HSBC-RMB_offshore_bonds

abc Global Research � Supply of offshore RMB bonds greatly lags demand due to regulatory hurdles � Expectation of RMB appreciation is the key driver, while onshore policy rates have mattered little � We expect annual issuance to hit RMB100bn in three years’ time and for demand to remain sound The renminbi-denominated financial markets have developed into a significant sector well ahead of the internationalisation of the currency. Accessibility by foreign investors, however, has been poor prior to the formation of an offshore RMB market in Hong Kong, also known as the CNH market. RMB is now a deliverable, convertible and transferable currency in the CNH market, and there are few restrictions on foreign investors wishing to access or offer RMB financial products. Since the first bond issuance in mid-2007, RMB75bn of bonds have been issued. Outstanding CNH bonds currently stand at RMB58bn in 42 issues. The market has a short average duration (of only 1.5 years), high credit quality (averaging between single-A and double-A) and low yield. It has so far shown little correlation with onshore rates, while expectations for the RMB to appreciate have been the most important driver. Although nearly doubling last year’s issuance, supply in CNH bonds has sharply lagged surging demand. Year-to- date net issuance matched only 17% of the net increase in RMB deposits in Hong Kong, resulting in a 90% bid only secondary market. Lengthy and rigorous regulatory approvals relating to bond issuance (by PRC issuers) and proceeds remittance (by offshore investors intending to use proceeds onshore) have been the major hurdles for the supply of CNH bonds. We expect the supply of CNH bonds to rise to RMB100bn annually by 2013 from RMB37bn so far this year. Attractive funding costs should invite more supply from both on- and offshore issuers, while growing RMB cross-border trade settlement business will underpin the demand side. Fixed Income China/Hong Kong RMB offshore bonds Developments, dynamics and outlook 13 December 2010 Becky Liu Strategist, Asian Credit Research The Hongkong and Shanghai Banking Corporation Limited +852 2822 4392 beckyjliu@hsbc.com.hk View HSBC Global Research at: http://www.research.hsbc.com Issuer of report: The Hongkong and Shanghai Banking Corporation Limited Disclaimer & Disclosures This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it 2 Fixed Income China/Hong Kong 13 December 2010 abc Introduction The offshore RMB bond market has demonstrated an extraordinary pace of development since the deregulation of offshore RMB in mid-2010. However, it is still in a preliminary stage. There is only RMB58bn of bonds outstanding in the CNH market, which is less than 1/4000 the size of the onshore interbank market. Initial accumulation of offshore RMB funding started over 10 years ago at a slow pace, from RMB settlement of border trades (1997), personal RMB business (2003), and RMB business for Designated Business Customers (DBCs) in Hong Kong (2005). In July 2007, an offshore bond market started to come into shape, marked by China Development Bank’s issuance of the first offshore RMB bond. It was followed by the pilot RMB trade settlement scheme and a broadening of offshore RMB business in 2009 and 1H10. Since July 2010, the market has entered an accelerated phase after most restrictions on offshore RMB business were lifted (Figure 1). From a regulatory standpoint, any foreign companies – including corporates, banks and non- Developments, dynamics and outlook � Sudden increase of RMB offshore funding has not been matched with a sufficient supply of RMB bonds � Strong demand has driven CNH bond yields far lower than onshore and Eurodollar peers � Expectations for the RMB exchange rate drive the demand side, while regulatory developments decide supply 1. Development of the offshore RMB market 1997 2003 2005 2007 2009 Feb -2010 June -2010 July -2010 and onwards RMB settlement of border trades Personal RMB business started DBCs RMB business started 1st RMB bond sale Initial cumulation of offshore funding Pilot programme for RMB trade settlement started RMB offshore business broadened RMB trade settlement scheme expanded Restrictions on offshore RMB business mostly lifted Formation phase of offshore bond market Acceleration phase of the CNH market RMB inter-bank market formed; CNH FX rate introduced; 1st RMB fund launched; 1st RMB security listed; 1st RMB deliverable forward traded... Source: HSBC 3 Fixed Income China/Hong Kong 13 December 2010 abc bank financials – can now open RMB corporate accounts with an authorised institution in Hong Kong. There’s no longer any restriction on currency conversion between the RMB and other currencies for corporate customers. There’s also