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Asia Markets Research

January 26, 2010

The CNH market


Summary
Ever since the global financial crisis, China is increasingly pushing for renminbi internationalization. Authorities are carefully building up avenues for circulation of the currency between onshore and offshore. Cross-border trade settlement in CNY is the cornerstone of these schemes, but portfolio flows and ODI are also being opened, be it at a very slow pace. The CNH market, ie. the deliverable CNY market offshore in Hong Kong, is the most visible result of renminbi internationalization. CNH deposits in Hong Kong tripled last year, mainly on the back of cross-border trade, and are expected to rise further rapidly. CNH product development is growing fast, from a low base. Foreign investors and corporates can now access a variety of FX and rates CNH products. This publication collects recent research notes on the CNH market. First, we explain how the avenues for CNH and CNY circulation fit together between onshore and offshore. Then, we make projections for growth in CNH deposits and trade settlement. Then, we categorize the FX and rates products that exist for foreign investors and corporates. Finally, we look at hedging and speculative opportunities available in the spot and forward CNH and CNY markets.
Chart: How CNY turns into CNH (and vice versa). For a larger version, see page 3.
Contents
Summary 1 How the CNH market fits in with RMB internationalization 2 Prospects of CNH business in Hong Kong 6 CNH and CNY products available for foreign corporates and investors 9 Opportunities in the spot and forward CNH market 11

China onshore

CNY
Exchange traded bonds CNY DF

Bert Gochet
(852) 2800 8325 bert.j.gochet@jpmorgan.com
Corp
Exchange traded shares

Yen Ping Ho
(65) 6882 2216 yenping.ho@jpmorgan.com

PBOC
Corp

Interbank bond market

FDI

Corp
Interbank bond mkt pilot program

Jason Mortimer
(852) 2800 8329 jason.j.mortimer@jpmorgan.com

HK residents and tourists

Corp

BoC

shareholder loan, equity capital injection, ('dim sum' bond proceeds)

QFII

Cross border trade

Grace Ng
Corp

Conversion quota

(852) 2800 7002 grace.h.ng@jpmorgan.com

CCY swap lines

ODI

Investor

Simon Song
(86-21) 5200 2833 simon.p.song@jpmorgan.com

Corp

Corp

HKMA

BoC(HK)

Corp

Participant bank

CNY NDF

Other central banks

CNH
Investor

CNH bond market

Corp

Singapore, New York, London, ...

CNH DF

USD
HK bank

Hong Kong

Offshore
Source: JP Morgan Legend: Financial product Central Bank Corporate Bank Investor CNH market

CNH-CNY flow, or CNY-USD flow

www.morganmarkets.com

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

J.P.Morgan Securities (Asia Pacific) Ltd The CNH market January 26, 2011

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

How the CNH market fits into the internationalization of the renminbi
China is carefully building up avenues for circulation of renminbi between offshore and onshore The CNH market in Hong Kong is the most visible result of this process. We show how all the pieces of the CNH and CNY market fit together.

Step 1: RMB leaves the Mainland


A so-called pilot program to allow direct settlement of RMB transactions for cross-border trade was launched in July 2009. Corporates in Shanghai and 4 cities of Guangdong province on the one hand, and Hong Kong/Macau/ASEAN on the other hand. This program was expanded in June 2010 to allow for RMB settlement between 365 corporates in 18 additional mainland provinces and all countries. In addition, the scope for RMB trade settlement was expanded to cover not only trade in goods, but also to trade in services and other current account transactions. In December 2010, the number of mainland exporters that is allowed to particpate in cross border CNY settlement was raised to 67,359 from 365. Mostly as a result of the RMB settlement pilot program, since mid-2009 cross-trade settlement picked up significantly, and reached a cumulative total of about CNY 500bn at the end of 2010 (our estimates). Of this number, the vast majority traded in Hong kong (and Singapore), and 80% was used for import of goods, versus only 20% for export. As a result, nearly CNY 300bn has flowed out of China through net imports in the last year and a half. When comparing the growth in trade settlement with CNH deposits in HK, there is a clear strong link between the two, and we can conclude that the main driver of deposit growth has been merchandise trade so far.

