Emerging Markets Asia Guide to China's CNH Market

Emerging Markets Asia
10 March 2011
CNH Market Guide

A precursor to internationalisation of the Chinese renminbi
Woon Khien Chia Emerging Markets Strategy +65 6518 5169 woonkhien.chia@rbs.com The CNH market standing literally for the Chinese yuan deliverable in Hong Kong was formally introduced in July 2010 when China allowed interbank clearing of CNY in Hong Kong to pave the way for the expansion of trade and investment settled in CNY. The market will continue to grow rapidly and in multiple directions, by adding asset classes and expanding geographically. The dim sum bond market will remain its dominant asset class which we estimate to reach CNY180bn by the end of 2011. It is a unique market as it represents a governments attempt to internationalize the use of its currency while maintaining a relatively closed domestic market. This has naturally created numerous challenges for policymakers in China and Hong Kong on how to deal with arbitrage gaps and risks of market bubbles. This guide provides the chronological events from its origins to formative years of the CNH market and discusses policy issues and future developments.
Kristine Li, CFA Asia Pacific Credit Strategy +65 6518 5732 kristine.li@rbs.com
Pin-Ru Tan Emerging Markets Strategy +65 6518 5170 pinru.tan@rbs.com www.rbsm.com/strategy Bloomberg: RBSR<GO>
The Royal Bank of Scotland
Contents
Introduction Origins and objectives
Stages of development Next phase
3 4
4 6
Market anomalies
One currency, three markets Synthetic CNH a misnomer CNH central clearing
8
8 11 12
Dim sum bond market

Definition and terminology July 2010 Big Bang Issuer base Investor base Issuer and investor risks Liquidity and depth Synthetic CNH or CNY-linked bonds Panda bonds
13
13 14 15 20 21 22 23 24
Policy challenges
No full-proof interim solutions Risks and opportunities for Hong Kong Intrinsic value of an internationalised CNY
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25 26 27
Appendix I
Chronology of CNH market developments
30
30
Appendix II
Issuance, settlement and custodian regulations
31
31
Appendix III
List of abbreviations List of Bloomberg and Reuters codes
32
32 32
Appendix IV
List of CNH bonds and certificates of deposits List of CNY-linked bonds List of panda bonds
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33 34 34
Appendix V
Related RBS publications
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Emerging Markets Asia | CNH Market Guide | 10 March 2011
Introduction
There are three reasons the CNH market standing literally for the Chinese yuan deliverable in Hong Kong has generated more than its fair share of interest from investors rather than businesses engaging in cross-border trade with China, despite the country running the worlds largest trade surplus and being the worlds biggest trading partner. Timing of the CNH market launch. Coming after the subprime crisis and running straight into the EU periphery sovereign debt problem, the US Federal Reserves ultra-easy policy provided substantial global excess liquidity, while the EU troubles provided plenty of uncertainty about the developed markets to make the CNH market very attractive to cash-rich global investors. An undervalued CNY. By most measures, the outcome of a successful internationalisation is a much stronger CNY against the USD. Hence, this has made people want to hold CNY for investment rather than spend it on purchasing Chinese goods. Rapid but lopsided development of the CNY trade settlement scheme. This is partly due to the same rationale that the perceived CNY undervaluation defeats one side (Chinas exports) of the trade settlement scheme while promoting the other side (Chinas imports). It is also partly because the heavy regulation over the settlement and clearance of CNY across the border is limiting its use for transacting goods in third-party markets. Two questions are often asked about the CNH market. Why are there only USD11bn of investable instruments vs USD57bn of CNY deposits based in Hong Kong? Why trade in the CNH FX market and not the CNY NDF market? The first question is asked from an investors perspective; the second, from a traders perspective. Both questions lead to a chain of questions about the future course of market activities and the long-term value of the CNH market. This primer not only chronologically lists the events that have shaped the CNH market thus far, but also addresses in an orderly manner the various issues to arrive at a full picture of the current state of market and its outlook. Brief answers to the above two questions are as follow. Global demand should continue to overwhelm local supply of CNHdenominated assets in Hong Kong because there are numerous prerequisites for setting up an offshore centre to offer deliverable CNY settlement. From an excess of 80%, the demand overhang will only improve to 76% this year, by our estimate. This is premised on Chinas ambition to internationalise the CNY. The premium of the CNH-denominated assets (currently only in the form of bonds, known also as dim sum bonds) should persist for a long while. With no intra-day trading limits, the CNH FX market has bigger market risks and no fewer regulatory risks than the CNY NDF market, which is fixed on the onshore CNY spot market. Wedged between the existing CNY NDF market and the onshore CNY market, it has created numerous anomalies among the three markets. There is also the remote risk that China decides to overturn the restricted offshore deliverability of CNY. Our suggestion is thus to trade the CNH FX market only for the purpose of trade or specifically approved investments. 3 Emerging Markets Asia | CNH Market Guide | 10 March 2011
Origins and objectives

Stages of development
CNY deposit-taking in Hong Kong The origin of the CNH market dates back to December 2003, when Hong Kong and China jointly permitted personal CNY services in Hong Kong. It is important to note that the intention in the early days was more of a symbolic gesture to bring Hong Kong residents closer to the mainland. Hence, there was no effort to broaden the types of personal CNY services for Hong Kong residents beyond CNY deposit accounts, CNY remittances and CNY credit cards. The conversion of HKD into CNY was also limited to CNY20,000 per day. After an initial burst, the pace of CNY deposit growth eventually slowed and by June 2009, just before the commencement of the CNY trade settlement scheme, it accounted for merely 0.90% of Hong Kongs total deposit base. CNY-denominated (dim sum) bond market Onshore financial institutions were given the go-ahead by the PBOC as well as the National Development & Reform Commission to issue CNY bonds in Hong Kong in June 2007. In the following month, China Development Bank became the inaugural issuer. In December 2008, the State Council allowed corporations with substantial business in China and onshore financial institutions to issue CNY bonds in Hong Kong. This meant that foreign banks incorporated in China could also tap into the budding CNH bond market in Hong Kong. The rules were further liberalised in February 2010, when the HKMA announced that institutions are free to issue CNY bonds in Hong Kong as long as they abide by existing regulations and do not remit the funds to China. This resulted in an accelerated pace of issuance and the coining of the term dim sum bonds. CNY swap lines from PBOC Emerging Markets Asia | CNH Market Guide | 10 March 2011 4
December 2003 symbolic gesture to allow Hong Kong residents to set up CNY deposits
July 2007 start of CNYdenominated bond market
December 2008 PBOC signed its first CNY swap line with Bank of Korea
The PBOC has signed a total of eight CNY swap lines with foreign central banks. While the first few swap lines were initially meant as stand-by facilities to ease any trade settlement difficulties during the 2008-09 credit crunch, China subsequently said the swap lines would remain in order to promote bilateral trade and investments. Figure 1 shows that the size of each swap line is not proportionate to the recipient countrys share of Chinas trade, suggesting that China holds other strategic interests in these countries. E.g. in Singapores swap line which was extended after the CNY trade settlement scheme expansion, China probably sees Singapore as another potential offshore CNH centre.
Figure 1: PBOC's CNY swap lines

