Bankers rarely complain about financial liberalisation. Relaxing the rules around money offers them the opportunity to make more of it, something that should be music to the ears of any financial salesman.
But the rapidity with which China has thrown open its currency market in recent months has shocked even the most progressive financiers.
“Usually markets liberalise much slower than expected, but it’s been the opposite case with China; the speed with which they’ve liberalised in the past few months has left us all racing to catch up,” says the head of fixed income at an investment bank in Hong Kong.
Shortly after announcing on June 19 that it would let the renminbi begin to appreciate once more, China began easing a slew of rules, mostly via Hong Kong. Banks have had their hands freed over collecting renminbi deposits, more borrowers have been allowed to issue offshore renminbi bonds, and the country’s trade settlement system has been greatly enlarged.
The easing of renminbi dos and don’ts (mostly the latter) has heralded a purple patch for innovation in an otherwise grey environment. Hong Kong’s financial markets are brimming with excitement over potential new products, and the money that can be made.
Hong Kong Exchanges and Clearing (HKEx), for example, which owns the city’s stock and futures exchanges, is considering launching a renminbi currency futures market. It looks set to be the first exchange outside of China to do so, and it has been conducting a soft consultation in the market about the planned offering.
Yet while all this activity is great news for Hong Kong, the city is a long way from translating this promising start into a successful extension of its financial industry.
Liquidity is a major problem. Put simply, the city lacks enough renminbi flows to structure appealing investment products and derivatives at competitive rates. Yet without such products, it will be difficult to deepen its renminbi flows.
But competition may prove to be the biggest threat to the city’s aspirations. And it is not emanating from traditional arch-rival Singapore, but from the hand that has been feeding it for some time – China itself.
Even as Beijing makes use of its Special Administrative Region as a hotbed for financial experimentation, it is also preparing an onshore product that could potentially steal the thunder of Hong Kong’s offshore renminbi hopes: non-resident accounts (NRAs).
These new financial vehicles are effectively onshore renminbi settlement accounts for offshore corporates. NRAs offer international companies the ability to get renminbi exposure directly, instead of going through Hong Kong.
They are exactly the sort of product Hong Kong banks are offering in an effort to increase liquidity in the currency in the city’s nascent market. Such liquidity is, of course, not a problem on the mainland.
But while Beijing may be establishing a direct channel between its onshore banks and international companies, what Hong Kong has in its corner is a free-market environment and the innovative trappings that come with it. Many corporates feel much more comfortable having accounts set up in a country known for just that.
Beijing seems to have consciously created a playing field with two opposing teams as it looks to build momentum in making the renminbi an internationally used currency. It’s a uniquely competitive, even capitalistic, way to hedge its bets over the best means of liberalising its currency.
It means that Hong Kong has no time to waste underpinning its credentials if it is to capitalise on the excitement being generated about its renminbi market.
Liquidity is the key
Hong Kong has in the past three months witnessed one of the fiercest periods in its history of changes in financial rules, allowing for a slew of new financial products (see box opposite).
These liberalisations were sorely needed for Beijing to realise its goal of making the renminbi an internationally used currency, given that only 1% of China’s trade is denominated in renminbi.
Hu Xiaolian, deputy governor of the People’s Bank of China (PBoC), is on record as saying that the renminbi has a long way to go before it can be viewed as an international currency.
To improve its usage offshore, and particularly in Hong Kong, Beijing has in essence allowed more banks and corporates to keep their money in renminbi. And it has given the banks the scope to create renminbi-denominated investment products and derivatives in which this money can be placed.
The products are essential. Companies and investors will only hold renminbi offshore if they can hedge the currency and invest it into liquid products that offer a good return.
“Two factors critical to Hong Kong’s evolution into a thriving Rmb offshore hub are liquidity and hedging [products],” says Sam Xu, senior product manager for J.P. Morgan in China. “The two feed on each other, and gaining critical mass will be a key part of the decision-making process among corporates considering incorporating Rmb into their treasury basket of currencies.”
Attracting more renminbi retail deposits is important for the banks because it lets them put more of the currency to work for higher-margin corporate clients. For example, a bank with a sizeable renminbi deposit base can offer renminbi loans to a corporate client to help finance its business.
Conversely, banks without good renminbi deposits need to rely on the interbank market to offer renminbi loans or create products.
“If the renminbi pool in Hong Kong is larger, then the bank may be able to fund the renminbi loan business with its own deposits, or be more confident about securing renminbi funds on the interbank market,” says Frances Cheung, senior strategist at Credit Agricole CIB.
The trouble is that no bank has meaningful levels of renminbi on tap yet, making it more expensive for them to offer the very products that would encourage more liquidity. It’s a potential Catch-22, and it’s not helped by the fact that retail account holders are limited to converting Rmb20,000 a day. That is not a large amount in the grand scheme of things.
The good news is that renminbi holdings are growing fast in the city. Hong Kong’s banking system accumulated renminbi deposits at the fastest pace in more than two years in July, with deposits in the currency jumping 15.6% from the previous month to a record Rmb103.7 billion (US$15.2 billion).
