China’s banking sector and the attractiveness of Dim Sum Bond

Antonello Avino in collaboration with Fjorda Vacchetti and Ludovico Gerli

March 2016

Abstract

China’s banking system has tremendously grown in recent years. ‘The Big Four’ keep dominating the Chinese banking system as well as they are playing an important role all over the world, mentioning in the first four positions of the largest banks ranking. In spite of its expansion, the banking sector is still suffering from serious structural and administrative issues. In order to deeply figure them out, we are going to perform a meticulous analysis of the banking sector, specifying what is the financial system adopted by China, what kinds of banks operate along with the first four banks and how the regulatory system has changed over time. Also, we are going to discuss the ‘parallel’ banking, well-known as ‘shadow banking’, which slowed down the growth of the banking system. Even though financial consequences of the global crisis on china have been extremely smalls, it still possible to focus our attention on changes and development of Chinese structure. This country suffered few losses in the short run whereas many projects (like the stimulus plan on 2008), reorganizations and reforms were planned in order to avoid contrary effects in the long run, both for real and financial economy. Finally, we will give a brief overview of the Dim Sum bond market aimed to internationalize the renminbi currency outside Mainland China and to lower the cost of capital. I Market-oriented or bank-oriented?

Economic history and empirical economic analysis showed that the corporate finance was influenced by two different models of government in the financial market: the so-called market-oriented system, and the bank-oriented system or oriented intermediation. The first system is characterized by the prevalence of the market as a form of external financing to companies: in addition to the self-financing, the capital is raised through the issue of shares and bond debt. The securities are freely treated in the market and their price is the most important mechanism to regulate the firm behaviour. In the case of the United States, before the creation of the first railway companies, firms usually drew upon the banking system just for short term needs due to the small size of companies and the basic level of technology. The growing financing needs caused by the expansion of industrial company was given by institutions specialized in long-term financing as mutual savings banks, pension funds, trust companies and the simultaneous explosion of the stock market. An increasing role was played by investment banks specialized in log term activities. These banks were the protagonists of the transformation in the American companies: in addition to providing direct venture capital, they encouraged mergers among customers and focused on supervision, offering financial and organizational advice. The extraordinary expansion of securities issued by public limited companies made the stock market, centralized in Wall Street, the main source of financing. Compared with the second system it shows greater allocative efficiency, the bank-oriented system is associated with the financial affairs of Germany and Japan and those of many continental European countries: the main form of external financing of firms is bank loan. Therefore, banks have played a crucial role in the industrial transformation of these countries. In bank-oriented system banks take the form of not-specialized institutions, as they provide both short and long term funding and support firms taking on their shares in the portfolio and by positioning the remaining to its customers. In this kind of system banks are the center of information disclosure and the stock market has

2 an inefficient and marginal role. It is suitable in case of rapid change and more responsive to technological innovations. We focused our analysis on two kinds of measure to judge whether the Chinese financial system is market- or bank-oriented dominated: firstly we compared the size of the market and the bank contingent to the GDP and secondly we worked out two structure indices, ”Structure activity” and ”Structure size”, that are mathematically equal to the log(market size/bank size). The data in figure 1 support the idea that China should be considered a bank-oriented system.

Figure 1: Comparison of financial system

China’s stock market is smaller than the other countries in the table in terms of the equity traded in the market as well as in terms of market capitalization. Whereas the banking system is significantly important looking to bank credit in function of the GDP. If we consider the German’s banking system as a benchmark for bank-oriented approach, China, with a ratio of 1.13, is more bank-oriented than Germany, which has a ratio of 1. Regarding the structure indices, China has a very low value (-2.407) compared with the other countries. The higher the value, the

3 more the system is market-oriented. As a matter of fact, we also reported a graph showing the total deposits in China and United States, which is market-oriented in nature. The high level of deposits in China supports our statement concerning the influence of the banking system.