Date of swap line agreement South Korea Hong Kong Malaysia Indonesia Argentina Belarus Iceland Singapore Dec-08 Jan-09 Feb-09 Mar-09 Mar-09 Mar-09 Jun-10 Jul-10 Size of swap line (CNY bn) 180 200 80 100 70 20 3.5 150 % of China's total trade 7.0 7.8 2.5 1.4 0.5 0.07 0.01 1.9 Source: PBOC, CEIC, RBS
CNY trade settlement scheme
The use of CNY for trade settlement led to significant growth of the CNY deposit base in Hong Kong, which has now grown to 4.6% of its deposit base (see Figure 2).
Figure 2: CNY deposits in Hong Kong (% of HKs deposit base) vs volume of CNY trade settlement (CNY bn)
400 350 300 250 200 150 100 50 0 Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 09 09 09 09 09 09 10 10 10 10 10 10 10 10 10 10 10 10 CNY deposits in HK (% of deposits in HK, RHS) CNY trade settlement 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
Source: PBOC, CEIC, RBS
Special QFII scheme
August 2010 PBOC opens up its interbank bond market to participants of the CNY trade settlement scheme
With no formal name, this scheme was announced in August 2010 with the intention to create incentives for key foreign agents to promote the CNY trade settlement scheme. Under this scheme, CNY-clearing banks in Hong Kong and Macau, overseas banks involved in CNY trade settlement and foreign central banks that are holding CNY obtained via currency swaps from the PBOC (see list in Figure 1 above) are permitted to invest their CNY holdings in the China interbank bond market. These investors, however, have to abide by investment quotas to be allocated by the PBOC. The first batch of investment quotas was reportedly allocated to Standard Chartered Bank, Hong Kong and Shanghai Banking Corporation, and Bank of China International in October 2010, but the size of these quotas was not revealed. Subsequently, the HKMA announced in December 2010 that it was allocated an investment quota of CNY15bn, which is very small in comparison to its total CNY300bn swap line. The pace of implementation for this scheme is likely to remain slow due to concerns about hot money going back to China (see the Policy challenges section). 5
July 2009 China launched the CNY trade settlement scheme, revealing its ambition to internationalise CNY
Chinas move to promote the use of CNY for the settlement of its goods exports and imports across the border in July 2009 was a marked shift in its policy agenda. The plan started as a pilot scheme to allow five selected coastal cities Shanghai, Guangzhou, Shenzhen, Zhuhai and Dongguan to settle their trade with Hong Kong, Macau and ASEAN member countries in CNY. In June 2010, the scheme was expanded to a total of 20 Chinese cities for cross-border trades with all of their foreign trade partners. The PBOC also sped up its approval process, increasing the number of eligible onshore participating firms from 365 in July 2009 to 67,359 by December 2010.
CNY settlement for Chinas outbound FDI
Repo facility BOC (HK) launched a repo facility in late February 2011 to facilitate intraday liquidity management of participating banks. Demand for the facility will be rather limited due to two reasons. First, there is a 2% haircut as commission for lending the funds, which seems punitive relative to the average yields of CNH bonds. Second, only bonds issued by Chinas Ministry of Finance, Chinas policy banks and Bank of China are eligible as collateral for the repo facility, making the repo facility rather limited in scope.
Next phase
The next phase will focus on broadening geographical scope of current offshore schemes and opening up the domestic market
This section highlights future lopments in the CNH market that regulators are deliberating, but have not been implemented. Mini QFII This scheme will allow onshore securities and fund management companies to raise funds in Hong Kong for investment into Chinas asset markets. We understand the current proposal requires that 80% of the funds are to be invested in the domestic interbank bond market. Given that the onshore market offers higher yields than the CNH market, this scheme will likely be very successful in attracting funds. The scheme could also help to dampen the current euphoria in the dim sum bond market, albeit the impact might be marginal since there would still be differences in credit quality and spectrum of issuers between the onshore and offshore markets. CNY-denominated IPO listing in Hong Kong Under this plan which was first flagged by the Chief Executive of Hong Kong Monetary Authority, investors would use their CNY funds to participate in CNYdenominated listings in Hong Kong. Investors without CNY funds can exchange for CNY via a liquidity facility that will be set up for this purpose, but all investment proceeds will have to be converted back into HKD via the same liquidity facility. Inward foreign direct investment settlement After having recently permitted the settlement of outward direct investment in CNY, the authorities are said to be considering the same for foreign firms direct investment into China. In this area, the aim wasnt so much to relieve the CNY liquidity overhang in Hong Kong but to promote two-way flow of CNY. More offshore CNH centres Hong Kong is the first offshore centre for CNH and is likely to remain the main centre. To achieve the goal of internationalising the CNY, especially in the area of trade, China would have to allow more CNH offshore centres to be set up. The recent move by Bank of China to allow its US customers to trade CNY is a case
January 2011 PBOC allows use of CNY for outward foreign direct investment
The PBOC launched a pilot programme in January 2011 to allow qualified domestic firms to use CNY for their outward direct investments. This means that selected banks and non-bank corporations are able to launch new overseas businesses as well as pay for mergers and acquisitions in CNY. Profits from these investments can also be repatriated in CNY.
We see three conditions for setting up an offshore CNH centre: strong trade ties with China, a CNY swap line from PBOC and the currency of the offshore CNH centre being traded in Chinas domestic market. The necessity of the first condition is obvious. The second condition is also necessary because the nondeliverable status of the CNY meant that the central bank of the designated CNH offshore centre must be given a CNY swap line, thus enabling it to intervene on occasions of stress in its CNH market. The third condition is also necessary to allow China-based banks and their counterparts in the CNH offshore centre to directly quote the cross exchange rates between their two currencies.
in point. The bank, which is majority state-owned, now allows its retail customers to exchange up to USD4,000 of CNY per day. There are no restrictions for corporate transactions as long as the firm engages in international trade, since the CNY trade settlement scheme has already been fully liberalised to all of Chinas external trading partners.
Market anomalies
One currency, three markets
There are now three CNY markets the onshore CNY market, the original offshore NDF market and the CNH market, younger than one year, wedged between them. This has created layers of pricing discrepancies from FX spot, FX forward, interest rates to credit spreads. It is important to state clearly up front that the onshore market has various trading regulations that do not apply to the two offshore markets namely, USD/CNY spot is subject to a +/-0.5% intra-day trading band and the authorities also set the deposit and lending rates for not only CNY but also USD and other key foreign currencies, such as EUR and JPY. Hence, the discrepancies among the three markets have resulted from not only the physical barrier to free flow of CNY liquidity across the border, but also the onshore trading restrictions and interest rate regulations. It was easy for two markets to co-exist with a physical barrier in the past. However, as the third market, the CNH market could find that either it has an advantageous position from which to influence the directions of the other two markets, or it will be pulled erratically by both. We examine these differences in the three markets in the areas of FX, interest rates swaps, bonds and cross-currency swaps. The next section on the dim sum bond market will discuss these issues relating to the credit market. See Appendix IV for list of Bloomberg and Reuters codes. FX spot and forward Emerging Markets Asia | CNH Market Guide | 10 March 2011 8
August 2010 USD/CNH trading kicked off
The USD/CNH spot market began trading in Hong Kong in August 2010, to meet non-trade-related demand for CNY. It was given the CNH code to differentiate it from the onshore CNY and the prevailing non-deliverable CNY, which have been trading since late 1998. Note that CNH is not listed under the International Organization of Standards (ISO). If the offshore deliverable CNY market starts trading outside of Hong Kong, it is still possible for market makers outside of Hong Kong to come up with yet another three-letter currency code to differentiate themselves from the CNH market currently cleared in Hong Kong. There are two differences between the CNH and the existing CNY NDF markets. First, the former is settled in CNY, while the latter is settled in USD; second, CNH spot trades real-time and therefore does not require an onshore fixing reference, unlike the CNY NDF, which takes a spot fixing from the onshore CNY market at 11am local time daily. While the CNH and NDF markets are both accessible by all offshore parties, the accessibility by onshore parties is more restricted in the NDF than the CNH market, which is open to onshore parties through trade and foreign direct investment (FDI). Figure 3 lists the basic features of the CNH, NDF and onshore CNY FX markets.
Figure 3: Comparison between CNH, CNY NDF and onshore CNY FX market as of 9 March 2011
CNH Settlement currency Spot fixing Access CNY None, real-time trading Any offshore participants. Onshore parties only with underlying trade and FDI. CNY NDF USD Fixed to onshore CNY spot at 9:15am Any offshore parties. Onshore parties only through their offshore affiliates. Onshore CNY CNY None, spot trades real-time Onshore parties subject to various capital control limits. Offshore parties with underlying trade through the central clearing system operated by BOC HK subject to quotas. Source: RBS
Figure 4: USD/CNH vs USD/CNY
6 .8 5 6 .8 0 6 .7 5
1700 1500 1300 1100
6 .7 0 6 .6 5 6 .6 0 6 .5 5
900 700 500 300 100
6 .5 0 6 .4 5 A ug 10
-1 0 0 -3 0 0 F e b 11
S e p 10
O ct 10 C N Y spot
N ov 10
D e c 10
Ja n 11
S p re a d (p ip s , R H S )
C N H spot
Source: Bloomberg, RBS
Figure 5: USD/CNH forward vs USD/CNY NDF and onshore USD/CNY forward, 9 March 2011
6.60 6.58 6.56 6.54 6.52 6.50 6.48 6.46 6.44 6.42 6.40 Spot 1m 3m Tenors Onshore CNY CNH Offshore NDF 6m 12m
USD/CNH spot is lower than USD/CNY spot onshore from which USD/CNY NDF derives its spot fixing
From inception until late last year, the CNH spot traded at a significant premium over the onshore CNY spot due to overwhelming demand for CNY by market participants with no underlying trade (see Figure 4). Most of the demand comes from investors of CNH-denominated bonds. Although these dim sum bonds offer much lower yields than the onshore bonds, they are still far more attractive for investors with no access to the onshore market than putting their money in CNY fixed deposits or getting negative implied interest rates from going long CNY in the NDF market.
However, two regulatory changes changed the situation above, almost entirely collapsing the spreads between the spot and forward rates between the CNH and NDF market. The first was the HKMAs move to impose a 10% cap on Hong Kong-based banks net FX open position in CNY. The second was the PBOCs move on 9 November 2010 to clamp down on regulatory loopholes, of which onshore banks and corporates have been taking advantage. Specifically, the rule to set a floor to Chinese banks net long FX cash positions had forced Chinese corporates to go to the offshore CNH market to buy USD spot for imports or sell USD forward to hedge exports. Interest rate swap
CNH IRS curve came about on demand by investors of CNH bonds
The interest rate swap market in CNH came about because investors (rather than issuers) needed swap their CNH bond returns from fixed to floating. The curve uses the onshore 3m Shibor (Shanghai interbank offer rate) as a fixing rather than follow the heavily traded IRS swap curve, which is fixed on the onshore 7day repo rate. This may be because of the intention to follow the USD IRS convention of fixing to the 3m Libor. Trading volume in the CNH IRS market remains low and largely used for hedging rather than speculation. For now, the curve takes its direction mainly from the repo-fixed IRS curve in its offshore traded non-deliverable (ie USD settled) form. The reason for this may be because the latter is the most actively traded CNY IRS curve offshore, which reflects the onshore interest rate condition. There is also an onshore IRS curve, which is fixed on the 3m Shibor, but it is at best half as liquid as the repo-fixed IRS curve. Sovereign benchmark
Sovereign benchmark curve is taken from issues by Chinese government
As the currency is issued by China, the sovereign benchmark curve should come from the Chinese government and not the Hong Kong SAR government. The first batch of CNY bonds issued by Chinas Ministry of Finance in September 2009 was kept small at CNY6bn, spread across the 2y, 3y and 5y tenors. This was a very tentative start in building a sovereign benchmark curve for the CNH market. Secondary market trading was limited to the interbank market. The MOF) issued another CNY5bn batch of bonds in December 2010, this time tapping into the 3y, 5y and 10y tenors to extend the yield curve. The Chinese governments intention was clearly to set a full sovereign benchmark curve to encourage issuance in the longer tenors. The sale was met with overwhelming demand, attracting CNY50bn worth of bids. The MOF also listed this second batch of bonds on the Hong Kong Stock Exchange to facility the secondary market trading of these bonds. These dim sum bonds of the Chinese government trade at about a 200bp discount in yields to the onshore issues (see Figure 6). Rising demand has been widening the discount over the onshore government bonds, which came under selling pressure from the PBOCs policy tightening.
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USD/CNH forward curve is above USD/CNY NDF curve, but below onshore USD/CNY forward curve this reflects the interest rate differentials among them
In the forward space, however, the two curves are on the opposite side. That is, the outright CNH forward rates are higher in USD terms than the outright CNY NDF rates. Because it is deliverable in CNY, the CNH forward curve has to reflect underlying positive CNY interest rates, whereas the NDF curve was reflecting negative CNY interest rates. On the other hand, given the lower interest rates in the CNH market vs the onshore CNY interest rates, the USD/CNH forward curve lies below the onshore USD/CNH forward curve. Figure 5 shows all three curves on an outright basis.
Figure 6: CNH vs onshore government bond curve as of 9 March 2011 Emerging Markets Asia | CNH Market Guide | 10 March 2011 11
4 .5 4 .0 3 .5 3 .0 2 .5 2 .0 1 .5 1 .0 0 .5 0 .0 2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
O ffs h o re c u rv e
O n s h o re c u rv e
Cross currency swap
Similar to CNH FX forwards, activity level is currently very low in CNH CCS
Just like the onshore CCS and existing offshore ND-CCS curves, the CNH CCS curve is inverted to price in market expectations for CNY appreciation. Investors of CNH bonds can earn additional pickup by paying the (negative) CCS to swap their CNH bonds to USD, which would remove their FX exposure to further possible CNY gains. Most investors, however, choose not to earn the extra yield pick-up to hedge away their FX exposure to CNY because they see much more appreciation in the currency than what the curve has priced in. Similarly to the CNH IRS curve, the CNH CCS market is illiquid with a wide bid/ask spread, with transactions mainly for hedging.
Synthetic CNH a misnomer

