cnh vs cny

Asia Markets ResearchJanuary 26, 2010

www.morganmarkets.com

Summary• Ever since the global financial crisis, China is increasingly pushing for

renminbi internationalization. Authorities are carefully building up avenuesfor circulation of the currency between onshore and offshore. Cross-bordertrade settlement in CNY is the cornerstone of these schemes, but portfolioflows and ODI are also being opened, be it at a very slow pace.

• The CNH market, ie. the deliverable CNY market offshore in Hong Kong, isthe most visible result of renminbi internationalization. CNH deposits inHong Kong tripled last year, mainly on the back of cross-border trade, and areexpected to rise further rapidly. CNH product development is growing fast,from a low base. Foreign investors and corporates can now access a variety ofFX and rates CNH products.

• This publication collects recent research notes on the CNH market. First, weexplain how the avenues for CNH and CNY circulation fit together betweenonshore and offshore. Then, we make projections for growth in CNH depositsand trade settlement. Then, we categorize the FX and rates products that existfor foreign investors and corporates. Finally, we look at hedging and specula-tive opportunities available in the spot and forward CNH and CNY markets.

The certifying analyst(s) is indicated by the notation “AC.” See last page of the report foranalyst certification and important legal and regulatory disclosures.

The CNH market

Bert Gochet(852) 2800 [email protected]

Yen Ping Ho(65) 6882 [email protected]

Jason Mortimer(852) 2800 [email protected]

Grace Ng(852) 2800 [email protected]

Simon Song(86-21) 5200 [email protected]

Contents

Summary 1How the CNH market fits in with RMB internationalization 2Prospects of CNH business in Hong Kong 6CNH and CNY products available for foreign corporates and investors 9Opportunities in the spot and forward CNH market 11

Chart: How CNY turns into CNH (and vice versa). For a larger version, see page 3.

Source: JP MorganLegend:

Financial product Corporate Investor CNH market

Central Bank Bank CNH-CNY flow, or CNY-USD flow

Offshore

China onshore

CNHUSD

CNY

Hong Kong

Singapore,New York,London, ...

PBOC

HKMA

Other central banks

Corp Corp

Corp

Corp

Corp

Exchange traded shares

Exchange traded bonds

Interbank bond market

CNH bond market

CNH DF

CNY DF

CNY NDF

BoC(HK)Participant

bank

BoC

Investor

Investor

HK bank

CCY

swap

line

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Asia Markets ResearchJ.P.Morgan Securities (Asia Pacific) Ltd

The CNH marketJanuary 26, 2011

How the CNH market fits intothe internationalization of therenminbi

• China is carefully building up avenues for circulation ofrenminbi between offshore and onshore

• The CNH market in Hong Kong is the most visible resultof this process. We show how all the pieces of the CNHand CNY market fit together.

The five steps of RMB InternationalizationEver since the global financial crisis, China isincreasingly pushing for renminbi internationalization.Authorities are carefully building up avenues for circulationof the currency between onshore and offshore. Cross-border trade settlement in CNY is the cornerstone of theseschemes, but portfolio flows and ODI are also beingopened, be it at a very slow pace.

Broadly speaking, China’s full process of RMBinternationalization will proceed in five steps: (1) RMBleaves the Mainland; (2) RMB circulates offshore; (3) RMBreturns to the Mainland; (4) Width and depth of theoffshore RMB market is enhanced, and, finally (5) Capitalaccount is opened.

The first three steps are meant to build up the circulationof RMB between onshore and offshore markets. These arerelatively small steps towards RMB internationalization andhave been implemented in Hong Kong as a test market thatis available for a vaariety of counterparties and with certainquotas. The final two steps towards the opening the capitalaccount are much more involved and have barely started.

Step 1: RMB leaves the MainlandA so-called “pilot program” to allow direct settlement ofRMB transactions for cross-border trade was launched inJuly 2009. Corporates in Shanghai and 4 cities of Guangdongprovince on the one hand, and Hong Kong/Macau/ASEANon the other hand. This program was expanded in June 2010to allow for RMB settlement between 365 corporates in 18additional mainland provinces and all countries. In addition,the scope for RMB trade settlement was expanded to covernot only trade in goods, but also to trade in services andother current account transactions. In December 2010, thenumber of mainland exporters that is allowed to particpate incross border CNY settlement was raised to 67,359 from 365.

Mostly as a result of the RMB settlement pilot program,since mid-2009 cross-trade settlement picked upsignificantly, and reached a cumulative total of about CNY500bn at the end of 2010 (our estimates). Of this number, thevast majority traded in Hong kong (and Singapore), and 80%was used for import of goods, versus only 20% for export.As a result, nearly CNY 300bn has flowed out of Chinathrough net imports in the last year and a half. Whencomparing the growth in trade settlement with CNH depositsin HK, there is a clear strong link between the two, and wecan conclude that the main driver of deposit growth hasbeen merchandise trade so far.