The five steps of RMB Internationalization


Ever since the global financial crisis, China is increasingly pushing for renminbi internationalization. Authorities are carefully building up avenues for circulation of the currency between onshore and offshore. Crossborder trade settlement in CNY is the cornerstone of these schemes, but portfolio flows and ODI are also being opened, be it at a very slow pace. Broadly speaking, Chinas full process of RMB internationalization will proceed in five steps: (1) RMB leaves the Mainland; (2) RMB circulates offshore; (3) RMB returns to the Mainland; (4) Width and depth of the offshore RMB market is enhanced, and, finally (5) Capital account is opened. The first three steps are meant to build up the circulation of RMB between onshore and offshore markets. These are relatively small steps towards RMB internationalization and have been implemented in Hong Kong as a test market that is available for a vaariety of counterparties and with certain quotas. The final two steps towards the opening the capital account are much more involved and have barely started.
Table 1: Milestones in RMB internationalization
Date Jul-09 Jun-10 Jul-10 Aug-10 Jan-11 Program Pilot program of RMB trade settlement

Step 2: RMB circulates offshore


Banks in Hong Kong have been allowed to accept CNY deposits since 2003. Depositors were initially retail who wanted to hold some renminbi in a bank account. Until two years ago, deposit growth was slow as there was nothing you could really do with the RMB except keep it on deposit (at a very low deposit rate). Chart 2 on page 4 shows how deposit growth in the early days was off to a slow start.

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

Pilot program expansion previous pilot program expanded to 18 additional provinces, for cross-border trades with all countries. Also, the scope now covers services trade. Amended Clearing agreement Pilot program for opening bond market Pilot program for RMB ODI settlement PBoC amended the Clearing Agreement with BoC (HK), expanding the scope of RMB business and increasing flexibility in RMB-denominated financial services. PBoC lauched another pilot program of opening China interbank bond market for three kinds of overseas institutions. PBoC announces another pilot program which allows qualified corporates to settle in RMB in overseas direct investment (ODI).

J.P.Morgan Securities (Asia Pacific) Ltd


The CNH market January 26, 2011

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

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

China onshore

CNY
Exchange traded bonds CNY DF

Corp
Exchange traded shares

PBOC
Corp

Interbank bond market

Corp
Interbank bond mkt pilot program

HK residents and tourists

Corp

BoC

shareholder loan, equity capital injection, ('dim sum' bond proceeds)

Cross border trade

Conversion quota

QFII

CCY swap lines

ODI

Corp

Investor

Corp

Corp

HKMA

BoC(HK)

Corp

Participant bank

CNY NDF

Other central banks

CNH
Investor

CNH bond market

Corp

Singapore, New York, London, ...

CNH DF

USD
HK bank

Hong Kong

Offshore
Source: JP Morgan Legend: Financial product Central Bank Corporate Bank Investor CNH market

CNH-CNY flow, or CNY-USD flow

FDI
3

J.P.Morgan Securities (Asia Pacific) Ltd The CNH market January 26, 2011

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

Chart 2: RMB deposits in Hong Kong RMB deposits in Hong Kong


bn yuan 300 250 200 150 100 50 0 2004 2005 2006 2007 2008 2009 2010

For the last six months, any retailer or corporateregardless of its country of domicile- has been able to do RMB business in HK, as long as they simply open a settlement account with BoC (HK). All their transactions are closely monitored by HKMA. But there is a restriction on clearing - banks can only square open positions of RMB with BoC(HK) for settlement of cross-border trade, subject to a quota (which was CNY8bn last year, and 4bn for 1Q11). Meanwhile, non-trade related transactions can only be squared in the CNH inter-bank market. This raises the important point that CNY can freely leave China and enter the CNH market as long as it is backed up by trade documents, but the reverse is not true. Say for example, a mainland based importer can pay in CNH for as many imports as he likes. This flow of CNY out of China into CNH happens without quota, and is the main reason why CNH deposits in Hong kong have picked up so strongly in 2010. But a non-China based buyer of Chinese goods is not necessarily guaranteed to be able to obtain CNH to pay for his purchases. After all, he will need to purchase the CNH in the market or from his banker, and eventually that position will need to be squared via BoC(HK) subject to the conversion limits set by PBOC. These limits were the topic of discussion late last year when it turned out that the CNY8bn conversion quota for 2010 had been exhausted ahead of year-end. Effectively, there had been more demand for CNH from non-China based corporates than authorities had expected, and the quota had already been filled. The quota for this year has been increased, with CNY4bn for the first quarter. It is believed that this will be sufficient for now. Over time though, the CNH liquidity in the Hong Kong market will become self sustainable and the quota approach will eventually be scrapped.