The name synthetic CNH is a misnomer. It came from bond issuers that wanted to jump on the bandwagon of dim sum bonds, but due to regulatory hurdles turned to issuing bonds linked to CNY, but settled in USD. The name is a misnomer because it gives the impression that the bond is fixed on the CNH spot rate, which would have required the creation of a ND-CNH forward curve for swapping or hedging the underlying CNH spot risk of these bonds for both issuers and investors. It gives the impression that a fourth market has surfaced. In reality, however, these synthetic bonds are linked to the onshore CNY spot and hence there is no need for a fourth forward curve, as it can readily use the existing NDF curve for swapping and hedging. More discussion is found in the next section, Dim sum bond market. However, if the CNH market continues to expand, it would not take long for market participants to start a NDF-CNH FX market, which could overtake but not completely kill off the NDF CNY market. The clear distinction between the two is in the spot fixings as previously mentioned, the CNH spot has no trading restriction, while the onshore spot (which provides the fixing for the NDF CNY) is currently restricted to a +/-0.5% intraday trading band. One can easily see how this difference in spot fixings can become an incentive for market participants to start a NDF-CNH market. On the flip side, as the deliverable CNH bond market continues to grow and deepen the secondary trading of its bonds, market players may wish to set up a ND-CNH market to pull the non-deliverable CNY issuers from linking to the
CNH central clearing

October 2010 Bank of China (HK) exhausted its CNY conversion quota for trade settlement
Bank of China (HK) has acted as the central clearing bank for CNY for Hong Kong-based banks since CNY deposit-taking was allowed in Hong Kong in 2003. After the CNY trade settlement scheme was introduced, BOC (HK) was given a conversion quota of CNY8bn for the full year in 2010. Exporters and importers participating in the trade settlement scheme can tap the onshore USD/CNY spot rate via BOC (HK) and BOC (HK) clears its positions with the PBOC. BOC (HK) exhausted its conversion quota by October 2010, as exporters were not swapping the CNY proceeds they took out from onshore into USD, which could have been used to net off the CNY requirements by importers. Hence, for a brief period late in 2010, HKMA had to assume the role for clearing CNY with PBOC, tapping its CNY200bn swap line extended by PBOC. For 2011, BOC (HK) has now been given stricter guidelines on the conversion quotas, which included an additional quarterly quota to be reviewed every quarter (CNY4bn for 1Q) on top of the CNY8bn annual cap. Furthermore, banks are now only allowed to approach BOC (HK) if they are net short or long CNY and for trade transactions due within three months. Hong Kong banks are now lobbying for a change in the central clearing system with a few alternative options adding more clearing agent banks, making HKMA the clearing bank and adding more clearing counterparties onshore rather than being limited to PBOC.
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onshore CNY spot to the CNH spot. Hence, we cannot discount the possibility that a NDF-CNH market could evolve at some point. However, it would still be a long way from driving out the current NDF-CNY market, as the CNH FX market will never overtake the onshore CNY FX market before China fully liberalises its capita account.
Dim sum bond market

Definition and terminology
Dim sum bonds commonly refer to CNH-denominated bonds
At the centre of the CNH market is the bond market for issuing CNHdenominated bonds, which has been nicknamed the dim sum bond market. The market has registered substantial growth since July 2010, with total outstanding bonds (including CDs) amounting to CNY74bn as of March 1, 2011. The issuer base has expanded greatly, in terms of both volume and the spectrum of credit names. The diversification of the investor base has been slower, however, even though it has broadened from Hong Kong-based banks and residents to foreign asset managers. The two important counterparts of the dim sum bond market are the synthetic CNH bond market and the panda bond market. As previously mentioned, in the FX world, synthetic CNH (ie non-deliverable in CNY and settled in USD instead) does not exist at least not now. The synthetic CNH bond market is thus linked to the existing CNY NDF and not CNH FX, which does not currently offer a nondeliverable form. The CNY NDF-linked bond market in fact started shortly after China allowed Chinese banks to issue CNY bonds in Hong Kong in 2007. After the CNH bond market took off two years later in 2010, issuers of these CNY NDFlinked bonds took on the new name, synthetic CNH bonds, to ride on the popularity of the CNH, or dim sum bonds. This has often confused investors that they are linked to CNH. Panda bonds are bonds issued in China by foreign entities based offshore. Due to the earlier tight issuance criteria and the onshore interest rate premium over the offshore CNH now, the panda market is not drawing interest away from the dim sum market. Emerging Markets Asia | CNH Market Guide | 10 March 2011 13
Two important counterparts are the synthetic CNH bonds and panda bonds
Figure 7: Chronology of regulatory changes* and milestones of CNH bond issues

Date January 2007 June 2007 July 2007 September 2007 December 2008 June 2009 October 2009 February 2010 July 2010 July 2010 July 2010 August 2010 October 2010 October 2010 December 2010 December 2010 Regulations and milestone issues * Chinese FIs were allowed to issue CNH bonds in HK by PBOC * Details of issuing CHN bonds by Chinese FIs were announced by PBOC and NDRC China Development Bank (a Chinese policy bank) issued first CNH bond Bank of China, the first issuer of Chinese commercial bank * Corporates with substantial business in PRC were allowed to issue CNH bonds in HK by State Council BEA, HSBC (PRC-incorporated foreign banks) issued CNH bonds Ministry of Finance of China (first sovereign issuer) * Issuer restrictions fully lifted to abide by HK regulations as long as proceeds not remitted into China * Limits on HK-based corps converting CNY lifted; types of CNY investment products fully liberalized, including CDs, CNY loans; CNY central clearing system set up Hopewell Highway (first non-PRC, non-FI issuer) CITIC Bank International (first issuer of CNH certificate of deposits) McDonalds (first multinational corp ) * PBOC expanded CNY clearing centres, allowing foreign banks to clear CNY with any PRC-incorporated banks Asian Development Bank (supranational, also first CNH issue traded on the HK stock exchange) VTB Bank (a government-owned Russian bank, first non-Asia emerging market issuer) Galaxy Entertainment (high-yield issuer) Source: Bloomberg, NDRC, PBOC, RBS
July 2010 Big Bang

Emerging Markets Asia | CNH Market Guide | 10 March 2011 14
China financial institutions were the first issuers in July 2007
Policy and regulatory changes have thus far been the key drivers shaping the CNH or dim sum bond market (see Figure 7 for chronology of regulatory changes). The market started in Hong Kong in July 2007, when China allowed PRC-incorporated financial institutions to raise funds in Hong Kong, with China Development Bank, a fully Chinese government-owned policy bank, the first issuer. These early issues primarily targeted Hong Kongs household sector, to absorb offshore CNY deposits sitting in Hong Kongs banking system and route the CNY funds back into China. The Big Bang for the dim sum market came in July 2010, when the HKMA fully opened up the market to all kinds of CNH-denominated products. Limits on Hong Kong-based companies converting CNY was lifted; types of CNY investment products were fully liberalised, including allowing banks to make CNY loans and issue CDs. A central clearing system for Hong Kong-based banks was set up at the same time to facilitate the envisaged expansion of the market. The name, dim sum bonds, came about only after the July 2010 move. Hong Kong-based corporations immediately took the opportunity to tap the market in July 2010, followed close behind by foreign financial institutions and non-FI companies outside Hong Kong. Prior to the July 2010 Big Bang, liberalisation steps were taken cautiously. The first move in December 2008 allowed foreign financial institutions with substantial business in China to issue dim sum bonds in Hong Kong. A few Hong Kong banks were then the first foreign financial institution issuers in 2009. The next significant change was in February 2010, when the HKMA clarified that any entity, including non-financial institutions, can issue CNH bonds in Hong Kong without prior approval as long as the issuer abides with Hong Kong regulations and the bond proceeds are not remitted into China. This led to a surge in issuance. Restrictions were fully liberalised by the HKMA for offshore issuers, but onshore issuers remain bound to onshore regulations. Chinese financial institutions still require approval for issuing of dim sum bonds in Hong Kong from PBOC, NDRC and CSRC, and their proceeds must be repatriated back onshore. Some prerequisites for these financial institutions include a minimum core capital adequacy ratio of 4%, profit track record for three consecutive years, sufficient loan loss provisions, and good risk management and corporate governance. Onshore Chinese non-FI companies are currently not allowed to issue in the CNH market directly, although they are not prohibited to issue through overseas subsidiaries. Because of their relatively more complicated procedure of getting approval, Chinese FI issuers have not been active issuers in the CNH market recently. On the other hand, once they obtain all required approvals for issuance, repatriating proceeds is relatively easy, which has become a daunting matter for non-FI issuers after the PBOC imposed the set of seven capital controls on 9 November 2010 (see next paragraph and next section on policy challenges). Repayment of principal and coupons on the bonds from onshore entities to offshore investors requires routine registration with SAFE, but the hard task is in seeking SAFEs approval for one-off remittance of proceeds. Consequently, Chinese commercial banks have recently started to use their offshore branches to issue CDs in the CNH market, retaining the proceeds offshore. Figure 8 summarises the regulatory requirements for the different types of issuers.
The Big Bang came in July 2010, when HKMA liberalised CNHdenominated investment products
In December 2008, HK FIs were the second group of dim sum bond issuers... In February 2010, HKMA fully opened up the market for all types of offshore issuers
Chinese non-FI companies are now the only group not allowed to issue a dim sum bond except through overseas subsidiaries
Figure 8: Summary of regulatory requirements for CNH issuers by type as of 9 March 2011
Onshore FIs Issuance China approval PBOC for issuer's qualification; NDRC for foreign borrowing quota; CSRC for issue amount Not required Not required Not required Offshore FIs Offshore corporates
HK approval Remittance of proceeds China approval HK approval Repayment of principal/interest China approval HK approval
Not required
Not required
SAFE, PBOC & MOFCOM Not required
SAFE, PBOC & MOFCOM Not required
SAFE & PBOC Not required
Registration with SAFE Not required
Registration with SAFE Not required
Registration with SAFE Not required Source: PBOC, State Council, SAFE, RBS
Figure 9: Two routes of remittance of CNH bond proceeds as of 9 March 2011