Step 2: RMB circulates offshoreBanks in Hong Kong have been allowed to accept CNYdeposits since 2003. Depositors were initially retail whowanted to hold some renminbi in a bank account. Until twoyears ago, deposit growth was slow as there was nothingyou could really do with the RMB except keep it on deposit(at a very low deposit rate). Chart 2 on page 4 shows howdeposit growth in the early days was off to a slow start.

Table 1: Milestones in RMB internationalization

Date Program DetailsJul-09 Pilot program of RMB

trade settlementpilot program first launched in Shanghai and 4 cities of Guangdong province, for cross-border trading with Hong Kong, Macau, and ASEAN.

Jun-10 Pilot program expansion previous pilot program expanded to 18 additional provinces, for cross-border trades with all countries. Also, the scope now covers services trade.

Jul-10 Amended Clearing agreement

PBoC amended the Clearing Agreement with BoC (HK), expanding the scope of RMB business and increasing flexibility in RMB-denominated financial services.

Aug-10 Pilot program for opening bond market

PBoC lauched another pilot program of opening China interbank bond market for three kinds of overseas institutions.

Jan-11 Pilot program for RMB ODI settlement

PBoC announces another pilot program which allows qualified corporates to settle in RMB in overseas direct investment (ODI).

Simon Song (86-21) 5200 2833Bert Gochet (852) 2800 8325

3



Chart 1: How CNY turns into CNH (and vice versa)


Source: JP MorganLegend:

Financial product Corporate Investor CNH market

Central Bank Bank CNH-CNY flow, or CNY-USD flow

Offshore

China onshore

CNHUSD

CNY

Hong Kong

Singapore,New York,London, ...

PBOC

HKMA

Other central banks

Corp Corp

Corp

Corp

Corp

Exchange traded shares

Exchange traded bonds

Interbank bond market

CNH bond market

CNH DF

CNY DF

CNY NDF

BoC(HK)Participant

bank

BoC

Investor

Investor

HK bank

CCY

swap

line

s Cros

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tr

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Conv

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The 2009 pilot program for cross-border trade kicked CNHdeposits up a notch. Since then, holding RMB in HK becamemeaningful for exporters and importers. Deposits increasedon the back of cross-border trade. From chart 2 you can tellhow deposits picked up pace from mid 2009. The pace ofdeposit growth over that period was broadly in line with thegrowth of China net imports settled in RMB. In other words,goods and service trade in the current account were the mainsource of RMB in HK over that period.

During this initial stage, Bank of China (HK) started toplay a special role in controlling the flow of RMB in HongKong. It was appointed as the clearing bank for alltransactions in the territory, ie. a de facto “central bank forRMB in Hong Kong”. BoC(HK) thereby became the lenderfor all RMB transactions, and also all RMB held by otherbanks was to be deposited with BoC.

In the days after the pilot progam announcement the accessto RMB in HK was only available to a limited amount ofcounterparties, and for a well defined set of purposes: retailcustomers (for RMB deposits and bonds), corporates (fortrade settlement), and depository institutions (for attractingdeposits).

Since mid-2010, the pace of development stepped upanother notch. In July, PBoC amended the ClearingAgreement with BoC (HK), expanding the scope of RMBbusiness. As part of that amendment, corporates were nowallowed to open RMB accounts and transfer funds acrossaccounts for any purpose, regardless of whether or not theyrelate to trade settlement. In addition, banks were allowed tointroduce RMB-linked products, such as CDs, deliverableforwards, mutual funds, and insurance products. InterbankCNH deposits and CNH deliverable forwards started tradingin the market. At the same time, CNH deposits startedballooning.

For the last six months, any retailer or corporate-regardless of its country of domicile- has been able to doRMB business in HK, as long as they simply open asettlement account with BoC (HK). All their transactions areclosely monitored by HKMA. But there is a restriction onclearing - banks can only square open positions of RMB withBoC(HK) for settlement of cross-border trade, subject to aquota (which was CNY8bn last year, and 4bn for 1Q11).Meanwhile, non-trade related transactions can only besquared in the CNH inter-bank market.

This raises the important point that CNY can freely leaveChina and enter the CNH market as long as it is backed upby trade documents, but the reverse is not true. Say forexample, a mainland based importer can pay in CNH for asmany imports as he likes. This flow of CNY out of China intoCNH happens without quota, and is the main reason whyCNH deposits in Hong kong have picked up so strongly in2010. But a non-China based buyer of Chinese goods is notnecessarily guaranteed to be able to obtain CNH to pay forhis purchases. After all, he will need to purchase the CNH inthe market or from his banker, and eventually that positionwill need to be squared via BoC(HK) subject to theconversion limits set by PBOC.

These limits were the topic of discussion late last year whenit turned out that the CNY8bn conversion quota for 2010had been exhausted ahead of year-end. Effectively, there hadbeen more demand for CNH from non-China basedcorporates than authorities had expected, and the quota hadalready been filled. The quota for this year has beenincreased, with CNY4bn for the first quarter. It is believedthat this will be sufficient for now. Over time though, theCNH liquidity in the Hong Kong market will become selfsustainable and the quota approach will eventually bescrapped.