The 2009 pilot program for cross-border trade kicked CNH deposits up a notch. Since then, holding RMB in HK became meaningful for exporters and importers. Deposits increased on the back of cross-border trade. From chart 2 you can tell how deposits picked up pace from mid 2009. The pace of deposit growth over that period was broadly in line with the growth of China net imports settled in RMB. In other words, goods and service trade in the current account were the main source of RMB in HK over that period. During this initial stage, Bank of China (HK) started to play a special role in controlling the flow of RMB in Hong Kong. It was appointed as the clearing bank for all transactions in the territory, ie. a de facto central bank for RMB in Hong Kong. BoC(HK) thereby became the lender for all RMB transactions, and also all RMB held by other banks was to be deposited with BoC. In the days after the pilot progam announcement the access to RMB in HK was only available to a limited amount of counterparties, and for a well defined set of purposes: retail customers (for RMB deposits and bonds), corporates (for trade settlement), and depository institutions (for attracting deposits). Since mid-2010, the pace of development stepped up another notch. In July, PBoC amended the Clearing Agreement with BoC (HK), expanding the scope of RMB business. As part of that amendment, corporates were now allowed to open RMB accounts and transfer funds across accounts for any purpose, regardless of whether or not they relate to trade settlement. In addition, banks were allowed to introduce RMB-linked products, such as CDs, deliverable forwards, mutual funds, and insurance products. Interbank CNH deposits and CNH deliverable forwards started trading in the market. At the same time, CNH deposits started ballooning.
4

Step 3: RMB returns to Mainland


For obvious reasons the third step in the internationalization of the currency- ie. letting RMB enter back into the Mainland- has been the slowest step to develop so far. But there is improvement, albeit at a small scale. There are two different approaches that are being taken to make progress on this front. The first is through a Mini QFII program. The second is to let selected offshore banks buy onshore bonds.

J.P.Morgan Securities (Asia Pacific) Ltd


The CNH market January 26, 2011

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

The Mini QFII is a program would allow CNH funds flow back into capital markets in China (including A shares) through the channel of financial products provided by HKbased Chinese security firms and asset managers (Note that Mini QFII is different from the plain QFII: in the latter, USD gets echanged for CNY and invested in mainland exchange traded products). Chinese media have reported on Mini QFII several times since last year. But an official approval has been delayed by concerns about hot money flows. Last week, Shang Fulin, the Chairman of CSRC again said that Mini QFII will be launched soon, but on a trial basis. HKMA officials have also hinted that this program is pending Chinas top leaders approval. The second approach is letting selected offshore institutions buy CNY bonds in the onshore interbank bond market. Under this scheme, three kinds of overseas institutions will be allowed to buy bonds onshore: (1) central banks who are already in cooperation with PBoC (such as through a currency swap line), (2) the RMB clearing banks in HK and Macau, and (3) overseas participation banks ie. those banks who are the participants in RMB cross-border trade settlement. The central banks and clearing banks would be able to access the Chinese interbank bond market directly or go through an agent bank such ICBC or BOC. The participation banks will have to go through an agent bank and cannot access the interbank market directly. But even for this limited amount of institutions restrictions apply, as one would perhaps expect. First, the bond investment needs an approval from PBoC. As far as we know, only HKMA, BNM and ICBC (Asia) have received an approval so far. Secondly, a quota will apply. In our

understanding, this would not be more than a few billion CNY to start. Third and perhaps most important, the source of RMB funds for the bond investment should be either (1) from currency swap lines with PBoC (note PBoC has opened up a total of CNY 800bn of swap lines with eight central banks since 2008. They are unused so far, but will be used for small size soon to kick off this program ), or (2) cash from RMB cross-border trade by participation banks, or (3) from proceeds from investing in RMB business. Fourth, each overseas institution can open only one RMB nostra account with one of the eligible onshore banks to do bond trades. The impact of this pilot program on the onshore markets (spot, forward, bond, etc) is limited in the near term, since time is needed for application, approval and setup of operations. In the future, however, this program will improve the circulation of RMB between onshore and offshore, and link together the RMB markets in the Mainland and HK. This channel can be considered the first tentative step toward an eventual opening of the capital account.

Step 5: Opening of capital account


Opening the capital account will be the last and most cautious step of the internationalization of RMB. On Jan 13th, 2011, the PBoC announced yet another pilot program which allows qualified corporates to settle overseas direct investment (ODI) in RMB. This is an important milestone in the opening of the capital account, although ODI settled in RMB will still need approval on a one-off basis. Lately, some officials have also started to suggest offshore companies use RMB for FDI too, but in our view it is too early for that to happen.

