Ever since Chinese authorities first floated the idea several years ago of the Shanghai Stock Exchange (SSE) launching an international board to sell renminbi-denominated shares in non-mainland entities, there has been a steady flow of speculation about when it would open for business. It looks increasingly as if that day will come in 2011. But there's a twist in this latest move to develop China's capital markets — the long-awaited RMB offering might not be on the SSE, but on the more established rival bourse in Hong Kong.

After a relatively rapid two years of tinkering with regulations and building trading platforms, Hong Kong's exchange now looks very close to beginning RMB equity issuance. “Right now, we have [fixed-income] RMB securities listed and traded on the exchange," says Lorraine Chan, spokesperson at Hong Kong Exchanges & Clearing (HKEx), the bourse's holding company. “In terms of our trading and queuing platform, we are all ready for supporting RMB-denominated securities.” According to a recent HKEx announcement, one final step left is a dry run in March to ensure that brokers' internal systems are also ready to go.

If Hong Kong does become the first exchange to launch an international RMB equity issue, will it dash Shanghai’s plans to become an international financial center? That's unlikely, say experts. Hong Kong's bid to expand its RMB offerings need not come at the expense of Shanghai's internationalization. But at this stage, nothing is a given, and it's clear that the battle of the bourses is only just beginning.

Diving into a S hallow P ool

A big difference between the two exchanges — which are now roughly the same size when measured by market capitalization — is RMB liquidity. Unlike Shanghai, Hong Kong has a relatively small pool of RMB that can be tapped. One reason is that its market for RMB products is still young, with the currency's use for trade settlement only launched in 2009 and the issuance of fixed-income products only gaining momentum over the past 18 months. That raises concerns about whether its RMB equity exchange will have enough liquidity to sustain a significant increase in trading volume.

“The liquidity problem could take a while to resolve,” says Simon Wong, regional economist at Standard Chartered Bank. According to the bank, there is currently around RMB 300 billion (US$46 billion) of liquidity circulating in the banking system in Hong Kong, which it expects to increase to RMB 2 trillion by 2015. "But at this point, the local exchange is still studying the appropriate size for IPOs," he notes. "They need to avoid draining liquidity from the market, so it will be a very gradual process.”

Another challenge for Hong Kong is the uncertainty about what issuers will be allowed to do with their RMB proceeds. While the currency can be freely traded and invested in Hong Kong and used for trade settlement, it cannot be easily repatriated to the mainland.Nevertheless, institutional and retail investors are likely to be attracted to RMB equities not least because of the anticipated appreciation of China’s currency, but also because it can be an attractive source of investment income beating today's fixed-income instruments and, especially, savings accounts.

“If you hold RMB in a deposit account in Hong Kong … you’re only getting 0.3% as a deposit rate, which is extremely low,” says Perry Kojodjojo, Asian foreign exchange strategist at HSBC. “If you invest in the equities of a company that offers good dividends or has good growth prospects, it will give you a better return.”

For mainland authorities, the measure of Hong Kong's success will not be the development of the exchange's equities, but the use of the RMB as an international currency. “Companies that raise RMB funds from the exchange market will primarily be using them to conduct regional trade, even if they won’t be using the funds in China,” says Standard Chartered’s Wong. “China is trying to promote the currency as a medium for settlement, not just for dealing with Chinese companies, but also among Asian companies.” The hope, he says, is that a liquid RMB securities market will increase the profile of the RMB as an investment currency and a reserve currency for central banks.

Indeed, while the development of the RMB equity market is undoubtedly big news, it is currently overshadowed by the currency's internationalization. “It’s only been in the recent few months that the Chinese have allowed the RMB market to grow, which is why this [equity issuance] has become a reality,” says Kojodjojo. “It is moving at a very quick pace, from where it was at the beginning of last year to now. Everyone is very surprised by how fast the development of the RMB market in Hong Kong has been," since developments like mainland authorities starting to allow the RMB to be used for trade settlement in 2009. “If you asked, ‘How fast will China open up its capital market?' two or three years ago, people would have said,‘It will take at least 10 to 20 years.' If you ask that question now, the timeline would have shrunk quite a bit [and] some people may now suggest five to 10 years.”