Figure 2: Total deposits in China and United States

4 II China’s banking sector

Before the beginning of economic reforms in 1978, China’s banking sector was largely controlled by the government. Macroeconomic changes required a new banking system more efficient and competitive. Hence, the Chinese government has tried to turn this centralized system into more market-oriented system where different categories of financial institutions and agencies can operate in the marketplace. Of course, banks are not completely autonomous but a genuine step forward has been taken. At present, there are four categories of banks operating in China. The first category involves three banks: the Agricultural Bank of China focusing on agricultural lending, China Development Bank which is responsible for infrastructure projects and Bank and China Exim Bank which provide financial services in order to contribute to the export of high-tech products and import of machinery. These three banks usually have to follow the directives dictated by the State Council. The second category is made up by the equitized banks, that is banks turned into joint-stock companies where the government is the main shareholder. These banks are listed in the table below.

Figure 3: China’s Equitized Commercial Banks

Even though they are no longer whole state-owned, most of their shares are not tradable and held by government authorities as PBOC and MOF. Therefore ”equitization” seems very far from the main goal of such a reform; the goal is to make these banks for-profit commercial banks minimizing the government’s intervention.

5 The third category involves local banks given by ”city commercial banks”, village and township banks, rural commercial banks and rural credit cooperative. As the equitized one, these banks were wholly-owned by local governments in the past and were used to locally deal with projects. The number of shares owned by the government has decreased over time: in 2009, just 18,5% of the shares of city commercial banks was owned by local governments. The main shareholders were Chinese banks, foreign banks and bank employees which were limited to 10%. This kind of banks finds quite difficult to compete with the previous categories of banks because of their small size. However, they usually are entrusted with dealing with city’s finances and government’s pension funds. The competitiveness with the major banks has made such institutions more efficient in China. Finally, the fourth category is composed of ”private” commercial banks where the government’s shareholding is almost null. The largest bank in this category is China Minsheng Bank and was the first private bank in which the majority of shares was not owned by the government.

III Shadow banking

”Shadow banking” is a well-known phenomenon in Cina. It involves banks that are unregulated and often unregistered. They provide the same financial services as a traditional bank, though. There are several reasons that made ”shadow” banks emerge in the banking system. First of all, they could be attractive because offer a higher interest rate compared with the other banks, roughly 10% per month or higher. However, borrowers usually use underground banks just for short-term credit so that they will surely pay the money back. Also, people could be interested in asking for an unregulated loan as camouflage for ”hiding” their wealth from authorities and the traditional loan is likely to require a much longer approval process. Moreover, underground banks could be a good opportunity for foreign firms to enter Chinese system. Hence, China’s Ministry of Finance and the State Administration of Foreign Exchange (SAFE) has been paying attention

6 to it. Actually this kind of illegal banking system was encouraged by the Chinese government with the creation of ”Credit Guaranteed Agencies”. The main purpose of such entities was to facilitate the access to credit for small and medium firms: CGA guarantees that the loan would be paid in case one of the firms is unable to pay back. The system could be highly profitable as we can see in figure 4 and gives an opportunity to start a business getting funds in an unconventional way when it is too difficult to get loans from traditional banks. After the Financial Crisis, these kinds of agencies grew very fast because the government reduces liquidity and, therefore, the availability of bank loan for the small and mid-size company was tightened. The Chinese government only helped the large company with liquidity needs. The rest of firms had to access to capital in another way. In 2011, the impact of the shadow banking on the banking system came to light with the series of failures in Wenzhou on the southeast coast of the People’s Republic, which prompted the government to take measures in order to experience the liberalization of the credit system. It turned out that about 60% of the city had loans with unregulated banks.

Figure 4: The amount of non-traditional finance neglecting traditional bank loans

7 IV Market in China

As we can see from Figure 5 China’s market is dominated by five equitized banks which own almost a half of total assets. The second largest kinds of banks is given by private banks with 15.6%. A small fraction of the market is given by the local banks, about 8%.

Figure 5: Market share of banks in China

V Regulatory system

The regulation system in China experienced a lot of changes over time to guarantee more transparency and efficiency. The current structure is shown in figure 6. Reformers turned the institutional approach into functional approach: before 1980 People’s Bank of China (PBC) was the unique financial supervisor and was under the authority of Ministry of Finance (MOF). Then the PBC started working separately, reporting directly to the State Council. In the past the PBC acted as the central bank as well as commercial banks, then The State Council decided to limit its role in dealing with monetary policy and financial stability. Initially, the banking role of PBC was performed by the three main banks, ABC, BOC and PCBC when they still were state-owned. The main functions of PBC are the following: -Implementing the monetary policy -regulating China’s currency(RMB)