J.P.Morgan Securities (Asia Pacific) Ltd The CNH market January 26, 2011

Asia Markets Research Grace Ng (852) 2800 7002 grace.h.ng@jpmorgan.com

Prospects for CNH business in Hong Kong


The Chinese authorities have pushed harder for RMB internalisation since the global financial crisis RMB deposits in Hong Kong jumped significantly last year, along with PBoC policy liberalisation Critical mass of offshore renminbi, most of which likely residing in Hong Kong, will increase rapidly. We forecast deposits in Hong Kong to rise to CNH 2.6-3.5tri in five years time. Notable scope of RMB internationalisation through merchandise trade, services, FDI and portfolio flows Since the onset of the global financial crisis in 2008, RMB internalisation has become an increasingly important policy target for the Chinese authorities. As the financial crisis reveals the pitfalls of existing international monetary arrangements, China joined other emerging countries to urge the International Monetary Fund to push ahead with reforms, giving developing economies a bigger say in the new international financial order. In addition, the Chinese government recognises that as Chinas importance in the global economy and financial system increases, RMB is set to play a bigger role in international trade and finance, particularly in Asia. In addition, from Chinas point of view, RMB internationalisation would help to reduce exchange rate risks for Chinese firms, strengthen the international competitiveness of Chinese financial instititutions (given their vast pool of RMB assets) and preserve the value of Chinas international savings1. Against this background, the Chinese government, especially the Peoples Bank of China, has been pushing harder for the progress of RMB internationalization since the crisis.
RMB deposits in Hong Kong
bn yuan 300 250 200 150 100 50 0 2004 2005 2006 2007 2008 2009 2010

Hong Kong banking sector deposits


HK$ bn 4000 3500 3000 2500 2000 1500 2004 2005 2006 2007 2008 2009 2010 Non HK$ deposits HK$ deposits

Mainland visitor spending in Hong Kong


HK$ bn 70 60 50 40 30 20 02 03 04 05 06 07 08 09 Total Mainland visitor spending Mainland visitor spending per capita HK$ 7000 6500 6000 5500 5000 4500 4000

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

Hong Kongs role as offshore RMB centre


For the private sector, the Hong Kong banking sectors RMB deposit taking since early 2004 has been an early step to officially incorporate RMB circulating offshore, which arises from real economic activities such as Chinese tourist spending overseas, into the banking system outside of mainland China. It is not difficult to understand the Chinese authorities decision to explore and expand offshore RMB business in Hong Kong. While Hong Kong is special administrative region of China, it is well-recognised as a vibrant financial centre with free flow of international capital, and with almost half of bank deposits in the form of nonHK$ currencies.
1. Internationalization of the Renminbi, BOK-BIS Seminar, March 2009, by Gao Haihong and YU Yongding.

J.P.Morgan Securities (Asia Pacific) Ltd


The CNH market January 26, 2011

Asia Markets Research Grace Ng (852) 2800 7002 grace.h.ng@jpmorgan.com

As of November 2010, outstanding RMB deposit in the Hong Kong banking sector came in at 280 billion yuan, equivalent to 3.9% of of Hong Kongs total M2 money supply. Meanwhile, the Chinese authorities introduced the RMB trade settlement scheme in July 2009, which was then expanded in various stages to cover more than 67,000 Chinese corporates from 16 provinces and cities by December 2010. In addition, the PBoC introduced a pilot scheme in August 2010, allowing eligible institutions outside the mainland to use their RMB funds to invest in Chinas domestic interbank bond market. Given the notable progress on policy liberalization, and with growing expectations on yuan appreciation in recent months, outstanding RMB deposit in Hong Kong banks jumped by 212% since June 2010, to reach 280 billion yuan by November, equivalent to 4.6% of Hong Kongs total M2 supply.