Equity injection Pre issuance Post issuance PBOC pre-approval is required; need to approve size, tenor, usage of proceeds Amount of registered capital is approved by MOFCOM for corporates; subsequent increase in registered capital should be approved by MOFCOM; SAFE processes equity injection based on MOFCOM's approval Around one month for PBOC pre-approval; around six months or longer on additional increase in registered capital from MOFCOM Shareholders' loan PBOC pre-approval is required; need to approve size, tenor, usage of proceeds Onshore entity is required to have sufficient foreign debt quota, which the unused foreign debt quota from any outstanding amount; cross-border shareholders' loan arrangement is approved by local SAFE, where the onshore entity is incorporated Around one month for obtaining PBOC's pre-approval; setting up a holding company for more foreign debt quota may need approval from MOFCOM, maybe six months or longer Source: PBOC, SAFE, RBS
Time frame
Dim sum bonds can be issued outside Hong Kong, but other countries lack CNY liquidity and direct central CNY clearing with China
Theoretically, CNH-denominated bonds can now be issued anywhere outside of China. Hence, we expect CNY bonds to be eventually issued in other international financial centres, such as Singapore or London. However, dim sum bond issuance in another offshore centre is unlikely to precede the setting up of a CNH FX market in that centre, which can clear CNH funds directly with China without going through Hong Kong. See earlier Market anomalies section for a discussion on conditions for setting up an offshore CNH market.
Issuer base
We expect new issuance to double in 2011 from 2010
Annual new issuance of CNH bonds grew by more than four times between 2007 and 2010 from CNY10bn to CNY41.2bn (including CNH bonds and certificate of deposits). The pace continues to accelerate, with new issues within the first two months of 2011 amounting to CNY13.5bn. The total net outstanding amount of
15
Repatriation of bond proceeds require approvals and procedures differ depending on whether funds are in equity or loan
Regardless of issuers identity, any repatriation of dim sum bond proceeds requires approvals by Chinese authorities. Repatriation of proceeds can generally take two routes equity injection and shareholders loan. While the procedure of the two routes differs, both routes require approvals from PBOC before issuance and Ministry of Commerce (MOFCOM) and SAFE after issuance (see Figure 9). The approval process could take six months or longer. Because of the lengthy process for obtaining approval for fund repatriations, we doubt new supply will grow as quickly as many expect. This means that supply should continue to lag demand for dim sum bonds, with the latter coming from the buildup of CNY deposits generated by Hong Kong residents and corporates engaging in cross-border trades with China.
CNH issues is currently CNY74bn, not including synthetic CNH bonds and privately placed deals (see Figure 10). Meanwhile, the stock of CNY deposits in Hong Kong grew by two and half times over the six months between June and December 2010, from CNY90bn to CNY315bn by the end of 2010 (see Figure 11). It grew by another CNY56bn in the first month of 2011, bringing the stock to CNY371bn. The stock of CNH bonds represents about 20% of total CNY deposits, which means demand for these bonds far outweigh supply by a large margin. We estimate that the CNY deposit base will continue to grow, to CNY700bn-800bn by the end of 2011, assuming the same monthly increase recorded in H2 2010. Therefore, even if new issuance of CNH bonds in 2011 triples from the 2010 level to push the CNH bond stock to CNY180bn by the end of 2011, it will reach only 24% of the CNY deposit base. Emerging Markets Asia | CNH Market Guide | 10 March 2011 16
Figure 10: New supply of CNH bonds in Hong Kong vs stock (CNY bn)
Figure 11: Net increase of CNY deposits in Hong Kong vs stock (CNY bn)
400 371 315
80 70 60 60
74
350 300 250
252
50 40 30 20 10 0 07 N e w is s u a n c e s 08 09 10 J a n -F e b 1 1 N e t in c re a s e A m o u n t o u ts ta n d in g N e t o u ts ta n d in g 10 10 22 16 12 14 35 40 200 150 100 50 0 07 08 09 10 Ja n 11 33 10 23 7 56 63 56
Types of issuers We can divide the dim sum bond issuers into four categories. Being the first issuers in the market, Chinese banks, both policy banks and commercial banks, hold the largest market share of 31% of the outstanding CNY bonds. Chinese policy banks continue to use the market as a wholesale funding source, whereas Chinese commercial banks have not been as active due to relatively tighter approval procedures for them. Instead, they are using their overseas subsidiaries to issue CNH bonds or CDs and use the proceeds offshore. Figure 12 gives the breakdown of the type of issuers. The second largest issuer category is foreign financial institutions, including ADB, IFC and World Bank, which account for 28% of amount outstanding amount. But by number of issues, they account for 47% of the total issues. This category also includes overseas subsidiaries of Chinese banks, which are seeing increased offshore CNY loan demand. Many foreign FI issuers choose to issue CDs as well. In total, all financial institutions account for 60% of CNH volume and 67% of number of deals (see Figures 13 and 14).
Still dominated by FI issuers; corporate issuers are rapidly emerging, but issue sizes are much smaller
Figure 12: Breakdown of CNH bond issuers by credit background and geographical location as of 9 March 2011
China Government Started in July 2009, 22% of outstanding market, tenor ranges from 2 to 10 years CDB and China EximBk, for diversified funding and attractive price Not as active as they used to be. Regulation constraints, but good benchmark for pricing Hong Kong Other Asia Other EM US, EU, UK Supranational/ multilateral agencies
Quasi govt policy banks Commercial banks IG Corp
ADB and World Bank issued. ADB has the longest tenor of 10 years Active issuers include Chinese banks' subsidiaries and HK banks doing business in China IG issuers are not so active as many good companies are cash rich Small component of the market, some issuers are not rated Source: Bloomberg, RBS ANZ issued VTB, a government through its HK owned Russian bank subsidiary first issued Deutsche, UBS, RBS tested the market in January 2011 MCDonald's/Caterpillar, non-PRC with extensive business in China
High yield
Figure 13: Outstanding bonds by issuer by issuance amount as of 9 March 2011

China MoF, 14bn, 19%
Figure 14: Outstanding bonds by issuers by number of issues as of 9 March 2011