8 -monitoring the gold market -coordinating inter-bank lending -dealing with official exchange Another supervision entity was created in 1992 to regulate the stock market along with the PBC, the Securities Commission of the State Council and the China Securities Regulatory Commission (CSRC). These two merged shortly after. In order to monitor its members and give them disciplinary measures when they break the law was also made up the ”Securities Association of China” (SAC). In 1998, the State Council created the China Insurance Regulatory Commission(CIRC) for the supervision of the insurance industry. After its creation, several laws was approved aimed to standardize the insurance industry such as ”Regulations on Qualifications of the Directors and Senior Managers of Insurance Companies”, ”Regulations on Administration of Insurance Salespersons” and ”Regulations on Investment Insurance Actuarial System”.

Figure 6: The Financial Regulatory Structure

Finally an agency supervision, the so-called China Banking Regulatory Commission (CBRC), was established in 2003 to regulate the banking sector. Its responsibilities involve supervision of banks, asset management companies, investment companies and depository financial institutions. There are two important laws supporting such

9 an agency: the ”Law of the People’s Republic of China on Banking Regulation and Supervision”, which allow the CBRC to supervise banking and non-banking financial institutions and the ”Law of the People’s Republic of China on Commercial Banks”, passed in 2006, that gave it more power of supervision. The existence of these three important supervisory agencies (CSRC, CIRC, and CBRC) turned the Chinese institutional system into the functional system. The MOF is responsible for the fiscal policy and the government’s budget. Its main role is given by the coordination of the three agencies described before. Plus, The MOF controls some banks and other financial institutions. For instance, it owns 50% of shares in the Agricultural Bank of China. The last important regulatory entity we want to mention is the ”State Administration of Foreign Exchange” (SAFE) which is responsible for the China’s foreign exchange reserves. It also works as a bank, offering credits to who wants to perform investments abroad. It invests its foreign reserves in safe and liquid assets like Treasury bond. Most of the assets are invested in the United States and just a small percentage (1%) in United Kingdom, France and Australia.

VI Foreign banks

Since China joined The World Trade Organization (WTO), foreign competitors could gradually enter the Chinese financial market. It was the first sign of liberalization towards the rest of the world. The agreement allows foreign banks to have the same treatment as Chinese banks concerning financial services (loans, issuing credit, and debit cards, etc) and legal restrictions. However, there are some exceptions as in the automobile sector: foreign banks cannot offer automobile financing. From 2001, the Chinese government passed some laws in order to meet the WTO’s directives. One of the most important points in the Chinese regulation is the distinction between foreign-funded banks and their branches. According to Decree No.478, these two kinds of banks should provide the same financial services but with a different minimum capital requirement: the foreign-funded banks have a

10 Figure 7: Foreign Banks in China minimum equal to 1 billion yuan, whereas their branches have a minimum capital of 200 million yuan. There are also requirements for the owner: he should own al least 10 billion in assets in a foreign-funded bank and 20 billion in a branch. In order to operate in China, foreign banks need a business license: they have to submit some documents that should be approved within six months. If the application is successful, the bank starts performing financial services using the own currency as a traditional bank. It can also offer services in renminbi if it was profitable for two consecutive years and operate in China at least for three years. Despite China’s regulation allow foreign banks to enter Mainland China, the government removed some privileges, of which banks from other countries could enjoy in the past like tax deductions in order to be more competitive against Chinese banks.