China: BoP current account, capital and financial account surpluses


% of GDP 12 10 8 6 4 2 0 2004 2005 2006 2007 2008 2009 2010ytd Current account surplus Capital and financial account surplus 1-3Q 1-2Q

China: merchandise trade


US$ bn, 12mma 140 120 Exports

Critical mass of offshore RMB rises rapidly


So far, the overall scale of offshore RMB in Hong Kong is still very modest. Despite the recent notable expansion, as of end 2010, the size of total RMB deposit in Hong Kong is equivalent to only 0.5% of total onshore yuan deposit in the mainland. Going forward, however, there are good reasons to expect the critical mass of offshore RMB, especially in the form of RMB deposits in Hong Kong, to rise rapidly in the coming years. At the first glance, Chinas sustained, elvated twin surpluses in the BoP current account as well as capital and financial accout (first chart) cast some doubt on the prospect for expanding the international use of RMB, as China continues to amass foreign currency assets via the twin surpluses in the external accounts. However, in practice it is indeed reasonable to perceive rather rapid increase in the use of RMB offshore. On the current account, in addition to the likelihood that an increasing share of overseas spending by Chinese tourists could be transacted in RMB, there is significant scope for expanding the size of merchandise trade settlement in RMB, especially starting from Chinese importers paying their import bills in RMB. Indeed, figures on RMB trade settlement so far last year suggest the majority is done on the import front (third chart). To gauge the potential scope of RMB trade settlement, a relevant benchmark for comparison is the use of JPY in merchandise trade settlement by Japanese corporates. According to latest data gathered by our fx strategy team in Tokyo, in aggregate, 41.0% of Japans exports are now settled in JPY, and the ratio on the import front stands at 23.6% (table). While such figures could serve as a benchmark for

100 80 60 40 20 2004 2005 2006 2007 2008 2009 2010 Imports

RMB cross border trade settlement


RMB bn 200 150 100 50 0 1Q10 2010 3010 Imports to China

Exports from China

Japan: breakdown of currency used for trade settlement


% share Exports from Japan Total exports To US To EU To Asia Imports to Japan Total imports From US From EU From Asia USD 48.6 85.9 49.9 49.9 USD 71.7 78.1 58.0 71.7 JPY 41.0 14.1 30.1 48.1 JPY 23.6 21.4 28.0 26.8 EUR 6.3 0.1 15.3 0.6 EUR 3.2 0.2 11.0 0.4 AUD 1.3 0.0 4.2 0.4 CHF 0.4 0.2 2.1 0.3 CAD Others 0.7 0.0 0.2 0.2 2.1 0.0 0.3 0.8

GBP Others 0.3 0.8 0.0 0.1 0.3 0.6 0.2 0.6

J.P.Morgan Securities (Asia Pacific) Ltd The CNH market January 26, 2011

Asia Markets Research Grace Ng (852) 2800 8325 grace.h.ng@jpmorgan.com

the long term potential scope of RMB trade settlement, for the medium term we have come up with more conservative scenario analysis regarding RMB trade settlement for the coming five years, with the focus on expanding RMB settlement on the import front at this early stage. Assuming the share of Chinas total imports settled in RMB will rise steadily towards 10% by 2015, and assuming average 10% annual growth in Chinas imports, along with a more modest share (up to 3%) of exports settled in RMB, the pool of total trade-related RMB deposits, most of which will likely reside in Hong Kong, could potentially rise to as much as 2,600 billion yuan in five years. This is a significant amount compared again the outstanding size of Hong Kongs M2 money supply at HK$ 7,111 billion as of November 2010. In an alternative scenario, if we assume that it is the group of emerging market economies, including non-Japan Asia, Latin America and Africa, that would see a notable rise in the share of their exports to China settled in RMB (given their closer economic ties with China, and the fact that China has in general held a trade deficit with this group), and assuming the share of Chinas total imports from this group to be settled in RMB will rise steadily towards 20% by 2015, the pool of total trade-related RMB deposits in Hong Kong could potentially rise to as much as 3,500 billion yuan in five years.

China: imports from emerging economies


US$ bn, 12mma 60 50 40 30 20 10 0 2004 2005 2006 2007 2008 2009 2010 Africa Latin America Asia ex-Japan

China: outward direct investment


US$ bn 60 50 40 30 20

2006

2007

2008

2009

Potential capital account RMB settlement


In addition to current account transactions regarding merchandise trade and services, going forward some capital and financial account transactions could be settled in RMB. In particular, the PBoC announced two weeks ago that outward foreign direct investment could now be settled in RMB. Indeed, Chinas outward FDI has risen notably in recent years, registering at US$56.5 billion in 2009, with 87% going to the emerging market economies, which would likely be keen to receive RMB for FDI-related transactions.