China MoF, 7, 12%
Corporates, 16bn, 22%
Corporates, 12, 21%
Chinese FI, 12, 21%
Foreign FI, 21bn, 28%
Chinese FI, 23bn, 31%
Foreign FI, 27, 46%
Chinas Ministry of Finance has issued a series of bonds since October 2009 across the curve up to 10y, which is now used as the sovereign benchmark curve (see earlier section under Market Anomalies). Foreign non-FI corporations joined the CNH market after the opening of the issuer base in February 2010. Corporate issuers currently account for 22% of outstanding amount. In this category, credit quality of issuers varies widely, from high-quality/brand name multinational corporations to high yield issuers. Some issuers even do not have a credit rating. High yield corporate issuers are currently a small group in the market that we think will remain small due to regulation constraints and the more credit-selective demand of investors that are not as yield hungry as they are looking for FX gains from the CNY exposure.
Incentives for issuers
17
In order of importance, we see the following five factors motivating issuers to enter the dim sum bond market. 1 Use of CNY onshore or offshore. Issuing CNH bonds only makes sense if the issuers have use of CNY, either onshore or offshore. This is because the CNY cross-currency swap market is deeply inverted, implying a substantial cost of as much as 500-600bp swapping the CNY proceeds into USD, not to mention that the market lacks liquidity. Emerging Markets Asia | CNH Market Guide | 10 March 2011 18
For Chinese banks, issuing CNH bonds is cheaper than raising fixed deposits onshore
2 Much lower interest rates in CNH than onshore CNY. This is due to the overhang of demand for CNH asset vs uninvested CNH deposits. For example, the Chinese government issued a 2y CNH bond in December 2010 at a coupon of 1.6% vs the prevailing 3.37% yield of the onshore traded 2y bond then. With our expectations of more rate hikes by PBOC, the cost benefit of issuing in the CNH market has become even more obvious. We compared the funding costs of recent CNH bond issues with current lending rate and fixed deposit rates set by the PBOC (see Figure 15). For example, the CNY500mn 3y CD issued by Bank of Communication in January 2011 was at a coupon of only 1.4%, much lower than the 3y fixed deposit rate of 4.15% at issuance time, which was recently raised to 4.5%. The same rationale applies for the non-bank corporates. Against the PBOCs guidance for 1y-3y base lending rate of 6.1%, a 10% discount from the base rate would still cost 5.5% for a large corporation. This compares with the 2% coupon paid by Caterpillar for its CNY1bn 2y dim sum bond and the 3% coupon paid by McDonalds for its CNY200mn 3y bond. China has raised interest rate three times since October 2010 after the 25bp hike in October 2010, the next two 25bp hikes were in December 2010 and February 2011. However, strong demand for offshore CNH products continues to drive down the yields of bonds traded in the secondary market (see Figure 16) as well as those of newly issued CNH bonds during this period. For example, the coupon on the 2y ICBC Asia issued on 8 October 2010 was set at 2.3%, the coupon on 2y Agriculture Bank of China (HK) issued on 15 December 2010 was 1.4% and the most recent 2y CD by ICBC Asia issued on 20 February 2011 has only a 1.1% coupon. 3 Fairly rule-free issuance environment in Hong Kong. After the HKMA clarified that all CNH bond issuers will be given similar treatment as issuers in HKD and other currency denomination as long as the proceeds are not intended for repatriation into China, it has become very attractive for issuers that do not have strong credit rating or face difficulties in raising funds onshore to come to the CNH market. 4 Strategic positioning. Seeing the significant potential of the CNH market, some banks and corporates are issuing dim sum bonds to put their footprint in a new market that clearly represents Chinas first step towards full liberalisation of its domestic market. 5 Benchmark building. The Chinese governments seven CNH bond issues from 2y tenor to 10y tenor since September 2009 were clearly intended to set a benchmark yield curve. China Development Bank, a policy bank, has indicated an intention to also build a more complete curve in the CNH market. Over time, we may see other major issuers attempting to do the same.
For non-bank corporates, issuing CNH bonds is cheaper than borrowing from banks
While onshore interest rates are pushed up by PBOCs rate hikes, coupons of CNH issues continue to fall
Figure 15: Coupons of recent CNH bonds (issue dates in brackets) vs PBOC policy targets on lending and deposit rates (%)
7 PBOC lending rates 6 5 4 PBOC deposit rates 3 2 ICBCM Jan'11 1 0 0y 1y 2y 3y 4y 5y 6y Hopewell Jul'10 MCD Aug'10 Caterpillar Nov'10 ICBCM Jan'11 Sinochem Jan'11 ICBCM Jan'11
Beijing Capital Feb'11 China Resources Nov'10
*ICBCM: Industrial & Comm Bank of China Macau, MCD: Macdonald's. Source: Bloomberg, RBS
Figure 16: Secondary trading of CNH bond issues by CDB and CGB, currently the two most liquid issues (YTM, bid %)
1 .5 1 .4 1 .3 1 .2 1 .1 1 0 .9 0 .8 0 .7 0 .6 0 .5 02 D e c
16 D e c
30 D e c C G B D e c 13
13 Ja n
27 Ja n
10 F e b
24 F e b
C D B N ov 13
Issuer base outlook
FI issuers will continue to dominate
The above-mentioned incentives will likely determine the evolution of the CNH bond markets investor base. First, we think financial institutions will remain as the dominant issuers. Chinese policy banks will continue to use this market as a stable wholesale funding source in addition to the onshore market; overseas subsidiaries of Chinese commercial banks will use this market to meet the demand of CNY loans outside China; and foreign banks with business in China will need to tap this market to supplement to their onshore deposit base. Next, we may see more first-time FI issuers from other foreign countries, especially Asia. Korean banks have indicated their interests to support Korean companies operating in China.
19
More diversified names from corporates
Multinational companies that have a significant presence in China will increasingly be using this market. However, repatriating money back to China has proved daunting. High-yield names are currently a small portion of the CNH market. We expect more issues from this segment, but they are unlikely to overtake investment-grade names given investors risk appetite.
Investor base
Prior to 2010, investors were mainly HK banks and individuals
Compared to the rapid expansion of the issuer base, the diversification of the investor base of CNH bonds has been slower. The set of incentives for investors is much simpler than for issuers and can be summarised into four areas. 1 CNY appreciation. This is the key motivation of virtually all dim sum bond investors. 2 Yield enhancement. Although this is a smaller consideration for most investors, the yields of dim sum bonds are nevertheless more attractive than the interest rates of either CNY fixed deposits offered by banks in Hong Kong or implied from the CNY NDF curve. For the former, the PBOC set an interest rate cap at 0.865% regardless of tenor, while the interest rates implied from the CNY NDF market are negative. This has helped to keep bond yields of dim sum bonds on the low side and in fact, the spreads continue to widen below onshore CNY bond yields as the onshore market undergoes a bear trend. 3 Limited access to onshore Chinese market. Foreign investors can enter Chinas onshore bond market with a QFII licence. Even then, they are restricted to investing in bonds listed on the exchanges, which are far smaller than the interbank bond market. 4 Diversification. The CNH market not only offers a new market for global investors portfolio diversification, its lower regulatory and settlement risks than the onshore market also give current QFII investors an alternative to diversify these onshore risks.
Asset managers, hedge funds and insurance companies are recent entrants
A noticeable change of investor base in 2010 was the entrance of asset managers both real money funds and hedge funds (see Figure 17). Prior to 2010, investors in the CNH market were predominantly banks in Hong Kong with CNY deposits and high-net-worth investors. In the recent new deals, real money fund managers, hedge funds and wealth management arms of banks account for the bulk of the investor base. Insurance companies have also entered the market lately, as they have started offering CNY-settled insurance products in Hong Kong. Previously some insurance companies offered non-deliverable CNY-linked products settling in HKD or USD. Sovereign wealth funds remain a group that has yet to venture into this market in a big way.
Dominance of Asia investors should continue to expand with CNY trade settlement
In terms of geographic breakdown of the investor base, the majority of Investors are still Asia-based, with a large portion from Hong Kong, where most of the CNY deposits reside. We expect that this will gradually change over time. Other Asian countries, such as Singapore, are preparing to set up their own offshore CNH centre Singapore banks have begun taking CNY deposits and are stepping up efforts to settle CNY trades. We also expect more investor participation coming 20
Corporate issuers are in the market mainly for the low cost benefit, an additional funding channel and investors demand. We expect to see more diversified names from the corporate sector, especially from the rest of Asia and other emerging markets, which have close trade relationship with Chinese companies.
from Europe and the US, especially given that they are unlikely to start an offshore CNH centre in their home market any time soon. Emerging Markets Asia | CNH Market Guide | 10 March 2011 21
Figure 17: Investor base breakdown of recent deals as of 9 March 2011
100%
80%
60%
40%
20%
0% G a la xy VTB S in o C h e m IC B C R o a d K in g S ve nska HB R B S Ldn
BANK
FM
R E T A IL
HF
IN S U R A N C E
O THE R S
Issuer and investor risks

Like any new market at its initial phase, there are many risk factors in the CNH market that we believe have been ignored or not fully reflected in market prices. Figure 18 summarises four types of risks, which we discuss in detail in the following. FX risk As much as FX appreciation is the key motivating factor for investors in CNH bonds, it is also the biggest risk here. First, the CNH CCS market is still very shallow. Second, the curve is deeply inverted, in line with the existing ND-CCS that extends from the NDF curve. It is thus expensive for issuers to swap away the CNH risk, but worthwhile for investors to do the swap to lock in the FX gain already priced into the curve, which might not be much after subtracting the substantial bid/ask spread. Third, as mentioned previously, the CNH market theoretically trades on a real-time basis, independent of the onshore CNY market, which gets a daily fixing by the PBOC in the morning and trades within an +/-0.5% band for the rest of the day. In this regard, even the CNY NDF is less risky than the CNH market because its spot fixing is taken from the onshore market. Interest rate risk As with the CNH FX forward and CCS curve, the CNH IRS is also very illiquid. Furthermore, it is takes the onshore 3m Shibor fixing and not the 7day repo fixing, which is used in the CNY IRS curve commonly traded by both onshore and offshore participants. To be clear, as China opens up its domestic markets, the premium of the CNH bonds will eventually be eroded in the long run.
Credit risk As the market is relatively underdeveloped, issuers face refinancing risk given that the average maturity of CNH bonds is only three years. This is also a result of investors appetite for duration being low given that they are mainly interested in the potential FX gain. On the flip side, this means that investors are underestimating their credit exposure, since credit risks are not fully reflected in the exceedingly low yields of CNH bonds. Regulatory risk There is a significant risk for issuers that they might not be able to obtain approval for remitting their bond proceeds back to China, but this risk looks fairly transparent in terms of procedural details. For investors, the risks are more opaque, as the progress of the market is still heavily dictated by Chinese regulators rather than Hong Kong regulators. However, we would rule out the risk that China closes down this market, making all existing CNH bonds nondeliverable and forcing existing CNY deposits offshore to be taken back. Chinas ambition to internationalise the CNY is very strong, but one that policymakers are careful not to rush into. Hence, we believe we should be prepared for tightening or fine-tuning of regulations if the CNH market continues to grow too rapidly in a lopsided fashion, as it has done thus far.
Figure 18: Four types of risks for issuers and investors as of 9 March 2011
Issuers FX Interest rate Currency swap market is shallow and expensive Investors Slower-than-expected CNY appreciation
Credit Regulatory
Illiquid interest rate swap market limits ability to issue longer tenor bonds Yields are significantly lower than onshore yields from same or similar or swapping of fixed rates to floating rates, especially since fixing rate is issuers onshore 3m Shibor, which is not active Due to the above, maturity of bonds is confined to below 3y sector, Credit risks are not fully priced in due to overhang of demand over supply; causing significant refinancing risk for issuers secondary trading remains thin Chinese Fis need to obtain approval prior to issuance. Repatriation of Chinese regulators ultimately dictate pace of market expansion, likely to proceeds is subject to stringent and time-consuming process tighten or fine-tune rules to arrest growth if too fast or too lop-sided Source: RBS
Liquidity and depth

Thin secondary trading due to small size, short tenor and buyand-hold investors
As the market is still in its infancy, secondary trading of CNH bonds is still rather thin. More than 90% of the bonds are issued in tenors of two to three years. Only ADB and the Chinese government have issued in the 10-year tenor and a few corporates have issued 5-year bonds (see Figure 19). Furthermore, the size of the bonds is relatively small, ranging from CNY1-2bn (USD150-300m). In fact, only eight out of the total 58 CNH bond issues are larger than CNY3bn, two of which came from Chinas MOF and the rest from two Chinese policy banks, two foreign banks and a state-owned Chinese resource company subsidiary (see Figure 20). On the other hand, investors have mostly been buy-and-hold types. We believe that with further deepening of the market, more diversified issuer base and the involvement of real funds, we will eventually see a pick-up in market turnover and pricing efficiency.
22
Figure 19: Amount of issues breakdown by tenor (total CNY 74bn as of 9 March 2011)
< 1 ye a r, 0 , 0% > 5 ye a r, 2 , 3% 5 ye a r, 4 , 6 %
Figure 20: Number of issues breakdown by size (total 58 issues as of 9 March 2011)
a bove C N Y 3bn, 3 C N Y 2 .1 -3 b n , 9 19
1 ye a r, 2 , 3 %
2 ye a r, 3 5 , 47%
3 ye a r, 3 0 , 41%
C N Y 1 .1 -2 b n , 10 17
Synthetic CNH or CNY-linked bonds