That is the highest level since regulators first allowed renminbi bank accounts in the country in 2004. Growth has been equally impressive on the trade settlement side. According to the PBoC, half-yearly settlement volumes grew from Rmb3.6 billion in the second half of 2009 to Rmb70.6 billion in the first half of 2010 (see graph on following page).
Yet for all this growth, the renminbi market in Hong Kong is still nowhere near deep enough to support a thriving daily market for US dollar/Chinese renminbi forwards and bonds. While about Rmb100 billion of renminbi is entrenched in Hong Kong and daily levels are rising, the city needs to amass trillions more to underpin a truly liquid set of markets.
Lacking that liquidity makes it expensive to purchase renminbi in the offshore spot market, which means that the market cannot price very competitive rates compared with the onshore market for the currency pair.
It’s this need to deepen renminbi holdings that explains Beijing’s rapid and continuing munificence when it comes to cutting the red tape surrounding the renminbi. If it wants its foreign-exchange experiment to proceed, it has little choice.
“We see Beijing’s efforts to support and facilitate the introduction of renminbi products as an attempt to pre-empt a potential bottleneck in the renminbi trade settlement scheme,” said Donna Kwok and Qu Hongbin, economists at HSBC, in a research report. “The development of offshore renminbi products expands the number of vehicles in which foreign investors and enterprises can park renminbi earnings and funds.”
The hope is that more renminbi will accumulate as liquidity slowly rises, and that banks will be able to create new, high-returning structured products. HSBC, J.P. Morgan and Deutsche Bank are among the names rushing to build their capabilities in the nascent offshore renminbi market in the expectation that the deposit base will keep surging.
Banks have also wasted no time in launching simple structured products, such as time deposits, to the retail market.
For example, the Hong Kong branch of the China Development Bank launched its second offshore renminbi-denominated note in two days on September 3. The bank’s local outlet issued a fixed-rate two-year certificate of deposit (CD) worth a total of Rmb1 billion, with a coupon of 2.1%. HSBC is charged with marketing the CD.
All banks are keen to talk up this new market, and say how they want to help develop it. There is a simple way the institutions could demonstrate such commitment: by offering derivative and product prices that encourage more clients to put money into renminbi products, even if it isn’t particularly profitable in the short term.
That might not sound palatable for banks that tend to focus on making a quick buck. But such endeavours would, in the long run, go a sizeable way to building their market share and enlarging the renminbi market in Hong Kong as a whole, ensuring that everybody’s a winner.
If Hong Kong’s banks fail to offer a concerted commercial response quickly enough, they could see the potential of the city’s renminbi market dissipate in the face of direct rivalry from NRAs in China.
The appeal for international corporates in setting up an NRA on the mainland is obvious. For a start, the renminbi is flush there, and cheap to buy. There is also a natural inclination to park the renminbi in the country of its origin.
However, the appeal of these new accounts will depend on a lot of factors, and as yet the NRAs are riddled with bureaucratic question marks.
Perhaps most importantly, the PBoC has yet to clarify whether it will allow a holder of an NRA to take renminbi out of the account and swap it back into their home currency before repatriating the proceeds.
There is also debate as to whether setting up an NRA will count towards the bank’s debt quota, which could constrain its ability to lend in foreign currency.
“If the Rmb in an NRA is counted as foreign debt, [Chinese] banks will have [fewer] economic reasons to offer the accounts as they can easily source Rmb from normal deposit accounts,” said Justin Chan, deputy head of global markets for Asia-Pacific and head of Hong Kong trading at HSBC.
The central bank is expected to release further guidance on the NRA accounts clarifying the above very soon. But the fact that it has not offered such guidance already is interesting. It’s possible that the central bank is giving Hong Kong some lead-time.
After all, if the central bank allows the NRAs to be as flexible as possible, they would certainly pull renminbi away from Hong Kong, ham-stringing already-tight liquidity.
“The PBoC is well aware of the consequences to Hong Kong if it makes it easy to move money out [of] the NRA account and swap it back in,” says a treasury official at a foreign bank in China who has discussed the issue with the central bank.
Banks that can offer services in both Hong Kong and China may be best placed to benefit from this tension. J.P. Morgan, for example, already has the PBoC’s permission to open NRA accounts.
Maintaining a head start
If Chinese banks can convince international companies that NRAs are secure, and offer them liquidity, good hedging and investment prospects, the instruments could pose a threat to Hong Kong.
The timing of the PBoC announcement clarifying how NRAs work will reveal just how much the central bank intends for local institutions to spar with their rivals in the Special Administrative Region.
But for the short term at least, Hong Kong has a head start, and it has made all the right moves. It has quickly set up a competitive system for raking in renminbi, putting all the right products in place to keep flows coming in and attracting important corporate clients.
What Hong Kong needs to do now is to show that a free market is more enticing than parking business in the renminbi’s home base.
The cost of financing expensive hedging products for corporate clients might hurt Hong Kong banks in the short term. However, do it right and Beijing would be convinced to keep using the city as its main port of call for currency operations.
Hong Kong’s offshore renminbi market offers banks and clients alike enormous opportunities. The bankers charged with building it would be well advised to do what they can to build it now, because they may not have it to themselves forever.