In addition, going further ahead, China could further open up avenues for domestic investors to invest overseas, which includes, but would not be restricted to, the Qualified Domestic Institutional Investor (QDII) program, in order to diversify the investment channels for the private sector. Part of this could be invested in RMB-denominated investment products offered in Hong Kong. The potential shift of every 1% of Chinas domestic deposit to RMB-denominated investment products in the Hong Kong financial market would amount to the equivalent of 700 billion yuan.

J.P.Morgan Securities (Asia Pacific) Ltd


The CNH market January 26, 2011

Asia Markets Research Jason Mortimer (852) 2800 8329 jason.j.mortimer@jpmorgan.com

CNH and CNY products for foreign investors and corporates


In this piece we provide an overview of CNY and CNH products for offshore investors and corporates, including FX, bonds, and swaps.

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


6.800 6.700 6.600 6.500 6.400
CNY Onshore CNY Onshore FWDS CNH Offshore CNH Offshore FWDs CNY NDF FWDS

Onshore CNY rates and FX products


The interbank onshore bond market is traditionally closed to offshore investors. However, in August 2010 a pilot program was launched whereby a select group of financial institutions will be given approval by PBOC to use their offshore RMB to participate in the onshore interbank market (see pages 4-5). The exchange-traded onshore bond market (which is much smaller than the interbank market) is in theory already accessible from abroad by any QFII holder, however a very limited amount of government bonds is held through QFII. Onshore deliverable FX Forwards are not accessible for offshore investors. Interest rate swaps (based

Aug-10

Dec-10

Mar-11

Jun-11

Sep-11

Jan-12

Apr-12

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

Offshore deliverable CNH market, and thedim sum market


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

Chart 2: Composite yield curves in Onshore CNY (green), Offshore deliverable CNH (blue), and Offshore NDF CNY (grey). Offshore CNH yields generally trade intermediate to Onshore CNY and Offshore NDF yields.
6.0 5.0 4.0 3.0 CNY T-Bill 2.0 1.0 0.0 -1.0 -2.0 -3.0 -4.0 -5.0 0 2 4 6 8 10 12
9

% CNY Deposit CNY ND-IRS (7d Repo) CNY IRS (7d Repo) CNY Govt CNH

CNY ND-CCS CNH Deposit CNH Forward FX Implied CNH CCS

CNY ND Forward FX

J.P.Morgan Securities (Asia Pacific) Ltd The CNH market January 26, 2011

Asia Markets Research Jason Mortimer (852) 2800 8329 jason.j.mortimer@jpmorgan.com

started trading around the same time. CNH deposit rates are based on quotes from BoC(HK), and given their one-way nature these rates are significantly lower than onshore deposit rates. The CNH interest rateswap market has gotten off to a false start: initial deals were based on (onshore) SHIBOR but this proved impractical and such swaps are no longer actively quoted. The dim sum bond market refers to CNH-denominated bonds that were issued offshore. The majority of dim sum bonds are denominated in CNH, but some other bonds are linked to CNY (but paid in USD). Chinas CNHdenominated benchmark sovereign bond curve is currently comprised of a single issue each of 3y, 5y, and 10y CGBs. These bonds were issued by the Ministry of Finance, in the Hong Kong market in December 2010. Their yields are significantly below mainland government yields, as they are commonly used as a CNY-appreciation proxy. Bond issuance in the CNH market has increased sharply since the lifting of restrictions on trading CNH in mid-2010. The current total of outstanding issuance is CNY59bi. The greatest issuers are banks (29%), government agencies (25%), and sovereigns (24%).

Table 1: Composition of bullet CNH bonds by issuer


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

Offshore CNY NDF


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

Graph 1: Composition of bullet CNH bonds by issuer type


FINANCIAL SUPRA- 2% NATIONAL 3% INDUSTRIAL 14% SPV 2% UTILITY - ELEC 1%

BANK 29%

Graph 2: CNH bond notional issuance increased dramatically since August 2010
mln CNH 60,000

40,000

20,000
GOVT NATIONAL 24% GOVT AGENCY 25%

0 Jan-10

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J.P.Morgan Securities (Asia Pacific) Ltd