Figure 8: US banks operating in China

11 VII How the global financial crisis affected Chi- nese economy

As we have seen before, the structure of Chinese financial system at the origin of the crisis, was still bank oriented even though many times and in several different ways the government tried to reform it. The general situation in 2008 was very similar to those of Germany-origin countries with the “big four banks” of china controlling almost every financial activity. It was still not possible for Chinese people and firms to invest in foreign market. They were obliged to invest savings into a particular government agency named “State Administration for Foreign Exchange” (SAFE from now on). Closeness and still poor globalization of Chinese economy made people think that none of the global financial crisis aspects, started in America, would have affected Asian economy from both a real and a financial point of view. As it is often the case this forecast was wrong. Many Chinese banks had American bonds and assets in their balance sheet in a measure that none would ever expected. Even if it was impossible to invest directly in a foreign market, SAFE invested people’s saving in US treasury bonds for a total amount of a quarter of the American public debt. Besides, the same institution held more than 70% of foreign currency in US dollars. At the same time the most famous big four banks mentioned before were investing in Fannie May and Freddy Mac securities for US$ 25,3 billon and in others credit derivatives linked to sub-prime American mortgages. The total amount of losses was about roughly US$ 20 billion and it would have been even higher if Fannie and Freddy declared default. The biggest exposure was presented by Bank Of China in august 2008 which literally burned up 2,8 billion dollars connected to Lehman Brothers securities and many other derivative. Other Chinese institutions that reported relatively large losses include the Industrial and Commercial Bank of China with a loss of about US$ 1.8 billion, China Construction Bank with a loss of about US$ 673 million. Even though losses were very high, they cannot compare those concerning Western Europe. Losses that affected financial system had reflection on Chinese real economy. In fact, many

12 export of the country, representing a huge proportion of total GDP, addressing Europe and America, immediately collapsed due to the lower purchasing power of these ones. This resulted in a dramatic impact on total GDP growth rate, which fall from 13% in April 2007 to 9% in November 2008, as we can see in the table below.

Figure 9: GDP growth betweeen 2007 and 2008

The substantial decrease in export made even production fall as well with a consequent reduction in price goods. However real economy’s reaction was even better. Many Asiatic countries such as Malaysia, Singapore, Japan, Thailand and China itself restored some traditional fiscal and monetary policies in order to face problems as recession and unemployment. Even if real economy’s situation developed during recent year, we are going to focus much more on Chinese financial system and how it changed after 2008.

13 Figure 10: Chinese GDP and GDP growth

VIII Capital market structure and development

Banks dominate the Chinese financial system, providing about three fifths of total credit to the private sector. This is not too different from European levels, but contrasts with the US system where financial markets and non-bank lenders provide significantly more credit than banks. The Chinese banking system is fairly concentrated, with five banks splitting almost half the total loan market, which is somewhat less concentrated than many national markets in Europe but more concentrated than in the US. However, one of biggest differences with European financial sector is that all these banks are basically majority-owned by the central government. A great portion of loans addresses government-staked enterprises, although in recent years it is decreasing, and the reason is twofold. First, the major borrowers have strong business positions and this makes them result in a lower credit risk. These firms are also sized and thus can diversify much more than others can. Secondly, and more intuitively, there is a wide perception that government will not let state-owned enterprise (SOE’s) default, as it is the case of smaller and private ones. Small and Medium Enterprises (SME) face thus many difficulties in accessing bank financing, even because of a tight control of interest rates. In fact, on 19 July

14 2013 the PBoC announced the elimination of controls on lending rates to ensure the profitability of banking industry and control the allocation of financial resources . This leads Chinese financial system to an increasing process of shadow banking and financial repression (the latest due to an arbitrarily use of interest rates in favor of borrowers barely above the inflation rate). As a result, leaders are encouraging the banking sector to lend more to smaller firms and have become more open to other avenues of credit provision, such as the Informal Sector. Lenders in this sector include loan sharks, pawn brokers, formal or informal cooperatives of locals lending to each other, State-Owned Enterprises (SOEs) relending out excess cash, and many other privately, and sometimes secretly (the reason of shadow banking), raised funds that invest in start-ups. Technically, these financial intermediaries are often in violation of Chinese law. Nevertheless, local governments, knowing the existence of these financial intermediaries, usually allow them to continue operating unless there is evidence that they may have done harm to the local economy. The composition and size of the Chinese informal financial sector, according to the IMF, is illustrated below.

Figure 11: Informal Financial sector

The most incredible characteristic of financial structure in china is that bond and

15 stock markets are still underdeveloped with respect to western countries but at same time, the former is heavier than the last one in terms or ratio over Chinese GDP. As we can see from the table below, there are important differences with US financial structure among all greatest financial markets.

Figure 12: Capital Market in trillion (US Dollars)

It is a matter of fact that Chinese financial market is continuously increasing in terms of volumes and influence on the market overall, proved by the last black Monday of crashes in market indexes, but it still has a lower funding role relatively to the bank financing. We will now explore the main features of bond market and stock market and their reform after the spillover effect of global financial crisis.