no restriction on the transfer of RMB funds between accounts and regions in the offshore market. Further details on regulatory developments, sources of RMB funding, settlement, and tax issues are available in the appendix section. Eligible and existing issuers Over time, the scope of eligible CNH bond issuers has been broadened. � PRC incorporated financial institutes – including PRC banks or PRC subsidiaries of foreign banks – became eligible to sell RMB offshore bonds in 2007. Initial issuances mainly targeted retail investors. � Since July 2010, all foreign investors became eligible to sell CNH bonds. Issuance has been shifting to institutional investors, but retail tranches remain available from sovereign and quasi-sovereign issuances. The CNH bond market started in 2007. Initial issuances were purely from PRC-incorporated financial institutions of 2-3 years’ duration. In late 2009, sovereign bonds issued by the Ministry of Finance (MoF) were sold for the first time outside of mainland China. Since July 2010, development has picked up sharply with a deluge of benchmark new issues being priced within a short timeframe of just a few months: � The first foreign corporate bond by Hopewell Highway Infrastructure in July � The first certificates of deposit (CDs) by Citic Bank International in July � The first multinational bond by McDonalds in September � The first supranational bond by the Asian Development Bank in October. It was also the first CNH bond of 10 years in tenor, and the first RMB-denominated security to list on the Hong Kong Stock Exchange � The first red-chip issuance by Sinotruk in October � The first high-yield issuance from Galaxy in December. 2. Size of domestic/offshore RMB bond markets, vs AxJ Eurobond market 58 2,749 1,765 0 500 1,000 1,500 2,000 2,500 3,000 Offshore (CNH) Onshore (inter-bank) Onshore (ex change) Ax J USD Eurobond RM B bn 187,547 Source: HSBC, Chinabond, Bloomberg 3. Summary of current regulatory framework of RMB business in Hong Kong CAN be done without any approval CANNOT be done or regulatory approval required Open RMB corporate account PRC-incorporated issuers need relevant approvals to sell offshore bonds Conversion between RMB and other currencies RMB transfer between accounts offshore Loans extended to personal or designated Business Customers are not permissible Extend RMB loans to corporates Non-mainland issuer issuing offshore RMB bonds Cross-border currency transfers under capital account require approval from relevant authorities Offer RMB products Invest in offshore RMB bonds and other products Cross-border currency transaction under current account Source: HKMA, HSBC 4 Fixed Income China/Hong Kong 13 December 2010 abc A seller’s market – strong demand but lagging supply The fast offshore funding accumulation is not matched by sufficient increase in supply of offshore RMB investment products. With RMB deposits at Hong Kong banks swelling by 246% year-to-date (+RMB155bn), net issuance of CNH bonds amounts to just RMB28bn – a mere 17% of the net increase in RMB offshore deposits (Figure 5). Strong demand The lack of alternative investment products and the low loan-to-deposit ratio of RMB have left Hong Kong banks with excess RMB liquidity, and therefore the need to park excess deposits in safe interest-bearing assets. As per data from the HKMA, the loan-to-deposit ratio for all currencies with Hong Kong banks is much lower than the ratio for HKD, at 59.6% and 73.6% respectively. This suggests an even lower ratio for non-HKD funds. In particular, the first RMB syndicated loan was only priced in early December in small size (between China Automation Group and nine Hong Kong banks comprising an RMB tranche of RMB50m). Note that none of the Hong Kong banks have tapped the HKMA’s swap line for RMB funding after the Hong Kong clearing bank BOC (HK) depleted its RMB8bn quota for trade-related FX settlements. That said, subsequent RMB cross- border trade settlements have been facilitated by the banks’ own long RMB positions and/or funding from the Hong Kong interbank market. Recent new issues all gained strong market traction. They were multiple times oversubscribed and have been constantly priced tighter than expected. Government and quasi-sovereign new issues priced since November all received strong 4. CNH bonds issued in Hong Kong SDBC BCHINA EXIMCH EXIMCH BCHINA BCOM CCB CGB BNKEA SDBC HSBC CGB SDBC BCHINA EXIMCH CNHTC ICBCAS RESOUR HPW ELL GALENT ASIA CAT CHM ERC CINDBK HSBC DB MCD UBS M TFG 0 2000 4000 6000 8000 10000 2007 2008 2009 2010 2007 to July 2010: Only mainland FIs allowed July 2010 onwards: All foreign issuers become eligible Source: HSBC, Bloomberg 5. Issuance of CNH bonds sharply lagging the growth of offshore deposit base 0 50 100 