Issuing CNY-linked bonds is attractive for onshore issuers facing regulatory or market hurdles in raising funds
The main issuers of CNY-linked bonds are the companies of lower credit quality. The tightening of rules on repatriating CNY proceeds from a CNH or dim sum bond issuance has only made this market more attractive to this group of issuers. CNY-linked issuance surfaced soon after the Chinese government allowed the policy banks to issue deliverable CNY (or CNH) bonds in Hong Kong in January 2007. Prior to December 2010, they were only issued as convertible bonds. The first conventional CNY-linked bond was issued in December 2010 by Shui On Land, a Chinese real estate developer. The trigger clearly came from the Big Bang of the dim sum, or CNH, bond market in July. Other Chinese and Hong Kong developers quickly followed suit. Both bonds and coupons of these synthetic bonds are linked to the onshore CNY spot rate (to reiterate, not the offshore CNH spot rate), but the proceeds are settled in USD. As it is easier to inject equity or make shareholders loans from an affiliated offshore entity to an onshore company in non-CNY, CNY-linked bond issuers usually retain their proceeds in USD form. Technically, since the proceeds are repatriated onshore in USD form, the issuer can choose to swap away the FX risk from the onshore market. However, most issuers do not swap away their FX risk and if they wish to, they would tap the cheaper offshore USD/CNY NDF and ND-CCS curves rather than the onshore curves. Compared to dim sum bonds, CNY-linked bonds generally have longer tenors of three to five years and larger sizes, ranging from CNY1bn to CNY6bn. This has helped to quickly deepen the secondary market. There are currently five issuers outstanding, with total six issues, amounting to CNY17.7bn. For investors, these synthetic bonds are even easier to access than the CNH market because they do not require investors to set up any CNH account since the bonds are settled in USD. According to deal statistics, the majority of primary market buyers of such bonds are retail investors through private banks, followed by mutual funds and hedge funds, whereas banks and insurance are not as active as they are in the CNH deals. In terms of geographical breakdown, Asian investors account for around 80% of the deals, followed by European investors; US investors remain on the sidelines. 23
Added attraction is easier repatriation rules for non-CNY funds
CNY-linked bonds are on average longer in tenor and larger in size than dim sum bonds
Investors are likewise attracted to its easier access than dim sum bonds, since they require no CNH account
Panda bonds
Panda bonds are also CNYdenominated bonds, but issued by foreigners onshore in China
Panda bonds are bonds issued in China by foreign entities based offshore. This market is clearly an option for foreign businesses to consider tapping into for CNY funding. But requirements in the past for issuers to be international agencies or foreign institutions with AAA credit ratings, as well as restrictions on the repatriation of proceeds, had stymied the growth of the panda market. Although the PBOC amended the rules in September 2010 to allow international agencies to convert their proceeds into foreign currencies before remit them overseas, issuers are still not attracted to the market because of the higher CNY interest rates term structure onshore compared to the offshore CNY market. See Appendix II for comparison of market features and regulations on issuance, clearance and settlement for CNH bonds, CNY-linked bonds and panda bonds.
Policy challenges
No full-proof interim solutions
Different vested interests made it challenging for China and Hong Kong to contain pressures in CNH market
The CNH market has brought many challenges to policymakers in China and Hong Kong. Finding solutions has been constrained by the separate vested interests on the two sides Chinas desire to control the pace of CNY appreciation vs Hong Kongs desire to keep its capital markets fully open. Consequently, these efforts to put up some boundaries around the market are unlikely to significantly slow its growth or reduce the premium in the CNHdenominated assets over their onshore counterparts. Following are the three biggest challenges. - To promote the use of CNY for transactional demand, especially in third markets. - To reduce the speculative element in the certain types of CNH products, notably the synthetic CNH/CNY NDF bonds that are bypassing Chinas domestic loan quotas. - To plug the arbitrage gaps between the CNH, CNY NDF and onshore CNY FX markets. Emerging Markets Asia | CNH Market Guide | 10 March 2011 25
Interim solutions try to clamp down on activities or channel excess CNY liquidity back onshore
The root cause of these challenges is the lack of full mobility of CNY liquidity between the offshore and onshore markets, which is to say that the CNY is not fully convertible. Hence, apart from instituting rules to directly restrain the growth of the market, other solutions focused on partially opening up avenues for CNY liquidity to flow back onshore. Unfortunately, these latter solutions which are really positive steps towards full market liberalisation run the risks of adding to Chinas inflation pressure; hence, we can see some resistance in implementing them at a fast pace. Following are the specific solutions implemented or proposed thus far. - Capital controls on onshore Chinese banks and corporates. On 9 November 2010, PBOC imposed seven new rules to curtail banks and corporates FX and cross-border activities to prevent excessive overseas borrowing and exporters over-invoicing, and limit non-banks net short USD positions. - Cap on Hong Kong-based banks net open exposure to CNY. On 23 December 2010, the HKMA imposed a cap on HK-based banks net open risk in CNY to 10% of their CNY assets or liabilities, whichever is higher. Naturally, banks chose to stay net long in CNY. Given that the banking system is facing many more CNY deposits that are liabilities to banks than there are CNY investable assets, banks are generally caught short CNY, which they have to square off in the CNH FX market. While this has helped to tighten the spread between CNH spot and onshore CNY spot, it has not stopped banks from taking in more CNY deposits than the borrowers or issuers have been able to take up as CNY loans or bonds. Hence, the excess demand over supply of CNH-denominated assets such as dim sum bonds remains unchanged, leaving the premium on these assets intact. - Central clearing quotas for CNH with PBOC. In addition to an all-time cap of CNY8bn on net outstanding short or long CNH being cleared with the PBOC through a central clearing bank (currently this is the BOC HK), there
- Special QFII. To reduce the excess CNY liquidity in Hong Kong chasing after too few assets, China created a special pipeline for QFII licences for offshore banks settling CNY trade and central banks with CNY swap lines from the PBOC to invest their excess CNY funds in the onshore interbank bond market. These special QFII licences must be applied for from PBOC and would be given quotas. To date, only the HKMA and a few HK-based banks have been given these special licences with very small quotas. Out of its CNY300bn swap line from the PBOC, HKMA was given a quota of only CNY15bn to use under its special QFII licence. - Mini-QFII. This scheme lets China-based asset management and securities companies directly tap into the retail investors in Hong Kong. The intention is to channel some of the overwhelming demand for CNY products from the CNH market to the onshore market. However, after much chatter and despite the lack of complexity in the scheme, it is still not launched, likely due to concerns about hot money going into China.
Risks and opportunities for Hong Kong

Two prerequisites for China to fully liberalise capital account interest rate deregulation and synchronising policy cycle with the US
The long-term solution to these challenges is for China to fully liberalise its capital account. We see two important prerequisites for this to happen: 1) domestic interest rate deregulation; and 2) an interest rate cycle more synchronised with the US. Both criteria are unlikely to materialise any time in the near future at least not in the current business cycle. Meanwhile, we believe two things are likely to continue, with potential risks in the event that the CNY internationalisation plan gets derailed. The one-sided progress in the trade settlement scheme will exacerbate the pressure for CNY appreciation from Chinas trade surplus, as imports will be paid by CNY but exports will continue to be received in foreign currencies. This is effectively the PBOC printing CNY to buy foreign goods while still earning foreign currencies from its exports. The PBOC has expanded its money stock of CNY in the open market, exported it to Hong Kong and is now preventing the money from returning to China. Hence, the premium in all CNH-denominated asset classes over onshore CNY assets will persist. As it is the first and likely to remain the leading offshore CNH centre for a few more years, Hong Kong has much to gain from the businesses the CNH market brings to its financial sector. However, this also increases Hong Kongs vulnerability to any policy mistakes or change of plans in China with regards to internationalising the CNY. The biggest risk albeit a very minute one, in our opinion is that China decides to entirely stop allowing CNY to be deliverable. This would not only lead to a messy process of converting CNY deposits and CNH-denominated investment products from CNY into HKD or USD, but might also undermine the image of Hong Kongs financial centre. On the flip side, the growing success of the CNH market would also increasingly draw Hong Kong savings away from HKD into CNH over time to the extent that
26
is a quarterly cap of CNY4bn on the quarterly amount of transactions. The aim is to limit the accessibility of CNY liquidity for activities without underlying trade of goods and services, which have no limits on CNY conversion.
the CNH becomes a favoured unit of transaction rather than a mere investment vehicle one day. It may then put a strain on the HKDs peg to USD.
Intrinsic value of an internationalised CNY