IX Stock Market

The general process of globalization affecting Asian capital market passed through some important reforms happened between 2007 and 2010. The first innovation was the promotion of stock index futures, carried out in 2010. This was supposed to be implemented in 2007, but was postponed by the State Council for 3 years because they “needed to reconsider the risks”. The other major financial innovation was carried out in 2010, allowing traders to do leveraged trading and short sales on 180 stocks chosen by the CSRC (China Securities Regulatory Commission). These two innovations grant substantial edges to the institutional investors in the markets because they allow them to hedge their risks better, and sometimes trade more aggressively. The bar for permission to do futures trading, leveraged trading, and short sales is high, making it hard for individual investors to use these tools. At the

16 same time there is a lack of large institutional investors, such as insurance companies and pension funds, because they are not allowed to invest in the stock markets.

X Stock exchanges

There are two main stock exchanges in china: the Shanghai Stock Exchange (SSE) and the Shenzhen Stock Exchange (SZSE). Another major Asian stock exchange is located in Hong Kong. The last one (HKSE) traditionally focused on the equities of locally based firms, but has expanded to trade a considerable volume of “H-shares,” shares of Chinese firms, usually majority owned by the government, which have gained permission to sell stock in Hong Kong. As it is possible to see there are many restrictions about trading Chinese share’s and this is due to a continuous influence of the government in all matter concerning financial transaction. SSE is the world’s 5th largest stock market by market capitalization at US 5.5 trillion as of May 2015. Unlike Hong Kong stock exchange, SSE is not entirely opened to foreign investors because of authorities controls and central government manipulation. In fact, it provided two different type of share to be traded: A shares and B shares. The formers were actually shares traded in Chinese currency and then priced in renminbi yuan whilst the last ones traded in US dollars. This is what initially made A-shares tradable just for mainland investors whereas B shares provided to foreign traders. After the implementation of a reform in December 2002 A-shares were established as purchasable with limitations by foreigners and more precisely by those who were included in the QFII program (Qualified Foreign Institutional Investors). The most reliable indicator of market performances is the SSE Composite which includes both A and B-shares. It has as base day 19 December 1990 with end at a current day and its recent history can be summarized as follows. The main companies listed on SSE, among the 1041, are three of the big four bank we said before (ICBC, PBoC, ABC), probably listed just for their tradable shares so that government will continue to hold the majority of the company. Two important petroleum firms and namely PetroChina and China petroleum Chemical, and some

17 Figure 13: SSE Composite over 10 years important insurance companies such as Ping An Insurance and China Life. SZSE is instead located in Shenzhen and has totally 1700 listed companies with a market capitalization of US 2.2 trillion as of June 2015. It is, like SSE, a limited exchange self regulatory organization (SRO) is able to set basic rules and regulations such as accepting new listings and market surveillance, but the CSRC holds the majority of regulatory abilities. SZSE most reliable index is the SZSE Component index that initially involved the top 40 listed companies in SZSE. The composition has changed recently (2015) and the index now represent around 500 listed companies.

Corporate bonds accounted for a very small proportion of the bond market until recently, yet between 2008 and 2012, total corporate issuance more than doubled, and corporate issuance stood just under 30% of the total bond market in 2012.

18 Figure 14: Comparison of SZSE Component SSE Composite index (13/11)

Figure 15: Distribution of bond market among different issuers

19 XI Dim Sum Bonds and their Role in the Internationalization of the Renminbi

The Chinese Government still regulates the free flows of funds in and out of China, for this reason Chinese financial markets are closed to foreign investors. But in recent years China is making visible steps towards the opening of tightly controlled capital markets, but the fully openness of the financial system can only be estimated. In the meantime, participants in global financial markets are focusing on the development of the country’s offshore renminbi market in the context of China’s master plan to internationalize its currency. The Chinese currency officially called renminbi (literally ’the people’s currency’ RMB) is the second most-used trade financing currency in the world (2013), ending in the top five of world payment currencies in 2014. Thanks to China’s economic growth in the last years the demand for RMB has rapidly increased especially in cross-border trade settlement and in RMB-denominated assets. These developments are the results of the long-awaited steps taken by the Chinese government and domestic regulators in the last few years to liberalize the RMB, that will gradually develop in an important regional and global currency. In order to promote that the Chinese government chose Hong Kong to become the first offshore renminbi market, but now offshore RMB currency trading centers have emerged across the globe in financial centers such as Tokyo, London, Luxembourg and New York. Firstly, we would like to stress that China’s currency has two names: RMB (renminbi) and CNY (yuan), but in the Hong Kong offshore market we have CNH that is the offshore yuan. The difference between the onshore yuan and the offshore yuan is that they yield in different ways as in Mainland China the interest rates are controlled by the government and in the Hong Kong offshore market interest rates are subject to market dynamics. The purpose of the offshore RMB market is to internationalize the RMB such that it becomes a global reserve currency and opens cross-border capital flows while keeping the inflation in mainland China in check. In this context the offshore RMB bond market has risen where the major investment product is the Dim Sum Bond.