150 200 250 2007 2008 2009 2010 RM B bn CNH outstanding bonds CNH deposit +RMB155bn (+246%) from end 09 +RMB28bn (+95%) from end 09 Source: HKMA, HSBC 5 Fixed Income China/Hong Kong 13 December 2010 abc books of 5-15x. Even the issuance from B/B3 rated Galaxy Entertainment was 10x oversubscribed despite offering a low yield of 4.625% (Figure 6). Attractive funding cost The current borrowing cost is attractive for both onshore and offshore issuers. In the domestic market, China’s lending and deposit rates are highly regulated – both rates are set by the government across all tenors, currently at levels much higher than onshore bond yields. Banks have little leeway to lower rates further, and even top-tier corporates have only up to a 10% discount from policy lending rates. Onshore bond yields, at the meanwhile, are high versus CNH bonds. Currently, the yields of CNH bonds are trading well inside onshore bonds and onshore deposit rates (Figure 7). For example, in the onshore market 3-year BBB- rated bonds from China Resources Power are yielding over 90bp inside China sovereign bonds, which are rated at Aa3/A+ by Moody’s/S&P. Compared with the bank lending rate of 3-5 years, it is as much as 366bp lower. At the same time, credit spread premiums required to compensate for weaker credit quality are also low. The yield differential between Aa3/A+ rated CHEXIM and BBB-rated China Resources Power bonds is only 35bp for the 3-year notes in the CNH market, while it is as high as 135bp for their 5-year notes trading in the Eurodollar bond market. Why does supply lag demand? Despite the favourable market dynamics, why is supply still lagging demand? First, there has been a broader channel for RMB funds to flow out from mainland to offshore than the other way around. As per the broadened trade-settlement scheme promulgated in June 2010, mainland importers in the expanded 20 provinces and cities can settle 6. Strong demand in latest issuances 15 7 5 9 13 0 20,000 40,000 60,000 80,000 CGB 3Y CGB 5Y CGB 10Y CDB 3Y CHEXIM 2&3Y 0 5 10 15 20 Issue amt (RMB m) Book size Ov ersubscribe (times, RHS) RMB m Times (X) Source: HKMA, HSBC, Bloomberg 7. CNH bond yields much lower than onshore rates CAT 2012 HPWELL 2012 CNHTC 2012RESOUR 2013 RESOUR 2015 SDBC 2013 EXIMCH 2013 1 2 3 4 5 6 7 3M 6M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 10Y Yi el d/ ra te (% ) Onshore CGB Lending rate Deposit rate AAA Corp Selectiv e offshore bonds Source: HSBC, Bloomberg, Chinabond 6 Fixed Income China/Hong Kong 13 December 2010 abc imports in RMB with any counterparty globally. However, on the flipside, only approved pilot enterprises in designated pilot districts can settle exports with overseas parties. Before December 2010, there had been only 365 mainland enterprises that were eligible to settle exports in RMB. As of 7 December, however, that number had surged by more than 180x to 67,359. In addition, part of the outflow was driven by recent opportunities to generate risk-free income. As per local media outlet Business China, around 80% of mainland imports are conducted between affiliated companies, which were reportedly able to make a 1-2% gain on the total settlement amount by taking advantage of low offshore (USD) lending rates vs high onshore (RMB) deposit rates, and appreciation priced in by offshore NDF. As a result, about 80% of RMB cross-border settlements have been mainland importers’ payments for offshore products, while only 10% are payments by offshore companies for mainland exports (Figure 8). Second, there remain lengthy and rigorous approvals relating to the issuance of CNH bonds and the remittance of proceeds. So far, only PRC-incorporated financial institutions are allowed to sell CNH bonds. There are not yet any regulations regarding CNH bond issuance by PRC-incorporated corporates. For PRC- incorporated FIs, approvals from the PBoC, NDRC and State Council are required to issue offshore RMB bonds. The entire process may take several months. With applications typically made at the beginning of the year, approvals have usually been obtained in the second half. This is leading to an interesting observation that all CNH bonds priced so far were issued in the second half of the year (note that foreign issuers only became eligible to sell CNH bonds in July 2010) (Figure 9). On top of stricter regulatory approvals, PRC issuers’ bond sales in the CNH market are smaller in size and shorter in tenor than onshore issuances, which also weaken mainland issuers’ incentive to sell offshore bonds despite cheaper funding costs. For example, China Development Bank’s typical issuance size in the offshore market is RMB10-20bn while tenors can reach 30 years. In the CNH bond market, CDB issuances were RMB1-5bn in size and 