Potential for CNY as world reserve currency is supported by sheer size of Chinas contribution to world trade
The overwhelming demand for CNY demonstrates both the Chinese governments ambition to internationalise its currency and the sheer size of China on the world economic map. As the worlds biggest contributor to global trade alongside the US (Figure 21), the transactional demand for CNY can potentially be as large as that for USD when CNY becomes truly internationalised. Considering further that China runs a huge trade surplus of USD180bn annualised (USD300bn at the peak in early 2009) in comparison to the USs USD650bn trade deficit, the worlds potential net transactional demand for CNY could be even larger than that for USD. Demand for an internationalised CNY will also come from the use of it as a store of value and for precautionary purposes. In this, think simply of the fact that as China now accounts for 30% the worlds USD9trn foreign reserves, the other 70% which does not belong to the Peoples Republic of China can potentially be held in CNY (Figure 22).
27
Figure 21: Share of world trade China vs US
Figure 22: Share of world reserves China vs G3 Emerging Markets Asia | CNH Market Guide | 10 March 2011 28
18% 16%
60% 50%
14% 12% 10% 30% 8% 6% 4% 10% 2% 0% 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 C h in a US 0% 48 52 56 60 64 68 72 76 80 84 88 92 96 00 04 08 C h in a US Ja pa n E u ro A re a 20% 40%
Source: IFS, CEIC, RBS
Source: Bloomberg, IFS, RBS
Figure 23: Foreign reserves to domestic base money cover China vs US (%)
140% 120% 100%
Figure 24: Stock of CNY and USD base money as % of world reserves excluding the countrys own reserves
90% 80% 70% 60%
80% 60% 40%
50% 40% 30% 20%
20% 0% 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10 C h in a US
10% 0% 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10 C h in a US
Source: CEIC, RBS
Source: CEIC, RBS
Bulk of demand in CNH market now is for investment rather than for buying China goods
It is not surprising, therefore, that the key driver in the CNH markets substantial growth has come from the demand for investment rather than trade. In fact, the goods and services trade channel is now the source for supplying CNY to satisfy the demand for investment. 80% of the trade settled in CNY with China has come from Chinas imports (releasing CNY to foreigners for exporting goods to China) than from Chinas exports (which takes CNY back into China). This has turned into a case of Says Law supply creates its own demand, causing a massive premium in the offshore CNH market over the onshore CNY market. Is this how the Chinese government has planned its path towards internationalising CNY? Perhaps not, as we see the government starting to regulate this market with the help of the Hong Kong Special Administrative Region (SAR) government.
which seems to worry policymakers
29
But the more the PBOC restricts CNY supply, the greater will be the appreciation pressure
Yet Chinese policymakers have to accept that the pressure on the CNY to appreciate will continue to grow in the course of internationalising it. In fact, the more the PBOC restricts its supply, the greater will be the pressure on the currency to appreciate. The intrinsic value of an internationalised CNY is far higher than its current exchange rate given that Chinas foreign reserves cover to the CNY money stock is more than 10x that of the US (Figure 23). This means that the PBOC can print as much as 10x more CNY without hurting its exchange rate as its foreign reserves would be able to back up that much of extra CNY stock. Similarly, we can look at how much CNY base money stock can be printed in proportion to world reserves net of Chinas own foreign reserve holdings (see Figure 24). If policymakers do not want the risk of overheating, then the alternative is to let the CNY appreciate.
Appendix I
Chronology of CNH market developments
December 2003 HKMA announced the beginning of CNY business on a trial basis in Hong Kong. This mainly involved the build-up of CNY retail deposits and limited personal CNY services. See HKMA circular for details. February 2004 Hong Kong became a centre of offshore CNY clearance personal CNY deposits, exchange, remittance and credit card businesses were allowed in Hong Kong. January 2007 PBOC and NDRC announced that financial institutions incorporated in China can issue CNY bonds in Hong Kong. June 2007 PBOC and NDRC released the set of rules for financial institutions incorporated in China to issue CNY bonds in Hong Kong. See State Council release for details. July 2007 China Development Bank issued the first CNY-denominated bond in Hong Kong. April 2009 The State Council announced a pilot scheme for CNY cross-border trade settlement in Shanghai, Guangdong, Shenzhen, Zhuhai and Dongguan. For more details, refer to the State Council release. June 2009 The trade settlement scheme was expanded to allow settlement with Hong Kong and ASEAN nations. September 2009 Chinas Ministry of Finance sold its first government bond in Hong Kong. February 2010 HKMA released a notice permitting banks to develop CNY business in Hong Kong as long as they comply with local regulations and do not entail fund flows back to the mainland. For more details, refer to the HKMA circular. June 2010 The trade settlement scheme was expanded to allow settlement with all nations and eligible firms were selected from 20 instead of five provinces in China. July 2010 PBOC and HKMA signed the Supplementary Memorandum of Cooperation on the following four areas: expanding the CNY trade settlement scheme to cover service trade and other current account transactions and extending the scheme from selected trading partners to the rest of the world; allowing Hong Kong banks to net settle CNY-trade related positions among each other before centrally clearing with the designated Clearing Bank; and allow non-bank FIs to open CNY accounts with HK banks. For more details, refer to the HKMA circular. August 2010 PBOC announced that foreign central banks with CNY swap lines from PBOC, and clearing and settlement banks for cross-border CNY trades can invest their CNY holdings in Chinas onshore interbank bond market, subject to a quota system implemented by PBOC. September 2010 To further improve the operation of offshore CNY clearing, effective from 1 October 2010, foreign banks may open a CNY settlement account with any PRC-incorporated banks (including the PRC-incorporated subsidiary of any foreign bank) onshore. For more details, refer to the PBOC release. October 2010 HKMA announced that the Bank of China had exhausted its CNY8bn conversion quota for trade settlement purposes. November 2010 SAFE announced measures to curb hot money inflows. See the SAFE announcement for details. December 2010 The number of onshore firms eligible for the CNY trade settlement scheme was increased from 365 to 67,359. For more details, refer to the Hong Kong government press release. December 2010 PBOC announced that the Bank of China will be assigned a conversion quota of CNY4bn for Q1 2011. January 2011 PBOC launched a pilot programme to allow onshore firms to settle their outward foreign direct investment in CNY. For more details, please refer to the PBOC announcement. 30 Emerging Markets Asia | CNH Market Guide | 10 March 2011
Appendix II
Issuance, settlement and custodian regulations
(As of 9 March 2011) CNH bonds
Issuers China's Ministry of Finance, financial institutions, corporations
CNY-linked bonds
Hong Kong and China property corporations
Panda bonds
Restricted to international development institutions and financial institutions legally incorporated in China Restricted to onshore institutional investors, commercial banks, fund managers, insurance companies, corporations and securities companies. 10 years CNY4bn CNY1bn N/A AA or above China Government Securities Depository Trust & Clearing Co., Ltd. Onshore custodian required Approval is needed for repatriation out of China.
Investors
Restricted to investors with CNY account, CNY clearing banks and cross-border trade settlement participating banks. 2-3 years CNY74bn CNY1bn-2bn CNY50-200mn Mostly unrated Euroclear, Clearstream or CMU No specific requirements Bonds issued by financial institutions must be repatriated back to China. Approval is necessary for repatriation by corporations PBOC, NDRC, HKMA
No restrictions. Investor based is diverse.
Usual tenors Amount outstanding Average issue size Average daily turnover Ratings Clearance and settlement Custodian Proceeds repatriation
3-5 years CNY17.7bn CNY1bn-2bn CNY500-1000mn High yields Euroclear, Clearstream or CMU No specific requirements No restrictions
Regulators
None
PBOC, MOF, SDRC, CSRC
Source: HKMA, PBOC, China MOF, Bloomberg, RBS
31
Appendix III
List of abbreviations
Abbreviations BOC CDB CSRC FDI HKEx HKMA MOF MOFCOM NDRC PBOC PRC QFII SAFE SHIBOR Full name Bank of China China Development Bank China Securities Regulatory Commission Foreign Direct Investment Hong Kong Stock Exchange Hong Kong Monetary Authority Ministry of Finance Ministry of Commerce National Development and Reform Commission People's Bank of China People's Republic of China Qualified Foreign Institutional Investors State Administration of Foreign Exchange Shanghai Interbank Offer Rate
Source: RBS
List of Bloomberg and Reuters codes

