Financial centers slugging it out for yuan business

The offshore yuan pie is expanding fast, but many cities want their slice of it, and Hong Kong must make greater efforts to maintain its position this year as the premier renminbi offshore center, analysts said.

It's facing intensifying competition from other financial centers, including London and Singapore.

Since 2007, when China began to internationalize its currency, offshore renminbi liquidity has ballooned to 1.2 trillion yuan ($198 billion). The yuan became the world's eighth most-used currency for trade settlement at the end of 2013.

With deposits of 827 billion yuan in its banking system, Hong Kong has gained a clear lead over other financial centers in attracting offshore yuan funds. Now it needs to increase investment channels, such as equity-linked notes, to maximize the deployment of those funds.

Banks in Hong Kong have called for policy support as they move to expand the yuan capital market by convincing more issuers from the mainland to raise long-term debt in the city.

The market for these dim sum bonds has certainly surged. Last year, total yuan bond issued offshore rose 12 percent to 137.4 billion yuan.

So far this year, issuers ranging from milk powder producers to property developers, insurers, banks and even sub-sovereign bodies have raised renminbi funds offshore.

For investors in these bonds, the return "was about 4 percent in 2013. For a Hong Kong- or US dollar-based investor, there was another 3 percent currency appreciation", said Cecilia Chan of the Asia-Pacific fixed income division of HSBC Global Asset Management (HK) Ltd. She said the yuan is expected to appreciate another 2 percent in 2014.

According to HSBC, the average maturity of offshore yuan bonds is 2.7 years. "That's quite short," said Chan, adding that the sector offers lower duration risk (which measures the price sensitivity of a financial asset to changes in interest rates) with good return.

"The past few months have been a busy time for dim sum bond issuers. We expect the momentum to continue on both the demand and supply side," Chan said. "As long as investors are willing to buy, there is no shortage of suppliers. Both Chinese and global names are welcomed."

Standard Chartered Bank Plc has forecast a big year for dim sum bonds in 2014. In a report published in January, the bank said: "We are constructive on dim sum bond market performance in the near term, as we expect the current loose (offshore yuan) liquidity conditions to continue for slightly longer.

"This is despite likely large supplies in the first quarter, driven by large refinancing needs and the widening onshore-offshore interest rate gap."

The historically wide cross-border rate gap will drive Chinese corporate issuers to seek funding in the offshore market, the report said. "We expect more issues, particularly certificates of deposit, to be easily refinanced."

Noting that the National Development and Reform Commission, China's top economic planner, had granted a quota of 75 billion yuan to State-owned entities to issue dim sum bonds, the bank said: "Quasi-sovereign names, including policy banks, are leading the way. They are likely to be followed by other State-owned banks."

As demand picks up, Chan said, the market is also likely to see long-maturity corporate bonds this year. However, that may lead to yields climbing.

"Longer duration bonds need to offer better returns to compete with US dollar bonds, because the US Treasury yield curve is very steep," she said.

The 10-year Treasury yield is about 3 percent. Adding in a credit spread of 2 percentage points, the yield will be 5 percent.

"For dim sum bonds, there is also currency risk. Besides, as the market is smaller, liquidity could be a problem. People would expect a decent yield pickup for long-term bonds. It depends on the quality of credit."

According to a report from UBS AG in December, global offshore yuan liquidity has leaped since cross-border trade settlement in the currency took off. Such liquidity rose from 60 million yuan in late 2009 to more than 1.2 trillion yuan by the end of 2013. Three-fourths of that capital remains in Hong Kong.

Despite its size, the offshore yuan market offers few investment channels other than dim sum bonds. Equity issues are few.

Hui Xian Real Estate Investment Trust Ltd, listed in 2011, was the first yuan-denominated stock issue in Hong Kong. In 2012, another Hong Kong-listed company, Hopewell Highway Infrastructure Ltd, issued yuan-denominated shares in the secondary market.

UBS said: "A shortage of (offshore yuan) bonds and other instruments relative to demand hinders both the efficient development of the dim sum bond market and (offshore yuan) liquidity growth."

That shortage also discourages turnover in the dim sum bond market, meaning the secondary market is illiquid, the bank said.

According to Nathan Chow, an economist at DBS Bank (HK) Ltd: "We expect 2014 to be a breakthrough year for offshore renminbi investment tools. There might not be yuan-denominated stocks, but we believe other products will see significant growth this year, especially investment vehicles such as equity-linked notes."

Chow said he believes that the daily individual conversion ceiling of 20,000 yuan in Hong Kong will soon be adjusted. Last October, when Hong Kong Monetary Authority Chief Executive Norman Chan visited Beijing, the People's Bank of China - the central bank - reacted favorably to his proposal to ease the limit.

In November, the Hong Kong Financial Services Development Council urged the Hong Kong government to "strive for further relaxation of the policies applicable to Hong Kong residents on renminbi exchange and remittance, in order to maintain the competitiveness of Hong Kong vis-a-vis other offshore renminbi centers."

"The revision of the cap is critical. The relaxation will largely fuel the demand, trade volume and variety of yuan products," Chow said.

"Very few people are interested in yuan-denominated investment tools such as equity-linked instruments, because it's too much trouble to acquire the principal," he said.

"Tight liquidity is also a bottleneck for yuan business. Smaller banks in particular find it hard to accumulate a sizable and stable capital pool to develop yuan products."

Shen Minggao, head of China research at Citibank, said that instead of lifting the daily yuan conversion ceiling in Hong Kong, it's more vital to widen access to the mainland capital market for overseas investors.

"What people want is products with reasonable return and controllable risk. For example, interbank negotiable certificates of deposit are attractive to foreign investors. But they are filtered out," he said.

Shen said that the segregation of the domestic market is slowing progress in the development of offshore yuan investment channels.

"Somehow, you need to allow people to have access to equities and real estate on the mainland so they have the underlying assets to develop yuan-denominated products offshore. You can't expect them to create investment instruments, such as mutual funds, with nothing."

Measures such as allowing foreign companies and individuals in the China (Shanghai) Pilot Free Trade Zone to invest in the mainland securities market are "a drop in the bucket", Shen said.

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