

This in turn allows them to offer CNH accounts to individuals and institutions for ‘general purposes’

The definition of ‘general purposes’ is broad, spanning CNH-denominated commercial loans and deposit-taking;

investment in CNH-denominated bonds (such as those trading in Hong Kong); interbank transactions involving FX,

money market and other derivative products; CNH FX services; and CNH investment products sold to customers.

Note that this rather liberal regime is still subject to the jurisdiction of the local regulator where the subsidiary or branch

operates. Moreover, the CNH fund movement must remain outside the mainland and, for certain transactions, may be

subject to the Hong Kong trade settlement bank’s underlying capabilities to square the position in the local CNH

interbank market.




VI. Frequently asked questions (con’d)

15

What is the difference between ‘general purpose accounts’ and cross-border trade activities? Which controls on

CNY fund transfers remain?

The ‘general purpose account’ is a new development (reflecting the PBoC/HKMA liberalisation measures) and can be

used for non-trade-related transactions. The ‘cross-border trade account’, in contrast, allows CNH to be used as a

currency for trade settlement (as it can be readily translated into CNY onshore).

The PBoC still has control over conversion involving CNO, and this will be mainly limited to trade-related transactions

(although the PBoC may approve other transactions). For non-trade-related fund movements, mainland banks have the

responsibility to seek approval or clearance from the PBoC for cross-border flows.

CNH can be readily transferred between different offshore accounts (so a Dubai resident, for example could move CNH

between accounts in different geographies), as long as there is no cross-border transfer back into the mainland.

2. Nostro and other account issues

What is the difference between setting up nostro accounts in Hong Kong and mainland China?

The use of a CNO nostro account with a mainland bank is limited to trade-related business and to the transfer of

balances into or out of mainland jurisdiction. It is subject to clearance from the PBoC or requires documentation

supporting its status as a cross-border trade-related remittance. A CNH nostro account with a Hong Kong participating

bank can be used for non-trade-related activities such as interbank placements, investments and transfer between

accounts outside the mainland. Subsidiaries and branches located outside the mainland and Hong Kong will typically

hold both types of account.

Should customers open a CNH account with a Hong Kong bank or a CNO account with a mainland entity?

If the account is a CNH account with a Hong Kong trade settlement bank, the funds’ mobility and usage are more flexible,

but liquidity could be worse. Hence, depending on the clients’ side of the transaction, the favourability or unfavourability

of market pricing may be amplified. (This would not affect trade-related transactions, which could enjoy onshore rates.)

The CNO NRA (Non-Resident Account) is more tightly regulated, but obviously the liquidity pool is huge, so pricing would

be closer to market. Therefore, non-trade-related transactions may well be settled through a CNH account, while trade-

related transactions could be settled through either a CNH or a mainland China CNO account.

Do CNH and CNO balances net out?

No. CNH nostro accounts attract interest charges (similar to other nostro accounts), while CNO overdrafts must be met

by borrowing from mainland nostro banks.

Why do trade-related CNH transactions enjoy onshore CNY rates?

Trade settlement banks are allowed to square trade-related CNH transactions with mainland entities, and hence can

access the onshore liquidity pool (subject to a cap on the daily limit for offshore trades). For non-trade-related

transactions, institutions such as Standard Chartered Bank (Hong Kong) Ltd. can only square the positions in the Hong

Kong interbank CNH market.




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Documents

SCB Research on CNH