In August, China took further steps to liberalize its currency and open its financial markets by launching a pilot program in Hong Kong to provide new channels for foreign investment in mainland assets. The program, initially limited to bonds, is expected to pave the way for holders of offshore deposits in renminbi (RMB) to invest in China’s A-share stock market. While these moves have been welcomed by analysts and economists, there is debate about whether they — along with other RMB-related actions this year — indicate a major turning point in China’s long-term foreign exchange policy.


As part of the latest initiative, the mainland’s China Merchant Securities and CITIC Securities announced cash injections of more than US$500 million into their Hong Kong units.  And in mid-August, Hai Tong Asset Management (Hong Kong), a subsidiary of China-based Haitong Securities, launched what it described as the first retail fund outside the mainland to be fully denominated in RMB. Initially, the brokerage said, the fund would invest in fixed-income assets.


The plan for the new A-share investment channels has not yet been finalized but is expected to be in place by late this year or in early 2011. Two types of stocks are issued in China: A shares, which are priced in renminbi, and B shares, priced in dollars. For a time, foreign investors were limited to B shares. Since 2003, however, a select number of foreign institutions have been allowed to trade in A shares under the Qualified Foreign Institutional Investor program, or QFII, but only after converting foreign currencies into RMB and subject to restrictions and quotas. The new initiative, dubbed mini-QFII, allows Hong Kong subsidiaries of domestic brokerages and fund managers to channel offshore RMB deposits back into mainland markets, though still subject to quotas. 


The first inflow of capital under the new initiative will be more of a trickle than a torrent. The initial quota of RMB 10 billion set for new bond market funds is minuscule compared with China’s fixed-income market of more than US$7 trillion. Even after the program permits offshore-RMB investment in A shares, the inflows will still be relatively small – the total market capitalization of A shares is around US$3.2 trillion.


Whether the burst of RMB-related activity this year signifies an approaching tsunami or simply a testing of the waters remains to be seen. As is generally the case with China’s financial reforms, the changes will be incremental. With that, most analysts are adopting a wait-and-see position. 


Nevertheless, though the initial flows under the bond and A-share programs will be a drop in the ocean, some analysts are decidedly optimistic. They say that the latest shifts could have much broader significance for China’s willingness to liberalize and internationalize its currency (ultimately giving the RMB reserve currency status alongside the dollar and euro) and could also reduce China’s dependence on the dollar for trade and further open its financial markets.


The mini-QFII program, after all, is following close on the heels of the June 19 announcement that the People’s Bank of China (PBoC), the country’s central bank, would allow the resumption of the renminbi’s movement against the dollar through “a managed floating exchange rate regime” tied to a basket of currencies. The move addressed, at least in part, complaints that the previous fixed-rate approach had artificially weakened the currency, giving China an unfair trade advantage.


An optimistic view is further supported by news that some of the world’s biggest banks are urging their corporate customers to use the renminbi, instead of the dollar, for trade deals with China, according to a report in The Financial Times. Banks started offering RMB trade settlements last year, after China announced a pilot program permitting the use of RMB in business transactions abroad. 


As global trade is settled more and more in RMB, foreign holders of the currency will find more investment options available to them because of the mini-QFII program. Indeed, those options should help spur the trend to settle in RMB.


An Historic Moment?


One of the most bullish views on the latest developments comes from Nomura International. The mini-QFII moves are a significant step in a “big bang” reform plan, Nomura says in a report written by its chief Asia equities strategist, Sean Darby, along with analysts Amy Lee and Mixo Das. “Excitingly, the changes in China’s capital account are occurring alongside reforms to the mainland financial markets, particularly the mainland A-share markets,” the Nomura team wrote.


Nomura predicts that the moves will accelerate inward investment of RMB because Hong Kong-based banks will now have access to higher-yielding instruments. “In the past, RMB rates were so low in Hong Kong because the banks had little opportunity to utilize the funds for lending or to develop financial products,” the report said. “Moreover, they had little access to China’s capital markets.” Now, along with other recent announcements, “we are close to getting two interbank markets for RMB allowing access to China’s financial markets. We think that perhaps the mini-QFII facility and the pilot scheme allowing foreign institutions access to China’s RMB market will be seen as the beginning of a ‘big bang.’ ”


The analysis is based not only on the August initiatives but also on the progressive expansion of RMB business in Hong Kong and other offshore centers, including Macau and member countries of the Association of Southeast Asian Nations (ASEAN). The use of RMB for cross-border trade settlement between Hong Kong and the mainland has multiplied geometrically this year, from RMB 400 million on a monthly basis until February 2010 to 2.5 billion in March, 2.9 billion in April, and 7.2 billion in May.


The market for RMB-denominated bonds issued in the Southeast Asia region has also been broadened. After initially being limited in 2007 to the mainland’s major domestic commercial and policy-oriented banks (such as the China Development Bank and the Export-Import Bank of China, which were established in 1994 to take over the policy-oriented loans of the state-owned commercial banks), the market was extended to foreign units of financial institutions in China in 2009 (with HSBC and Bank of East Asia’s mainland units both issuing bonds in July of that year). Now, it has been extended to non-financial foreign corporations operating in China, with fast-food giant McDonald’s on Aug. 19 announcing an RMB-denominated issue in Hong Kong worth RMB 200 million.