The CNH market January 26, 2011

Asia Markets Research Yen Ping Ho (65) 6882 2216 yenping.ho@jpmorgan.com

Opportunties in the spot and forward CNH market


USD/CNH to stay in discount to onshore spot. Regulatory reforms are needed to correct the imbalance, but an overhaul not expected anytime soon. USD/CNH-USD/CNY converged late-2010, but move is temporary and event driven. In principle, there is a large overlap in participants who can access the offshore NDF and offshore USD/CNH DF. However, they fundamentally roll to a different spot rate All corporates and institutions, regardless of nature of business or investor type, can open CNH accounts and access CNH products as long as they comply with normal banking regulations in Hong Kong with no additional approvals from SAFE or HKMA

Mainland capital account remains closed and RMB funds cannot flow freely from Mainland to HK and to global markets, the lack of free arbitrage should leave USD/CNH biased to a negative spread against onshore USD/CNY. While a move to a free capital account would allow offshoreonshore convergence, this is not expected anytime soon. Fundamentally, the PBoC remains extremely sensitive against allowing offshore investor (or speculative) demand to impact onshore spot. USD/CNH-USD/CNY converged late-2010, but move is temporary and event driven. While USD/CNH rallied into USD premium against USD/CNY late-2010, we view the move as a knee-jerk reaction to HKMA regulatory refinements. In particular, headlines surrounding position limits on CNH had triggered a one-off readjustment of USD/CNH exposures. That said, the details of the regulations do not alter the fundamental elements driving the USD/CNH-USD/CNY spread. They remain 2 separate markets (and arguably more so following the HKMA refinements). We would view USD/ CNH-USD/CNY spot convergences as potential opportunities to be short USD/CNH.

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


USD/CNH to stay largely in USD discount to onshore spot. In the lack of free capital flow and amid global investor access, USD/CNH is expected to stay in USD discount against onshore spot. Particularly, still thin CNH liquidity conditions are still far from sufficient to absorb global demand shocks. Hence, USD/CNH has tended to extend below onshore spot especially when CNY appreciation fervor rises. With spot USD/CNY expected to trend lower to 6.30 through 2011, USD/CNH is similarly expected to gravitate lower with some additional downside bias Regulatory reforms are needed to correct the imbalance, but an overhaul not expected anytime soon. Insofar as the
Chart 1: USD/CNH trading at USD discount to onshore spot
6.85 6.80 6.75 6.70 6.65 6.60 6.55 6.50 6.45 6.40 Aug-10 USD/CNH spot USD/CNY spot

1. Imperfect convergence in spot CNH and CNY


The lack of strict arbitrage suggests CNH and CNY will remain fundamentally different markets. However, a lack of pure arbitrage does not stop convergence trades in spot: a) When a wide gap opens between onshore and offshore spot USD/RMB, this may motivate banks to position for convergence. Banks, even those who are not funded by CNH deposits, may fund CNH cash via sell/buy USD/CNH swaps and buy spot. However, the scarcity of CNH liquidity suggests risk that the bank may be unable to cover the forward delivery leg of the sell/buy USD/CNH swap. Taken together with the risk that offshore spot may not actually converge, this is far from a risk free trade (and not strictly an arb). b) Corporate flow as a force for convergence. Corporates receiving CNY cash from bilateral trade may find it more profitable to buy USD against RMB via a lower offshore USD/CNH spot rather than the clearing rate through the Clearing Bank. In light of this, non-resident corporates could migrate their RMB billing centre to Hong Kong, where RMB accrued from payments by Mainland buyers could be offloaded at a more favorable USD/CNH spot. Mainland
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J.P.Morgan Securities (Asia Pacific) Ltd The CNH market January 26, 2011

Asia Markets Research Yen Ping Ho (65) 6882 2216 yenping.ho@jpmorgan.com

entities may also establish re-invoicing centres in Hong Kong, as a means to channel CNH payments to offshore subsidaries as an alternative for offshore financing. These suggest an underlying bid for offshore USD/CNH insofar as it trades at an USD discount to onshore. Conversely, corporates requiring RMB for payments to merchandise trade counterparties in Mainland, may find it cheaper to generate RMB cash via USD/CNH if it trades above the onshore rate. Overall, we still expect USD/CNH to remain biased to the downside against onshore spot. To be sure, convergence trades will anchor USD/CNH to the general trend of onshore USD/CNY, but in the lack of pure and unrestricted arbitrage offshore RMB will still be vulnerable to global demand shocks. This suggests offshore USD/CNH will tend towards a USD discount to onshore spot, as the 2 remain fundamentally separate markets. We would view USD/CNHUSD/CNY spot convergences as potential opportunities to be short USD/CNH.