Step 3: RMB returns to MainlandFor obvious reasons the third step in the internationali-zation of the currency- ie. “letting RMB enter back into theMainland”- has been the slowest step to develop so far. Butthere is improvement, albeit at a small scale. There are twodifferent approaches that are being taken to make progresson this front. The first is through a “Mini QFII” program.The second is to let selected offshore banks buy onshorebonds.


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bn yuanRMB deposits in Hong Kong

2004 2005 2006 2007 2008 2009 2010

Chart 2: RMB deposits in Hong Kong

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The “Mini QFII” is a program would allow CNH funds flowback into capital markets in China (including A shares)through the channel of financial products provided by HK-based Chinese security firms and asset managers (Note thatMini QFII is different from the plain “QFII”: in the latter, USDgets echanged for CNY and invested in mainland exchangetraded products). Chinese media have reported on Mini QFIIseveral times since last year. But an official approval hasbeen delayed by concerns about hot money flows. Lastweek, Shang Fulin, the Chairman of CSRC again said thatMini QFII will be launched soon, but on a trial basis. HKMAofficials have also hinted that this program is pendingChina’s top leaders’ approval.

The second approach is letting selected offshoreinstitutions buy CNY bonds in the onshore interbank bondmarket. Under this scheme, three kinds of overseasinstitutions will be allowed to buy bonds onshore: (1)central banks who are already in cooperation with PBoC(such as through a currency swap line), (2) the RMBclearing banks in HK and Macau, and (3) “overseasparticipation banks” ie. those banks who are theparticipants in RMB cross-border trade settlement. Thecentral banks and clearing banks would be able to access theChinese interbank bond market directly or go through anagent bank such ICBC or BOC. The participation banks willhave to go through an agent bank and cannot access theinterbank market directly.

But even for this limited amount of institutions restrictionsapply, as one would perhaps expect. First, the bondinvestment needs an approval from PBoC. As far as weknow, only HKMA, BNM and ICBC (Asia) have received anapproval so far. Secondly, a quota will apply. In our

understanding, this would not be more than a few billionCNY to start. Third and perhaps most important, the sourceof RMB funds for the bond investment should be either (1)from currency swap lines with PBoC (note PBoC has openedup a total of CNY 800bn of swap lines with eight centralbanks since 2008. They are unused so far, but will be usedfor small size soon to kick off this program ), or (2) cash fromRMB cross-border trade by “participation banks”, or (3) fromproceeds from investing in RMB business. Fourth, eachoverseas institution can open only one RMB nostra accountwith one of the eligible onshore banks to do bond trades.

The impact of this pilot program on the onshore markets(spot, forward, bond, etc) is limited in the near term, sincetime is needed for application, approval and setup ofoperations. In the future, however, this program will improvethe circulation of RMB between onshore and offshore, andlink together the RMB markets in the Mainland and HK. Thischannel can be considered the first tentative step toward an“eventual” opening of the capital account.

Step 5: Opening of capital accountOpening the capital account will be the last and mostcautious step of the internationalization of RMB. On Jan13th, 2011, the PBoC announced yet another pilot programwhich allows qualified corporates to settle overseas directinvestment (ODI) in RMB. This is an important milestone inthe opening of the capital account, although ODI settled inRMB will still need approval on a one-off basis. Lately, someofficials have also started to suggest offshore companiesuse RMB for FDI too, but in our view it is too early for thatto happen.


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Grace Ng (852) 2800 [email protected]

Prospects for CNH business inHong Kong

• The Chinese authorities have pushed harder for RMBinternalisation since the global financial crisis

• RMB deposits in Hong Kong jumped significantly lastyear, along with PBoC policy liberalisation

• Critical mass of offshore renminbi, most of which likelyresiding in Hong Kong, will increase rapidly. We fore-cast deposits in Hong Kong to rise to CNH 2.6-3.5tri infive years time.

• Notable scope of RMB internationalisation throughmerchandise trade, services, FDI and portfolio flows

Since the onset of the global financial crisis in 2008, RMBinternalisation has become an increasingly importantpolicy target for the Chinese authorities. As the financialcrisis reveals the pitfalls of existing international monetaryarrangements, China joined other emerging countries tourge the International Monetary Fund to push ahead withreforms, giving developing economies a bigger say in thenew international financial order. In addition, the Chinesegovernment recognises that as China’s importance in theglobal economy and financial system increases, RMB is setto play a bigger role in international trade and finance, par-ticularly in Asia. In addition, from China’s point of view,RMB internationalisation would help to reduce exchangerate risks for Chinese firms, strengthen the internationalcompetitiveness of Chinese financial instititutions (giventheir vast pool of RMB assets) and preserve the value ofChina’s international savings1. Against this background,the Chinese government, especially the People’s Bank ofChina, has been pushing harder for the progress of RMBinternationalization since the crisis.