Function CNH main page USD/CNH spot exchange rate HKD/CNH cross exchange rate CNH interest rate swaps CNH deposit rates CNH cross currency swaps CNY NDF points CNY onshore FX forward points CNH bonds Bloomberg OTC CNY CNH CNH Curncy HKDCNH Curncy CGSW1 Index CCDOF1T Index CGUSSW1 Index CCNI1M Index CCO1M Curncy OTC CNHBOND Reuters CN/OFFSHORE n.a. HKDCNH= CNYIRS=TRHK CNHDEPO= CNUSCS=TRHK CNYNDFSPRD=R CNHFWD= O#HKCNYBOND Source: RBS
Appendix IV
List of CNH bonds and certificates of deposits
Bond EXPORT IMPORT BANK CHINA BANK OF CHINA HSBC BANK CHINA CO LTD BANK OF EAST ASIA CHINA CHINA DEVELOPMENT BANK CHINA DEVELOPMENT BANK HSBC BANK CHINA CO LTD CHINA GOVERNMENT BOND CHINA GOVERNMENT BOND CHINA GOVERNMENT BOND CITIC BK INTL LTD HOPEWELL HIGHWAY INFRAST HONGKONG & SHANGHAI BK MCDONALD'S CORP CHINA DEVELOPMENT BK/HON CHINA DEVELOPMENT BK/HON BANK OF CHINA BANK OF CHINA ICBC ASIA LTD BK TOKYO-MITSUB UFm HK DEUTSCHE BANK AG (HK) ICBC ASIA LTD ICBC ASIA LTD CHINA DEVELOPMENT BANK CHINA DEVELOPMENT BANK ASIAN DEVELOPMENT BANK SINOTRUK HONG KONG LTD HONGKONG & SHANGHAI BK EXPORT IMPORT BANK CHINA UBS AG HONG KONG CHINA RESOURCES POWER HL CHINA RESOURCES POWER HL CHINA MERCHANTS HLDG HK CHINA GOVERNMENT BOND CHINA GOVERNMENT BOND CHINA GOVERNMENT BOND CATERPILLAR FINANCIAL SE EXPORT IMPORT BANK CHINA CHINA GOVERNMENT BOND GALAXY ENTERTAINMENT GRO VTB CAPITAL SA CHINA POWER INTERNATIONA AGRICULTURAL BK CHINA HK AGRICULTURAL BK CHINA HK AUST & NZ BANKING GRP/HK BK OF COMMUNICATIONS HK INTL BK RECON & DEVELOP ROYAL BK OF SCOTLAND PLC SINOCHEM OFFSHORE CAPITA INTL FINANCE CORP Size (CNY mn) 3,000 1,000 1,000 4,000 2,000 1,000 2,000 3,000 2,500 500 500 1,380 114 200 100 1,000 2,200 2,800 1,000 20 200 117 47 2,000 3,000 1,200 2,700 90 4,000 200 1,000 1,000 700 2,000 2,000 1,000 1,000 1,000 3,000 1,380 1,000 800 500 500 200 500 500 100 3,500 150 Coupon 3.40 3.40 4.58 2.80 2.45 3.20 2.60 2.25 2.70 3.30 2.68 2.98 2.00 3.00 1.95 2.10 2.65 2.90 2.25 1.98 2.00 2.30 2.65 2.73 2.70 2.85 2.95 1.80 2.65 2.50 3.75 2.00 2.90 1.00 1.80 2.48 2.00 1.95 1.60 4.63 2.95 3.20 1.20 1.40 1.45 1.40 0.95 1.80 1.80 1.80 Tenor (years) 3 3 2 2 2 2 2 2 3 5 1 2 1 3 1 2 2 3 2 1 2 2 3 3 3 10 2 1 3 2 5 2 3 3 5 10 2 2 2 3 3 5 1 2 2 2 2 3 3 5 Issue date 04-Sep-08 22-Sep-08 13-Jul-09 23-Jul-09 20-Aug-09 20-Aug-09 14-Sep-09 27-Oct-09 27-Oct-09 27-Oct-09 20-Jul-10 13-Jul-10 17-Aug-10 16-Sep-10 10-Sep-10 13-Sep-10 30-Sep-10 30-Sep-10 24-Sep-10 24-Sep-10 28-Sep-10 22-Oct-10 22-Oct-10 14-Oct-10 11-Nov-10 21-Oct-10 29-Oct-10 19-Nov-10 02-Dec-10 22-Nov-10 12-Nov-10 12-Nov-10 19-Nov-10 01-Dec-10 01-Dec-10 01-Dec-10 01-Dec-10 02-Dec-10 20-Dec-10 16-Dec-10 23-Dec-10 23-Dec-10 23-Dec-10 23-Dec-10 24-Dec-10 10-Jan-11 14-Jan-11 20-Jan-11 18-Jan-11 27-Jan-11 Maturity date 04-Sep-11 22-Sep-11 13-Jul-11 23-Jul-11 22-Aug-11 20-Aug-11 14-Sep-11 27-Oct-14 27-Oct-12 27-Oct-11 20-Jul-11 13-Jul-12 17-Feb-11 16-Sep-13 12-Sep-11 13-Sep-12 30-Sep-13 30-Sep-12 24-Sep-12 26-Sep-11 28-Sep-12 22-Oct-13 22-Oct-12 14-Oct-13 11-Nov-13 21-Oct-20 29-Oct-12 19-May-11 02-Dec-13 22-Nov-12 12-Nov-15 12-Nov-13 19-Nov-13 01-Dec-20 01-Dec-15 01-Dec-13 01-Dec-12 02-Dec-12 20-Dec-12 16-Dec-13 23-Dec-13 23-Dec-15 24-Dec-12 23-Dec-11 24-Dec-12 10-Jan-13 14-Jan-13 20-Jan-14 18-Jan-14 27-Jan-16
33
Bond PCD STORES GROUP IND & COM BK CHINA MACAU IND & COM BK CHINA MACAU BECL INVESTMENT SVENSKA HANDELSBANKEN AB ROAD KING INFRAST (2011) ICBC ASIA LTD BK OF COMMUNICATIONS HK
Size (CNY mn) 750 1,000 1,000 1,150 170 1,300 3,000 1,000
Coupon 5.25 1.55 1.45 4.75 1.40 6.00 1.10 1.00
Tenor (years) 3 2 1 3 2 3 2 2
Issue date 01-Feb-11 09-Feb-11 09-Feb-11 21-Feb-11 28-Feb-11 25-Feb-11 25-Feb-11 04-Mar-11
Maturity date 01-Feb-14
09-Feb-12 21-Feb-14 28-Feb-13 25-Feb-14 25-Feb-13 04-Mar-13 Source: Bloomberg, RBS
List of CNY-linked bonds

Bond SHUI ON DEVELOPMENT HOLD CHINA SCE PROPERTY HOLDI EVERGRANDE REAL ESTATE G EVERGRANDE REAL ESTATE G SHUI ON DEVELOPMENT HOLD LDK SOLAR CO LTD Size (CNY mn) 3,000 2,000 5,550 3,700 3,500 1,200 Coupon 6.88 10.50 7.50 9.25 7.63 10.00 Tenor (years) 3 5 3 5 4 3 Issue date 12/23/2010 1/14/2011 1/19/2011 1/19/2011 1/26/2011 2/28/2011 Maturity date 12/23/2013 1/14/2016 1/19/2014 1/19/2016 1/26/2015 2/28/2014 Source: Bloomberg, RBS
List of panda bonds

Bond ASIAN DEV BANK INTL FIN CORP INTL FIN CORP HSBC BANK CHINA HSBC BANK CHINA ASIAN DEV BANK BK TOKYO-MIT UFJ Size (CNY mn) 1,000 1,130 870 1,000 2,000 1,000 1,000 Coupon 3.34 3.40 3.20 4.58 2.60 4.20 2.43 Tenor (years) 10 10 7 2 2 10 2 Issue date 14-Oct-05 14-Oct-05 15-Nov-06 13-Jul-09 14-Sep-09 08-Dec-09 21-May-10 Maturity date 14-Oct-15 14-Oct-15 15-Nov-13 13-Jul-11 14-Sep-11 08-Dec-19 21-May-12 Source: Bloomberg, RBS
34
13-Feb-13
Appendix V
Related RBS publications
Alert | China | Inflation fighting stays on 7 March 2011 Alert | China | Unabated capital inflows 3 March 2011 Alert | CNY rates | Whats eating the 7day repo? 28 February 2011 EM Trade Idea | China | Greater conviction in higher rates, stronger FX 21 February 2011 Top View | China | Money is slowing inflation is not 17 February 2011 Alert | China | Inflation Climbed in January 15 February 2011 Alert | CNY rates | Tactical front-end trade 10 February 2011 Top View | China | Higher inflation a new normal 8 February 2011 Alert | CNH rates | China MOF sets new benchmark 15 November 2010 1 December 2010 Top View | CNY rates | Dim sum or Panda? 15 November 2010 EM Fixed Income Primer | China fixed income market 13 October 2010 Emerging Markets Asia | CNH Market Guide | 10 March 2011 35
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The PRC government continues to regulate conversion between CNY and foreign currencies, including the Hong Kong dollar, despite the significant reduction over the years by the PRC government of its control over routine foreign exchange transactions under current accounts. The Peoples Bank of China (PBOC) has established a clearing and settlement system for participating banks in Hong Kong pursuant to a Settlement Agreement relating to the clearing of CNY Business between PBOC and Bank of China (Hong Kong) Limited. However, the current size of CNY and CNY denominated financial assets in Hong Kong is limited, and its growth is subject to many constraints which are directly affected by PRC laws and regulations on foreign exchange. 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As a result, the value of such payments in CNY (in Hong Kong dollar or other applicable foreign currency terms) may vary with the prevailing exchange rates in the marketplace. If the value of CNY depreciates against the Hong Kong dollar or other foreign currencies, the value of a CNY payment received by a party in Hong Kong dollar or other foreign currency terms will decline. Interest rate risk - The value of the transaction is susceptible to interest rate fluctuations, including Chinese CNY Repo Rates and/or the Shanghai Interbank inter-bank offered rate (SHIBOR).
ii.
iv.
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Emerging Markets Asia Guide to China's CNH Market

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Emerging Markets Asia

CNH Market Guide

The Royal Bank of Scotland

Dim sum bond market

Emerging Markets Asia | CNH Market Guide | 10 March 2011

The Royal Bank of Scotland

The Royal Bank of Scotland

Origins and objectives

July 2007 start of CNYdenominated bond market

Figure 1: PBOC's CNY swap lines

The Royal Bank of Scotland

CNY trade settlement scheme

Source: PBOC, CEIC, RBS

Special QFII scheme

Emerging Markets Asia | CNH Market Guide | 10 March 2011

The Royal Bank of Scotland

CNY settlement for Chinas outbound FDI

Emerging Markets Asia | CNH Market Guide | 10 March 2011

The Royal Bank of Scotland

Emerging Markets Asia | CNH Market Guide | 10 March 2011

The Royal Bank of Scotland

August 2010 USD/CNH trading kicked off

The Royal Bank of Scotland

Figure 4: USD/CNH vs USD/CNY

1700 1500 1300 1100

900 700 500 300 100

Source: Bloomberg, RBS

Source: Bloomberg, RBS

Emerging Markets Asia | CNH Market Guide | 10 March 2011

The Royal Bank of Scotland

CNH IRS curve came about on demand by investors of CNH bonds

Sovereign benchmark curve is taken from issues by Chinese government

Emerging Markets Asia | CNH Market Guide | 10 March 2011

The Royal Bank of Scotland

Source: Bloomberg, RBS

Cross currency swap

Synthetic CNH a misnomer

The Royal Bank of Scotland

CNH central clearing

Emerging Markets Asia | CNH Market Guide | 10 March 2011

The Royal Bank of Scotland

Dim sum bond market

Figure 7: Chronology of regulatory changes* and milestones of CNH bond issues

The Royal Bank of Scotland

July 2010 Big Bang

China financial institutions were the first issuers in July 2007

The Royal Bank of Scotland

SAFE, PBOC & MOFCOM Not required

SAFE, PBOC & MOFCOM Not required

SAFE & PBOC Not required

Registration with SAFE Not required

Registration with SAFE Not required

Figure 9: Two routes of remittance of CNH bond proceeds as of 9 March 2011

Emerging Markets Asia | CNH Market Guide | 10 March 2011

The Royal Bank of Scotland

350 300 250

50 40 30 20 10 0 07 N e w is s u a n c e s 08 09 10 J a n -F e b 1 1 N e t in c re a s e A m o u n t o u ts ta n d in g N e t o u ts ta n d in g 10 10 22 16 12 14 35 40 200 150 100 50 0 07 08 09 10 Ja n 11 33 10 23 7 56 63 56

Source: Bloomberg, RBS

Source: Bloomberg, RBS

The Royal Bank of Scotland

Quasi govt policy banks Commercial banks IG Corp

Figure 13: Outstanding bonds by issuer by issuance amount as of 9 March 2011