2-3 years in tenor. Foreign issuers, although no approval is required in terms of bond issuance, are subject to mainland authorities’ approval if they wish to remit proceeds to the onshore market. There’s currently no specific PRC law/rule in place regarding the remittance of capital account items in RMB (as opposed to USD). As such, all remittances of CNH proceeds in RMB require special approval 8. Breakdown of RMB cross-border trade settlement (between July 2009 and July 2010) Ex ports 11% Total Imports 78% Imports betw een affiliated companies Serv ices and others 11% Source: HSBC, the Business China 9. All CNH bond issuance took place in the second half 0 5,000 10,000 15,000 Jan Mar May Jul Sep Nov RM B (m ) 2007 2008 2009 2010 Source: HSBC, Bloomberg 7 Fixed Income China/Hong Kong 13 December 2010 abc on a case-by-case basis. There are generally two forms of remittance: � Shareholder loans between the offshore issuing entity and its onshore operating entity. Approval from the PBoC (top-level officials, such as the deputy governor) and SAFE (local SAFE for amount up to USD300m, central SAFE for the amount beyond) is required. The amount of remittance can be up to difference between the total investment amount and the registered capital of the onshore subsidiary. This type of approval enables not only initial proceeds remittance to onshore upon issuance, but also the remittance from onshore to offshore for interest and principal payments in future dates. This has been the preferred method for non-FI issuers. � Equity injection is injecting capital to a (usually newly established) onshore entity. Approval from the PBoC, SAFE and MOC is required. Initial approval enables only the remittance of bond proceeds onshore, while offshore liabilities are usually serviced by dividends subsequently (which are under the current account and therefore no separate approval is required). So far only Hopewell Highway Infrastructure’s proceeds have been remitted under this method. CNH bonds not driven by onshore rates… There has been limited interaction between the on- and offshore RMB bond markets which are dominated by different groups of issuers and investors. RMB bonds trading in the onshore market are highly susceptible to the change or expectation of change in China’s policy rates. Historical performance has suggested that the correlation between onshore government bond yields and the policy rate can be as high as 0.95 (Figure 10). During the last rate hike cycle (2006-08), onshore bond yields had followed closely the move of domestic policy rates. A similar situation was also seen during the rate cut cycle during the sub-prime crisis: the yield of the 7-year CGB dropped from over 4% to 2.15% as the 1-year deposit rate was cut from 4.14% to 2.25% in just three months (October to December 2008). The strengthening in onshore bonds was despite ongoing risk aversion in the broader market indicated by the continued decline in the onshore A-share stock market index. However, this correlation has yet to be seen in the CNH market. As the government surprisingly hiked policy rates by 25bp on 20 October and subsequently raised the reserve ratio three times since November, the onshore 7-year benchmark 10. Onshore CGB performance highly correlated with policy rates 11. CNH bond performance shows little correlation with onshore bonds 2 3 4 5 05 06 07 08 09 10 0 1,000 2,000 3,000 4,000 5,000 6,000 CGB (7-y r, onshore) 1Y deposit rate A-share index (RHS) Yield (% ) 2.5 3 3.5 4 10/09 01/10 04/10 07/10 10/10 Yi el d (% ) CGB (7-y r, onshore) CGB (5-y ear, CNH) Source: HSBC, Bloomberg Source: HSBC, Bloomberg 8 Fixed Income China/Hong Kong 13 December 2010 abc CGB bond yield has shot up by 63bp to 3.77% from 3.14%. On the contrary, CGB bonds trading in the CNH market saw their steepest decline in yield during the period while showing a much lower level of volatility, from over 3% to 1.9% (Figure 11). …but by FX expectations The expectation for the RMB to appreciate has been the most important factor driving offshore entities to receive RMB and invest in RMB CNH bonds. Figure 12 shows the amount of RMB deposits in Hong Kong versus market expectations of a change in RMB exchange rates. Before the outbreak of the subprime crisis, RMB NDFs had been pricing in annual appreciation of 3-10% and RMB deposits showed a steady increase. Starting in April 2008, as the expectation for RMB FX shifted from 10% annual appreciation to 3% annual depreciation, deposits in Hong Kong declined in sympathy by over 30%, from RMB78bn to RMB53bn. Note that, by then, retail conversion (subject to a RMB20,000 daily cap per individual) has been the main source of RMB offshore deposits, and therefore a slower pace of change. This time around, the pac