1500

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HK$ bn Hong Kong banking sector deposits

2004 2005 2006 2007 2008 2009 2010

HK$ deposits

Non HK$ deposits

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HK$ bnMainland visitor spending in Hong Kong

HK$

02 03 04 05 06 07 08 09

Total Mainland visitor spending

Mainland visitor spending per capita

1. “Internationalization of the Renminbi”, BOK-BIS Seminar, March 2009, by Gao Haihong andYU Yongding.

In practice, an international currency has to play the roles ofstore of value, medium of exchange and an unit of account,for both residents and non-residents, both the private sec-tor and public sector. At the official, public sector level,China has signed a number of bilateral swap arrangements,denominated in RMB, with central banks from other Asianand emerging economies, including Korea, Hong Kong, Ma-laysia, Russia, Indonesia, Argentina, etc, since the onset offinancial crisis, with the total amount of swap arrangmentsaccumulating to more than 800 billion yuan.

Hong Kong’s role as offshore RMB centreFor the private sector, the Hong Kong banking sector’sRMB deposit taking since early 2004 has been an earlystep to officially incorporate RMB circulating offshore,which arises from real economic activities such as Chinesetourist spending overseas, into the banking system outsideof mainland China. It is not difficult to understand the Chi-nese authorities’ decision to explore and expand offshoreRMB business in Hong Kong. While Hong Kong is specialadministrative region of China, it is well-recognised as avibrant financial centre with free flow of international capi-tal, and with almost half of bank deposits in the form of non-HK$ currencies.

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bn yuanRMB deposits in Hong Kong

2004 2005 2006 2007 2008 2009 2010

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Japan: breakdown of currency used for trade settlement % shareExports from Japan USD JPY EUR AUD CAD Others

Total exports 48.6 41.0 6.3 1.3 0.7 2.1To US 85.9 14.1 0.1 0.0 0.0 0.0To EU 49.9 30.1 15.3 4.2 0.2 0.3To Asia 49.9 48.1 0.6 0.4 0.2 0.8

Imports to Japan USD JPY EUR CHF GBP OthersTotal imports 71.7 23.6 3.2 0.4 0.3 0.8From US 78.1 21.4 0.2 0.2 0.0 0.1From EU 58.0 28.0 11.0 2.1 0.3 0.6From Asia 71.7 26.8 0.4 0.3 0.2 0.6

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US$ bn, 12mmaChina: merchandise trade

2004 2005 2006 2007 2008 2009 2010

Exports

Imports

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RMB bnRMB cross border trade settlement

1Q10 2010 3010

Imports to China

Exports from China

As of November 2010, outstanding RMB deposit in theHong Kong banking sector came in at 280 billion yuan,equivalent to 3.9% of of Hong Kong’s total M2 money sup-ply. Meanwhile, the Chinese authorities introduced theRMB trade settlement scheme in July 2009, which was thenexpanded in various stages to cover more than 67,000 Chi-nese corporates from 16 provinces and cities by December2010. In addition, the PBoC introduced a pilot scheme inAugust 2010, allowing eligible institutions outside the main-land to use their RMB funds to invest in China’s domesticinterbank bond market. Given the notable progress onpolicy liberalization, and with growing expectations on yuanappreciation in recent months, outstanding RMB deposit inHong Kong banks jumped by 212% since June 2010, toreach 280 billion yuan by November, equivalent to 4.6% ofHong Kong’s total M2 supply.

Critical mass of offshore RMB rises rapidlySo far, the overall scale of offshore RMB in Hong Kong isstill very modest. Despite the recent notable expansion, asof end 2010, the size of total RMB deposit in Hong Kong isequivalent to only 0.5% of total onshore yuan deposit in themainland. Going forward, however, there are good reasonsto expect the critical mass of offshore RMB, especially inthe form of RMB deposits in Hong Kong, to rise rapidly inthe coming years.

At the first glance, China’s sustained, elvated “twin sur-pluses” in the BoP current account as well as capital andfinancial accout (first chart) cast some doubt on the pros-pect for expanding the international use of RMB, as Chinacontinues to amass foreign currency assets via the “twinsurpluses” in the external accounts. However, in practice itis indeed reasonable to perceive rather rapid increase in theuse of RMB offshore. On the current account, in addition tothe likelihood that an increasing share of overseas spendingby Chinese tourists could be transacted in RMB, there issignificant scope for expanding the size of merchandisetrade settlement in RMB, especially starting from Chineseimporters paying their import bills in RMB. Indeed, figureson RMB trade settlement so far last year suggest the ma-jority is done on the import front (third chart).

To gauge the potential scope of RMB trade settlement, arelevant benchmark for comparison is the use of JPY in mer-chandise trade settlement by Japanese corporates. Accord-ing to latest data gathered by our fx strategy team in Tokyo,in aggregate, 41.0% of Japan’s exports are now settled inJPY, and the ratio on the import front stands at 23.6%(table). While such figures could serve as a benchmark for

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% of GDPChina: BoP current account, capital and financial account surpluses

2004 2005 2006 2007 2008 2009 2010ytd

Current account surplus

Capital and financial account surplus

1-3Q

1-2Q

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US$ bnChina: outward direct investment

2006 2007 2008 2009

the long term potential scope of RMB trade settlement, forthe medium term we have come up with more conservativescenario analysis regarding RMB trade settlement for thecoming five years, with the focus on expanding RMB settle-ment on the import front at this early stage.