20 The campaign for the promotion of the RMB at an international level began at the end of 2000. The biggest step in these direction was the issuance of the first Dim Sum Bond in 2007 by China Development Bank. Consequentially in 2010 with the rise of Dim Sum Market and of commercial transaction in RMB , the need of regulation was clear. Nowadays the Chinese Regulatory System allows the current account to be fully convertible. Regarding capital account firms can do directly cross-border investment, whereas retail investor have to go trough QDII (Qualified Domestic Institutional Investors) and QFII (Qualified Foreign Institutional Investors). RMB offshore centers can now be found in Singapore,Taiwan,London,Paris,Frankfurt and Luxembourg. But only Hong Kong has the monopoly of the offshore market thanks to tight relationship with the Chinese Government. In July 2007, when the first dim sum bond was issued in Hong Kong new regulation was established such as the publication of the ’Interim Measures for the Administration of the Issuance of RMB Bonds in Hong Kong by Onshore Financial Institutions’ by the National Development and Reform Committee (NDRC). After in 2010 NDRC implemented the regulation scene with new rules and issued the ’Elucidation of Supervisory Principles and Operational Agreements Regarding Renminbi Business in Hong Kong’ and signed a ’Supplemental Memorandum of Cooperation’ with the Monetary Authority of Hong Kong. This new regulation encouraged the expansion of dim sum bond issuer pool by the Chinese government and by multinational corporations such as McDonald’s and Caterpillar.

XII Dim Sum Bonds Characteristics

Dim Sum are RMB-denominated bonds issued in Hong Kong offshore market. The major growth of this market happened when Chinese government expanded these bonds beyond Mainland financial institutions to include multinational and international institutions (2010). In addition the Chinese government established new regulation concerning remittance of bond proceeds (2011). In fact Mainland issuers are required to remit proceeds of offshore RMB bond issuance to the

21 mainland. Other classes of issuers are not required to remit proceeds to the mainland, they can keep the proceeds offshore or remit them to China. We can distinguish Dim Sum in certificates of deposit (CD) and bonds. CDs normally have a shorter tenor than bonds (maturities ranging from one month to five years), and this makes them popular with issuers like Chinese banks such that approximately 70% of the total issuance of dim sum bonds was CDs (2013). The majority of dim sum bonds (over 95% between 2007 and 2014) are the ones with fixed-rate coupons, with an average coupon of 4.1% (between 2011 and 2014). The majority of investors in dim sum market are buy-and-hold types, who prefer the fixed-rate bonds to exclude interest rate risk if they hold the bonds to maturity. In fact less than 5% of dim sum bond issuances between 2007 and 2012 have been bonds with floating interest rate or zero-coupon bonds . Over 90% of dim sum bonds have a short tenor of one to three years, this because of the risk-aversion of investors who invest in dim sum bonds as a one-way bet on the RMB appreciation against the U.S. Dollar. As a result this mindset developed a nascent fixed-income market. This relatively short-term focus of buyers has made the dim-sum market less attractive to issuers in need of longer-term funding. Only sovereign and supranational issuance have longer maturities (es. China’s Minister of Finance issued a five-year tranche in 2009). Although dim sum bond investors normally hold their bonds until maturity and trading on the secondary market is rare, some dim sum bonds (130 out of 800 issues between 2007 and 2012) are listed on exchanges globally to attract investors who prefer disclosure requirements and monitoring from exchanges. While Singapore and Hong Kong have the most listings of dim sum bonds, Luxembourg, London and Frankfurt are also popular with issuers to attract more European investors.

