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| Special Report |

Delphine Arrighi, +852 3983 8568 Kelvin Lau, +852 3983 8565 Nicholas Kwan, +852 2821 1013
Standard Chartered Bank (Hong Kong) Limited Standard Chartered Bank (Hong Kong) Limited Standard Chartered Bank (Hong Kong) Limited
Senior Rates Strategist Regional Economist Head of Research, East
Delphine.Arrighi@sc.com Kelvin.KH.Lau@sc.com Nicholas.Kwan@sc.com

Robert Minikin, +852 3983 8567 Stephen Green, +86 21 3851 5018 Thomas Harr, +65 6530 3617
Standard Chartered Bank (Hong Kong) Limited Standard Chartered Bank (China) limited Standard Chartered Bank, Singapore
Senior FX Strategist Head of Research, Greater China Head, Asian FX Strategy
Robert.Minikin@sc.com Stephen.Green@sc.com Thomas.Harr@sc.com

Will Oswald, +65 6307 1527


Standard Chartered Bank, Singapore
Head of Fixed Income Research
Will.Oswald@sc.com

The new CNH market


15:15 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

Highlights
V. Important similarities and
• The offshore CNY market in Hong Kong (CNH) has sprung to life.
differences with the Eurodollar
• Comparisons with the Eurodollar market are inevitable, but there are
market ..................................... p.12 important differences.
• We expect significant CNH liquidity growth as a result of CNY trade
settlement, tourist receipts and other CNY flows.
VI. Frequently asked questions
................................................. p.14 • New spot FX and deposit markets have developed as new rules limit
CNY fungibility.
• CNH bond issuance could grow quickly, if the transfer of funds to
mainland China is relaxed further.
• Rapid product innovation could mean the sophistication of the CNH
market quickly runs ahead of the onshore market.
• Standard Chartered, as one of the leading CNY trade settlement
banks, is in the midst of these CNY/CNH flows and is active in building
these markets.
• We include an FAQ section on technical issues in the CNH market.

Important disclosures can be found in the Disclosures Appendix

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


Special Report | 27 August 2010

I. The new CNH market

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.

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Special Report | 27 August 2010

II. How the CNH market was built

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

80
70
60
50
40
30
20
10
0
Dec-09

May-10
Jan-10

Jun-10
Feb-10

Mar-10

Apr-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 and
earn 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.
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Special Report | 27 August 2010

II. How the CNH market was built (cont)

• 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).

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Special Report | 27 August 2010

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

Chart 2: Set to rise


CNH deposits in Hong Kong vs. onshore deposit base

100 0.20%

80
0.15%

60
0.10%
40

0.05%
20

0 0.00%
Jun-04

Oct-04

Jun-05

Oct-05

Jun-06

Oct-06

Jun-07

Oct-07

Jun-08

Oct-08

Jun-09

Oct-09

Jun-10
Feb-04

Feb-05

Feb-06

Feb-07

Feb-08

Feb-09

Feb-10
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.

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Special Report | 27 August 2010

III. The CNH market today

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.

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Special Report | 27 August 2010

III. The CNH market today (cont)

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.

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Special Report | 27 August 2010

III. The CNH market today (cont)

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%
Source: Standard Chartered Research

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.

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Special Report | 27 August 2010

III. The CNH market today (con’d)

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.

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IV. How quickly can CNH liquidity be built?

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


From trade settlement From tourism receipts Deposits in Hong Kong

Hong
Kong's
CNY trade Hong annual
CNY trade settlement Kong CNY
settlement annual annual tourism
% of annual flows, tourism receipts CNH
China's imports of flows, from receipts from deposits, CNH CNH
total Growth in goods from imports of (excl. Growth in mainland annual deposits, deposits, CNH
imports of imports of settled in imports of goods + airfares), tourism (excl. gross annual net cumulative Total deposits,
goods goods CNY goods services total receipts airfares) inflows inflows net inflows deposits % of total

USD bn USD bn USD bn USD bn USD bn USD bn USD bn USD bn USD bn


(1) (2), (3) (4) (1), (8) (5) (6) (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%

(C) = (D) =
(A) (B) (A) + (B) (C) x 50% (E)

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
Source: Standard Chartered Research

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Special Report | 27 August 2010

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

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

1,200

1,000

800

600

400

200

0
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
Source: Standard Chartered Research

11
Special Report | 27 August 2010

V. Important similarities and differences with the


Eurodollar market

Comparisons will inevitably be made between the CNH and the Eurodollar markets. The Eurodollar market grew rapidly
from 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 domestic
currency: 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.

12
Special Report | 27 August 2010

V. Important similarities and differences with the


Eurodollar market (con’d)

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 reserve
requirement 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 Hong
Kong 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.

13
Special Report | 27 August 2010

VI. Frequently asked questions

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.

14
Special Report | 27 August 2010

VI. Frequently asked questions (con’d)

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.

15
Special Report | 27 August 2010

Disclosures Appendix

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Data available as of 15:00 GMT 27 August 2010. This document is released at 15:15 GMT 27 August 2010.
Document approved by: Nicholas Kwan, Head of Research, Asia
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