• Assuming the share of China’s total imports settled inRMB will rise steadily towards 10% by 2015, and assum-ing average 10% annual growth in China’s imports, alongwith a more modest share (up to 3%) of exports settled inRMB, the pool of total trade-related RMB deposits, mostof which will likely reside in Hong Kong, could poten-tially rise to as much as 2,600 billion yuan in five years.This is a significant amount compared again the out-standing size of Hong Kong’s M2 money supply at HK$7,111 billion as of November 2010.

• In an alternative scenario, if we assume that it is thegroup of emerging market economies, including non-Ja-pan Asia, Latin America and Africa, that would see a no-table rise in the share of their exports to China settled inRMB (given their closer economic ties with China, andthe fact that China has in general held a trade deficit withthis group), and assuming the share of China’s total im-ports from this group to be settled in RMB will risesteadily towards 20% by 2015, the pool of total trade-re-lated RMB deposits in Hong Kong could potentially riseto as much as 3,500 billion yuan in five years.

Potential capital account RMB settlementIn addition to current account transactions regarding mer-chandise trade and services, going forward some capitaland financial account transactions could be settled in RMB.In particular, the PBoC announced two weeks ago that out-ward foreign direct investment could now be settled inRMB. Indeed, China’s outward FDI has risen notably in re-cent years, registering at US$56.5 billion in 2009, with 87%going to the emerging market economies, which would likelybe keen to receive RMB for FDI-related transactions.

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US$ bn, 12mmaChina: imports from emerging economies

2004 2005 2006 2007 2008 2009 2010

Asia ex-Japan

Latin America

Africa

In addition, going further ahead, China could further openup avenues for domestic investors to invest overseas,which includes, but would not be restricted to, the QualifiedDomestic Institutional Investor (QDII) program, in order todiversify the investment channels for the private sector.Part of this could be invested in RMB-denominated invest-ment products offered in Hong Kong. The potential shift ofevery 1% of China’s domestic deposit to RMB-denominatedinvestment products in the Hong Kong financial marketwould amount to the equivalent of 700 billion yuan.

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CNH and CNY products forforeign investors andcorporates

• In this piece we provide an overview of CNY and CNHproducts for offshore investors and corporates, includingFX, bonds, and swaps.

Onshore CNY rates and FX products

The interbank onshore bond market is traditionally closedto offshore investors. However, in August 2010 a pilotprogram was launched whereby a select group of financialinstitutions will be given approval by PBOC to use theiroffshore RMB to participate in the onshore interbank market(see pages 4-5). The exchange-traded onshore bond market(which is much smaller than the interbank market) is intheory already accessible from abroad by ‘any’ QFII holder,however a very limited amount of government bonds is heldthrough QFII. Onshore deliverable FX Forwards are notaccessible for offshore investors. Interest rate swaps (based

off the 7-day repo, 1-year deposit, and 3-month SHIBOR) aretraded onshore as well. For foreign investors, they areavailable in ND-form offshore.

Offshore deliverable CNH market, andthe’dim sum’ market

Deliverable CNH spot FX began trading in August 2010,tending to trade with a USD-discount to onshore CNY spot,but sometimes closing the gap. CNH deliverable forwards

Chart 1: Spot/FWD FX markets in CNY, CNH, & NDF CNY

Chart 2: Composite yield curves in Onshore CNY (green), Offshore deliverable CNH (blue), and Offshore NDF CNY(grey). Offshore CNH yields generally trade intermediate to Onshore CNY and Offshore NDF yields.

Jason Mortimer (852) 2800 [email protected]

-5.0

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Aug-10 Dec-10 Mar-11 Jun-11 Sep-11 Jan-12 Apr-12

CNY Onshore CNH Offshore CNY NDF FWDSCNY Onshore FWDS CNH Offshore FWDs

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started trading around the same time. CNH deposit rates arebased on quotes from BoC(HK), and given their one-waynature these rates are significantly lower than onshoredeposit rates. The CNH interest rateswap market hasgotten off to a false start: initial deals were based on (on-shore) SHIBOR but this proved impractical and such swapsare no longer actively quoted.

The ‘dim sum’ bond market refers to CNH-denominatedbonds that were issued offshore. The majority of ‘dim sum’bonds are denominated in CNH, but some other bonds are‘linked to CNY’ (but paid in USD). China’s CNH-denominated benchmark sovereign bond curve is currentlycomprised of a single issue each of 3y, 5y, and 10y CGBs.These bonds were issued by the Ministry of Finance, in theHong Kong market in December 2010. Their yields aresignificantly below mainland government yields, as they arecommonly used as a CNY-appreciation proxy. Bond issuancein the CNH market has increased sharply since the lifting ofrestrictions on trading CNH in mid-2010. The current total ofoutstanding issuance is CNY59bi. The greatest issuers arebanks (29%), government agencies (25%), and sovereigns(24%).