‘An Historic Intermediate Step’


Not everyone is as bullish as Nomura.


The recent changes amount to “an historic intermediate step,” says Robert Minikin, Standard Chartered senior foreign exchange strategist in Hong Kong. “It’s historic in terms of building international use of the RMB. It’s an extremely important step forward and, in particular, it will allow overseas banks to invest back into the local bond market rather than holding deposits simply with the clearing bank — and that is a critical development.”


Nonetheless, Standard Chartered notes that RMB investment inflows are likely to be relatively insignificant, having no major impact on the currency or financial markets. A report by Minikin, along with rates strategist Delphine Arrighi and regional economist Kelvin Lau, estimates that less than RMB 30 billion will be immediately eligible for the program — due to limitations on the number of institutions that can participate and the relatively low level of eligible RMB deposits in Hong Kong (retail deposits are not initially eligible for the bond scheme).  


“Right now, Hong Kong has a total of RMB 89 billion of deposits,” the report says. “Of that, we believe that the majority is still retail money rather than receipts from trade settlement or corporate money . . . The bottom line is that only a limited amount of offshore RMB deposits in Hong Kong is likely to be immediately eligible to buy onshore RMB bonds.”


Minikin also notes that the incremental nature of China’s reforms, including the mini-QFII, provides a strong indication that mainland regulators want to keep tight control over the currency’s movements and market access.


“In the near term, it’s also true that the PBoC keeps close control over the extent to which the offshore banks’ onshore markets are fungible — and, in that sense, it’s wrong to see it as a ‘big bang,’ ” Minikin says. “It’s right to see it as an intermediate step in the right direction. I think we will look back, many years in the future, and see this as an important step forward towards the internationalization of the renminbi and a more generalized liberalization of China’s capital account.”


Plans for Onshore Equities


Currently, legal foreign investment in onshore RMB-denominated equities has been limited to 97 major institutions under the QFII program, with total investment quotas of only around US$30 billion (not significant enough to have a major market impact). The size of the quotas under the mini-QFII will initially be a fraction of that amount.


The rationale behind this go-slow approach is discussed in a research report issued in August by Ying Jian, a Bank of China (Hong Kong) economist.


According to the report, the mini-QFII and other pilot programs allow Hong Kong to be a testing ground in which mainland regulators can slowly liberalize their currency regime and internationalize the RMB, without losing control over the currency or risking volatility. “Capital account convertibility has to be implemented in a gradual and steady manner,” the report said, noting that “South American and Southeast Asian countries have . . . offered important lessons in their financial liberalization as international funds posed attacks on their financial markets amid premature liberalization.” 


By limiting RMB initiatives to Hong Kong, the report said, the mainland can adjust the pace of internationalization according to “policy needs and market development, and maintain control over the inflow and outflow of RMB funds.” Within this controlled framework, trials of different kinds of RMB transactions can be conducted in Hong Kong to test the market’s reaction, the report added.  


In this gradualist model, currency liberalization remains distant and financial stability is the priority. As RMB pricing power remains in China, the report by the Bank of China (Hong Kong) noted, “funds cannot flow freely between the two markets, [and an] offshore financial crisis would not affect the onshore market.”


Low Impact Seen


Over the long term, China’s stated policy is to promote the internationalization of the RMB and reduce the country’s reliance on the dollar for trade settlement. But the nation’s incremental approach, if maintained, will not necessarily yield quick results, or profits.


Fraser Howie, managing director of Asia-focused brokerage house CLSA in Singapore, points out, for instance, that investments in the established funds under  QFII and the Qualified Domestic Institutional Investor program (QDII), which allows outflows for investment in approved foreign securities, have not resulted in major gains – particularly as China’s currency appreciation failed to materialize. He argues that the new mini-QFII program may be another false dawn.


“The question of how important this is cannot really be decided, and we’ll only know in several years time,” says Howie. “If there is a substantial change in the currency, not just if it goes one way but if it actually starts showing volatility reflective of risk appetite for China, the domestic situation and the international situation, and, say, the freeing up of interest rates… then today will actually have been significant.” But, he adds, “history is probably going against it because almost every other cross-border initiative has basically been a damp squib compared to what people had believed it could be.”


Howie argues that the QDII and the QFII have both been far less revolutionary than many had forecast. “Each one of these steps has been announced as a ‘step forward’ and a ‘liberalization’ but what’s not necessarily happening with all of these steps is everything being pulled together to make a coherent picture,” he says. “It’s still a little bit here and a little bit there, all with some sort of international cross-border dimension … but it’s not necessarily leading to what you think it was going to.”


Howie says there is no reason to think that recent reforms indicate a big bang. “The fundamental problems are not going to be resolved until you liberalize interest rates and make the currency convertible.”