USD/CNH forwards peeling off the deposit curve NDF USD/CNY depo implied CNH 6.65 CNH 6.60
6.55 6.50 6.45 6.40 spot 3M 6M 12M

USD. This means that participants cannot enter long USD/ CNH offshore DF unless they are already long CNH cash or can easily fund in CNH. The inability to transact in large enough sizes, unwind risks and wide bid-offers on CNH DFs also feature to some part. In addition, both forward curves roll into different spot rates. And this implies basis risk when trying to cover the delivery leg of USD/CNH. Trading the NDF vs CNH would hence constitute taking views on 2 different underlyings, which remains far from a risk-free arb. That said, there is technical appeal to being on the short USD/CNH side of the CNH vs NDF convergence trade given the tendency for offshore spot to trade below onshore. This is apparent particularly at the longer-end of the USD/CNH curve where forwards are in USD discount and substantially off implied pricing from the deposit curve. However, amid fixing risks, liquidity risks and wide bid-offers on USD/CNH

2. Offshore CNY NDF vs offshore CNH DF


In principle, there is a large overlap in participants who can access the offshore NDF (non-deliverable forward) and offshore DF (deliverable forward) curves. However, liquidity constraints to trading the offshore DF has limited the convergence trade. For a start, the offshore deliverable leg settles with CNY notional while NDFs are settled only in

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

USD/CNY
(4) "cross-border" hedging

(1) global CNH demand

(3) onshore-offshore arb

(1) Corporates (4) "cross-border" hedging

(2) CNH vs NDF convergence trades

USD/CNY onshore DF USD/CNH offshore DF

(3) onshore-offshore arb

USD/CNY NDF

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*dashed arrows represent limited/restricted convergence flows

J.P.Morgan Securities (Asia Pacific) Ltd


The CNH market January 26, 2011

Asia Markets Research Yen Ping Ho (65) 6882 2216 yenping.ho@jpmorgan.com

DFs, risk reward is attractive only on wide spreads of USD/ CNH against NDFs. To be sure, the curves could converge increasingly as offshore CNH liquidity improve in Hong Kong. However, trading volumes on the offshore DF have extremely thin. Even factoring strong growth, the market is not expected to achieve the threshold needed to anchor the offshore NDFs anytime soon. If anything, the market has so far been happy to acquire CNH via a lower USD/CNH spot, as CNH in HK can be deployed in positive return assets as opposed to negative carry in the NDF curve. Such demand dynamics may also leave a wedge between markets.

from trading counterparties constrain the scope to position in the NDFs. The recent regulatory changes by SAFE may also have reduced the ability of Mainland corporates to take on such trades. Given the depth of NDF trading liquidity offshore, onshore-offshore arb have had only limited ability to compress the onshore-offshore spread.

4. Onshore CNY forwards vs offshore CNH DF


In theory, there may be scope for some cross-border hedging by naturally hedged entities. For example, Mainland corporates with both export and import operations would typical net out export and import invoices to negate foreign exchange risks. However, those with entities outside Mainland could migrate the import invoicing centre offshore where long USD/RMB hedging can be accrued at the lower USD/CNH rate.

3. Onshore CNY forwards vs offshore NDF


Onshore-offshore arbitrage across the forward curves has been going on for some time. Given that the NDFs trade at a persistent USD discount to onshore forwards, corporates registered Mainland may sell onshore USD/CNY forward as a hedging transaction with underlying documentation, but at the same time buy USD/CNY NDFs via a separate but same name entity registered offshore. The trades can been aggregated in accounting books as a pure arbitrage gain, though leaving the underlying USD receipt as a FX unhedged position. To some extent, the onshore-offshore arbitrage flow has helped anchor the NDFs to a spread against onshore. However, the small subset of entities able to execute these trades and limited ability to bring the positions on balance sheet have constrained the flow impact of such deals. Corporates can only sell USD/CNY onshore up to sizes prescribed by underlying invoices, and limited credit lines

Summary
Current regulations ensure offshore USD/CNH remains a fundamentally different market from onshore. Convergence trades may narrow the difference. But in a world of unrestricted CNH access, CNH will remain susceptible to demand-side shocks, and USD/CNH will be biased lower against onshore. Leakages across the 3 forward curves suggest some scope for arbitrage or convergence across markets. See summary chart 2 (flows numbered as outlined by text in preceding pages).

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J.P.Morgan Securities (Asia Pacific) Ltd The CNH market January 26, 2011

Asia Markets Research

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