Offshore CNY NDFThe offshore traded CNY NDF is the grand dame of allChina products for foreigners, and has been actively tradedfor years. The non-deliverable cross currency swap (NDS)curve extends from the NDF curve. The interest rates impliedby the NDF and NDS curves are negative up till 5 years, asthe forwards imply a strengthening of the CNY.

Issuer Issue Maturity NotionalName Type Date Date (mil CNH) Tenor CouponAGR BK CHINA(HK) BANK 12/23/10 12/23/11 500 1 1.20AGR BK CHINA(HK) BANK 12/23/10 12/24/12 500 2 1.40ASIAN DEV BANK SUPRA-NATIONAL 10/21/10 10/21/20 1,200 10 2.85ANZ BANKING HK BANK 12/24/10 12/24/12 200 2 1.45BANK OF CHINA BANK 9/22/08 9/22/11 1,000 3 3.40BANK OF CHINA BANK 9/30/10 9/30/12 2,200 2 2.65BANK OF CHINA BANK 9/30/10 9/30/13 2,800 3 2.90BEA CHINA LTD BANK 7/23/09 7/23/11 4,000 2 2.80BK OF COMM - HK BANK 1/10/11 1/10/13 500 2 1.40BK TOKYO-MIT UFJ BANK 9/24/10 9/26/11 20 1 1.98CATERPILLAR FINL FINANCIAL 12/1/10 12/1/12 1,000 2 2.00CHINA DEV BANK GOVT AGENCY 8/20/09 8/22/11 2,000 2 2.45CHINA DEV BANK GOVT AGENCY 11/11/10 11/11/13 3,000 3 2.70CHINA DEVELOP BK GOVT AGENCY 9/10/10 9/12/11 100 1 1.95CHINA DEVELOP BK GOVT AGENCY 9/13/10 9/13/12 500 2 2.10CHINA DEVELOP BK GOVT AGENCY 9/13/10 9/13/12 1,000 2 2.10CHINA GOVT BOND GOVT NATIONAL 10/27/09 10/27/11 3,000 2 2.25CHINA GOVT BOND GOVT NATIONAL 10/27/09 10/27/12 2,500 3 2.70CHINA GOVT BOND GOVT NATIONAL 12/20/10 12/20/12 3,000 2 1.60CHINA GOVT BOND GOVT NATIONAL 12/1/10 12/1/13 2,000 3 1.00CHINA GOVT BOND GOVT NATIONAL 10/27/09 10/27/14 500 5 3.30CHINA GOVT BOND GOVT NATIONAL 12/1/10 12/1/15 2,000 5 1.80CHINA GOVT BOND GOVT NATIONAL 12/1/10 12/1/20 1,000 10 2.48CHINA MERCHANTS INDUSTRIAL 11/19/10 11/19/13 700 3 2.90CHINA POWER INT UTILITY - ELEC 12/23/10 12/23/15 800 5 3.20CHINA RESOURCES INDUSTRIAL 11/12/10 11/12/13 1,000 3 2.90CHINA RESOURCES INDUSTRIAL 11/12/10 11/12/15 1,000 5 3.75CITIC BANK INTL BANK 7/20/10 7/20/11 500 1 2.68DEUTSCHE BANK AG BANK 9/28/10 9/28/12 200 2 2.00EXP-IMP BK CHINA GOVT AGENCY 9/4/08 9/4/11 3,000 3 3.40EXP-IMP BK CHINA GOVT AGENCY 12/2/10 12/2/12 1,000 2 1.95EXP-IMP BK CHINA GOVT AGENCY 12/2/10 12/2/13 4,000 3 2.65GALAXY ENTERT GP INDUSTRIAL 12/16/10 12/16/13 1,380 3 4.63HONG & SHAN BANK BANK 8/17/10 2/17/11 114 1 2.00HONG & SHAN BANK BANK 11/19/10 5/19/11 90 0.5 1.80HOPEWELL HIGHWAY INDUSTRIAL 7/13/10 7/13/12 1,380 2 2.98HSBC BANK CHINA BANK 9/14/09 9/14/11 2,000 2 2.60ICBC ASIA BANK 9/24/10 9/24/12 1,000 2 2.25ICBC ASIA BANK 9/24/10 9/24/12 1,000 2 2.25ICBC ASIA BANK 10/22/10 10/22/12 117 2 2.30ICBC ASIA BANK 10/22/10 10/22/13 47 3 2.65INT BK RECON&DEV SUPRA-NATIONAL 1/14/11 1/14/13 500 2 0.95MCDONALD'S CORP INDUSTRIAL 9/16/10 9/16/13 200 3 3.00ROYAL BK SCOTLND BANK 1/20/11 1/20/14 100 3 1.80SINOTRUK HK LTD INDUSTRIAL 10/29/10 10/29/12 2,700 2 2.95UBS AG HK BANK 11/22/10 11/22/12 200 2 2.50VTB CAPITAL SA SPECIAL PURPOSE 12/23/10 12/23/13 1,000 3 2.95FUNG CHOI MEDIA FINANCIAL 12/14/07 12/14/11 190 4 0.00