XIII Dim Sum Issuers and Investors

Among the reasons for issuers to raise funds in the dim sum bond market there are for example the opportunities for cross-border arbitrage. Since Chinese companies can get access to both offshore RMB denominated (CNH exchange rate) and mainland

22 (CNY exchange rate) market by issuing dim sum bonds and ’panda bonds’ (bonds issued in mainland china) they can take advantage of this. Other reasons include also the necessity of hedging RMB operating expenses as well as lowering the cost of borrowing compared to the higher cost on the Chinese mainland market. RMB appreciation potential and the increasing demand of global investors who look for diversification of their investment portfolio is one of the reason why dim sum bond market is growing so rapidly. Generally 80% of dim sum bonds issuers are financial institutions and non financial corporations, and the remaining 20% are sovereigns and supranational financial entities. On the other hand, the majority of the investors in dim sum bonds are either commercial banks or private banks,funds and asset managers. In terms of geography, the major holders of dim sum bonds are investors based in Asia, since Hong Kong and Singapore are the key CNH markets and major sources of offshore RMB liquidity. Dim Sum Bonds became popular among issuers because they offer cheaper funding than issuance of USD in Hong Kong or onshore RMB bonds in mainland China ( 3.69% average dim sum yield instead of the 5.99% minimum 3-year onshore loan rate by PBOC in March 2012). Popularity is also due to the fact that international issuers do not need mainland regulatory approval to issue dim sum bonds in HK, which is a free market, whereas they would need such approval to issue bonds directly in the Mainland market.

XIV Future Prospects of Dim Sum Bond Market

The recent development of dim sum bond market offers new opportunities to domestic firms and foreign investors. In fact, international investors have the opportunity to enter RMB market avoiding the regulatory system and investing directly in offshore RMB bonds, Consequentially the increase of CNH sources globally will further increase the demand for dim sum bonds, for example considerable interest is being shown in these products from European investors. Even if dim sum bond market has yet to mature and reach the critical mass to become an asset class in most international portfolios, it is already evident that

23 portfolios including dim sum bonds benefit in terms of diversification. However, such bonds will have to compete with the wider range of RMB investment options in the future. New offshore RMB channels for foreign investors opened by the Chinese government, such as the Renminbi Qualified Foreign Institutional Investor Program (RQFII) and the recent launch of the Shanghai Hong Kong Stock Connect, will provide new access to Chinese stock and funds. RQFII program enables funds from the offshore RMB markets to be invested in the domestic A- shares (shares listed on the mainland stock exchanges and available so far only for Chinese mainland investors), whereas the Shanghai Hong Kong Stock Connect will give foreign investors access to A-shares listed on Shanghai Stock Exchange through Hong Kong Stock Exchange as well as mainland Chinese investors access to H-shares listed on Hong Kong Stock Exchange. Recently, because of the euro zone sovereign debt crisis and the global economic slowdown, dim sum market suffered a deterioration. Investors are becoming more cautious in taking credit risk from dim sum bonds as there is a lack of ratings and covenant protection for the majority of these products. Dim sum bonds offer documents contained little disclosure of issuers operational performance beyond their audited financial statements. This risk consciousness caused dim sum bonds yields to rise in this last years. For these reasons the last step taken by the Chinese government to support the growth of the dim sum bond market include improvement of mainland corporate issuers’ creditworthiness. Dim sum bond market, as the first offshore market for RMB-denominated capital assets, has experienced rapid growth during the last three years and will continue to play an essential role in the internationalization of the Chinese currency. The increasing use of RMB globally as trade and investment currency has made dim sum bonds an attractive option for investors as a way to profit, in particular from future appreciation and diversification. With the announcement of the individual swap agreements and clearing banks in European RMB offshore centers, Europe can play the lead role in accelerating the internationalization process of the currency. Given the efforts of the Chinese government to liberalize cross-border transactions and create the conditions for the RMB to become an international currency, it is

24 reasonable to expect that dim sum bond market will develop into a mature debt market with its primary focus in Asia. Despite the temporary downshift in supply and demand, many industry experts still believe that the market will continue to grow over long term, given that dim sum bonds are of the most important financial instruments for the Chinese government to promote the offshore RMB business.

Figure 16: GDP growth betweeen 2007 and 2008

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