Some 750 miles away in Shanghai, many investors have resigned themselves to no longer asking that question. “With China, there is a lot of bureaucracy and things are slower than what you want," says an observer involved with the launch of Shanghai's international board. "But they are very serious. It is a real project and American law firms and accounting firms are helping [the exchange] with the rules…. There are reasons for the slowness, and some of them are political.”

The Hare and the Tortoise?

While Li Ka-Shing, Hong Kong’s richest tycoon and patriarch of Cheung Kong Holdings and Hutchison Whampoa, is said to be preparing to raise RMB 10 billion by listing Chinese property assets in Hong Kong in the first half of this year, a number of international blue-chip companies have set their sights on Shanghai for eventual listings. One of those blue chips waiting in the wings is HSBC, the U.K.-based, dual London- and Hong Kong-listed bank with 100 branches and sub-branches throughout China along with stakes in a number of Chinese financial institutions.

Another blue chip keeping an eye on developments is New York-listed Coca-Cola. "We are open-minded about the potential of listing our stock on the Shanghai Stock Exchange," says Geoff Walsh, group public affairs and communications director of Coca-Cola Pacific. "At this time, we are in the early stages of learning about progress on the new regulatory framework.”

But there's a cloud on the Shanghai horizon. Although the roster of global companies pondering Shanghai listings is reassuring, the lack of clarity thus far about listing requirements leaves observers wondering whether the SSE's new board will be limited to high-profile blue-chip companies, or "trophy listings." While global exchanges like Hong Kong as well as London, New York and Singapore also aim to attract big-name blue chips, their listing criteria is rule-based and not done — as feared might be the case with the SSE – by exchange or government authorities cherry-picking listings.

“It will be interesting to see whether it will be free and open or more approval-based,” says Fraser J. T. Howie, managing director of brokerage house CLSA in Singapore and co-author of several books on China's financial sector, including his latest Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise. “Everyone would want an HSBC listing, but will [the Chinese authorities] be brave enough or open enough to have, say, a start-up Brazilian oil-product company or an Indian company listing there? That is what I think the Chinese will have a hard time dealing with. They will likely balk at that idea, and I think that’s why we’ll be underwhelmed by [Shanghai's international board]."

Howie says he's "absolutely certain that small companies will want to go to China to list…. But we don’t know whether the international board will be an environment where these types of companies can actually do so."

Awaiting the 'Go'

So is the international board smoke without fire? “I could think of about a dozen foreign-related developments in China's market over the past 20 years, which are almost all independent of each other that are all allegedly internationalizing or developing cross-border flows," Howie says, citing examples like when authorities allowed "B-share" listings in U.S. dollars in Shanghai and in Hong Kong dollars in Shenzhen, or red chips, which are mainland Chinese companies incorporated in Hong Kong that can now list on non-Chinese exchanges. "But ultimately, they are all very isolated, individual buckets in which you can operate. There’s lots of activity, but all walled off from each other and I expect the international board will be something similar. Instead of building more courtyards, they should be knocking down more walls.”

While the international board will be considered a triumph for city officials and the companies involved, it will also likely be a boon for China’s investors. “It will surely be a good development, particularly in terms of giving local equity investors access to great foreign companies that they see growing everyday in China,” says Stephen Green, Shanghai-based chief China economist for Standard Chartered.  “There are some issues to do with dovetailing regulatory standards across different exchanges and FX controls. But I do not see any downside, so I am keenly awaiting the 'go.'”

Howie agrees that the market debut in Shanghai of international companies and red chips will be attractive for local investors. “China is awash with liquidity,” he says, “and in that environment, you could list a pig’s head on a stick.”