Graph 1: Composition of bullet CNH bonds by issuer type

BANK29%

GOVT AGENCY25%

GOVT NATIONAL24%

INDUSTRIAL14%

SUPRA-NATIONAL

3%

FINANCIAL2%

SPV2%

UTILITY - ELEC1%

Table 1: Composition of bullet CNH bonds by issuer

Jason Mortimer (852) 2800 [email protected]

0

20,000

40,000

60,000

Jan-10 Apr-10 Jul-10 Oct-10 Jan-11

mln CNH

Graph 2: CNH bond notional issuance increased dramati-cally since August 2010

11



Opportunties in the spot andforward CNH market

• USD/CNH to stay in discount to onshore spot. Regulatoryreforms are needed to correct the imbalance, but anoverhaul not expected anytime soon. USD/CNH-USD/CNYconverged late-2010, but move is temporary and eventdriven.

• In principle, there is a large overlap in participants whocan access the offshore NDF and offshore USD/CNH DF.However, they fundamentally roll to a different spot rate

• All corporates and institutions, regardless of nature ofbusiness or investor type, can open CNH accounts andaccess CNH products as long as they comply with normalbanking regulations in Hong Kong with no additionalapprovals from SAFE or HKMA

USD/CNH spot to stay in discount vs USD/CNY

USD/CNH to stay largely in USD discount to onshore spot.In the lack of free capital flow and amid global investoraccess, USD/CNH is expected to stay in USD discountagainst onshore spot. Particularly, still thin CNH liquidityconditions are still far from sufficient to absorb globaldemand shocks. Hence, USD/CNH has tended to extendbelow onshore spot especially when CNY appreciationfervor rises. With spot USD/CNY expected to trend lower to6.30 through 2011, USD/CNH is similarly expected togravitate lower with some additional downside bias

Regulatory reforms are needed to correct the imbalance,but an overhaul not expected anytime soon. Insofar as the

Mainland capital account remains closed and RMB fundscannot flow freely from Mainland to HK and to globalmarkets, the lack of free arbitrage should leave USD/CNHbiased to a negative spread against onshore USD/CNY.While a move to a free capital account would allow offshore-onshore convergence, this is not expected anytime soon.Fundamentally, the PBoC remains extremely sensitiveagainst allowing offshore investor (or speculative) demandto impact onshore spot.

USD/CNH-USD/CNY converged late-2010, but move istemporary and event driven. While USD/CNH rallied intoUSD premium against USD/CNY late-2010, we view the moveas a knee-jerk reaction to HKMA regulatory refinements. Inparticular, headlines surrounding position limits on CNH hadtriggered a one-off readjustment of USD/CNH exposures.That said, the details of the regulations do not alter thefundamental elements driving the USD/CNH-USD/CNYspread. They remain 2 separate markets (and arguably moreso following the HKMA refinements). We would view USD/CNH-USD/CNY spot convergences as potentialopportunities to be short USD/CNH.

1. Imperfect convergence in spot CNH andCNY

The lack of strict arbitrage suggests CNH and CNY willremain fundamentally different markets. However, a lack ofpure arbitrage does not stop convergence trades in spot:

a) When a wide gap opens between onshore and offshorespot USD/RMB, this may motivate banks to position forconvergence. Banks, even those who are not funded byCNH deposits, may fund CNH cash via sell/buy USD/CNHswaps and buy spot. However, the scarcity of CNH liquiditysuggests risk that the bank may be unable to cover theforward delivery leg of the sell/buy USD/CNH swap. Takentogether with the risk that offshore spot may not actuallyconverge, this is far from a risk free trade (and not strictly anarb).

b) Corporate flow as a force for convergence. Corporatesreceiving CNY cash from bilateral trade may find it moreprofitable to buy USD against RMB via a lower offshoreUSD/CNH spot rather than the clearing rate through theClearing Bank. In light of this, non-resident corporates couldmigrate their RMB billing centre to Hong Kong, where RMBaccrued from payments by Mainland buyers could beoffloaded at a more favorable USD/CNH spot. Mainland

Chart 1: USD/CNH trading at USD discount to onshore spot

Yen Ping Ho (65) 6882 [email protected]

6.406.456.506.556.606.656.706.756.806.85

Aug-10 Sep-10 Oct-10 Nov-10 Dec-10

USD/CNH spotUSD/CNY spot

12



Chart 2: Summary of notable f lows across USD/RMB curves (numbers correspond to the text)

*dashed arrows represent limited/restricted convergence flows

(1) Corporates

(1) global CNH demand

(2) CNH vs NDF convergence trades

USD/CNY onshore DFUSD/CNH offshore DF

USD/CNY NDF

(3) onshore-offshore arb

(3) onshore-offshore arb

(4) "cross-border" hedging

(4) "cross-border" hedging

USD/CNY

entities may also establish re-invoicing centres in HongKong, as a means to channel CNH payments to offshoresubsidaries as an alternative for offshore financing. Thesesuggest an underlying bid for offshore USD/CNH insofar asit trades at an USD discount to onshore. Conversely,corporates requiring RMB for payments to merchandisetrade counterparties in Mainland, may find it cheaper togenerate RMB cash via USD/CNH if it trades above theonshore rate.

Overall, we still expect USD/CNH to remain biased to thedownside against onshore spot. To be sure, convergencetrades will anchor USD/CNH to the general trend of onshoreUSD/CNY, but in the lack of pure and unrestricted arbitrageoffshore RMB will still be vulnerable to global demandshocks. This suggests offshore USD/CNH will tend towardsa USD discount to onshore spot, as the 2 remainfundamentally separate markets. We would view USD/CNH-USD/CNY spot convergences as potential opportunities tobe short USD/CNH.

2. Offshore CNY NDF vs offshore CNH DF

In principle, there is a large overlap in participants who canaccess the offshore NDF (non-deliverable forward) andoffshore DF (deliverable forward) curves. However, liquidityconstraints to trading the offshore DF has limited theconvergence trade. For a start, the offshore deliverable legsettles with CNY notional while NDFs are settled only in

USD. This means that participants cannot enter long USD/CNH offshore DF unless they are already long CNH cash orcan easily fund in CNH. The inability to transact in largeenough sizes, unwind risks and wide bid-offers on CNH DFsalso feature to some part. In addition, both forward curvesroll into different spot rates. And this implies basis risk whentrying to cover the delivery leg of USD/CNH. Trading theNDF vs CNH would hence constitute taking views on 2different underlyings, which remains far from a risk-free arb.

That said, there is technical appeal to being on the shortUSD/CNH side of the CNH vs NDF convergence trade giventhe tendency for offshore spot to trade below onshore. Thisis apparent particularly at the longer-end of the USD/CNHcurve where forwards are in USD discount and substantiallyoff implied pricing from the deposit curve. However, amidfixing risks, liquidity risks and wide bid-offers on USD/CNH

USD/CNH forwards peeling off the deposit curve


6.40

6.45

6.50

6.55

6.60

6.65

NDFdepo implied CNHCNH

USD/CNY

spot 3M 6M 12M

13



DFs, risk reward is attractive only on wide spreads of USD/CNH against NDFs.

To be sure, the curves could converge increasingly asoffshore CNH liquidity improve in Hong Kong. However,trading volumes on the offshore DF have extremely thin.Even factoring strong growth, the market is not expected toachieve the threshold needed to anchor the offshore NDFsanytime soon. If anything, the market has so far been happyto acquire CNH via a lower USD/CNH spot, as CNH in HKcan be deployed in positive return assets as opposed tonegative carry in the NDF curve. Such demand dynamicsmay also leave a wedge between markets.

3. Onshore CNY forwards vs offshore NDF

Onshore-offshore arbitrage across the forward curves hasbeen going on for some time. Given that the NDFs trade at apersistent USD discount to onshore forwards, corporatesregistered Mainland may sell onshore USD/CNY forward asa hedging transaction with underlying documentation, but atthe same time buy USD/CNY NDFs via a separate but samename entity registered offshore. The trades can beenaggregated in accounting books as a pure arbitrage gain,though leaving the underlying USD receipt as a FXunhedged position.

To some extent, the onshore-offshore arbitrage flow hashelped anchor the NDFs to a spread against onshore.However, the small subset of entities able to execute thesetrades and limited ability to bring the positions on balancesheet have constrained the flow impact of such deals.Corporates can only sell USD/CNY onshore up to sizesprescribed by underlying invoices, and limited credit lines

from trading counterparties constrain the scope to positionin the NDFs. The recent regulatory changes by SAFE mayalso have reduced the ability of Mainland corporates to takeon such trades. Given the depth of NDF trading liquidityoffshore, onshore-offshore arb have had only limited abilityto compress the onshore-offshore spread.

4. Onshore CNY forwards vs offshore CNH

DF

In theory, there may be scope for some cross-borderhedging by naturally hedged entities. For example,Mainland corporates with both export and import operationswould typical net out export and import invoices to negateforeign exchange risks. However, those with entities outsideMainland could migrate the import invoicing centre offshorewhere long USD/RMB hedging can be accrued at the lowerUSD/CNH rate.

SummaryCurrent regulations ensure offshore USD/CNH remains afundamentally different market from onshore. Convergencetrades may narrow the difference. But in a world ofunrestricted CNH access, CNH will remain susceptible todemand-side shocks, and USD/CNH will be biased loweragainst onshore.

Leakages across the 3 forward curves suggest some scopefor arbitrage or convergence across markets. See summarychart 2 (flows numbered as outlined by text in precedingpages).


14



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