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EMERGING MARKETS RESEARCH
December 2011
ASIA LOCAL MARKETS
2012 GUIDE
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FOREWORD
Representing more than 20% of global GDP and expected to contribute around 60% of
global growth in 2012, Emerging Asia continues to be a focal point for international
investors. However, the idiosyncratic nature of Asian policies and markets makes it
challenging for many to get a sufficiently deep understanding of the markets and the subtledifferences among various instruments. Our Asia Local Markets Guide 2012 is intended to
provide such an understanding and better position investors to take advantage of the many
opportunities that exist in the region.
In this publication, we detail the monetary, currency and fiscal policies as well as the
regulatory environment in key Emerging Asia bond and currency markets. We also provide
insights into the transmission of monetary policy into financial markets, detailing the
various instruments that are traded in each market and identifying the main drivers.
This guide is intended to help facilitate a dialogue with our analysts and with the trading
and sales professionals at Barclays Capital who are dedicated to serving your investment
needs providing you with the information and analysis that we hope will lead to more
informed investment decisions.
We welcome feedback and look forward to working with you in 2012 and beyond.
Jon Scoffin
Head of Research, Asia Pacific and Head of Credit Research
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TABLE OF CONTENTS
CHINA 4
Monetary policy environment ................................................................................................................. 4Money markets and policy rate transmission...................................................................................... 7
Interest rate derivatives........................................................................................................................... 12Bond markets ............................................................................................................................................ 14Fiscal policy and credit ratings.............................................................................................................. 18Fixed income instruments reference guide........................................................................................ 19Currency policy and foreign exchange markets................................................................................ 20FX reference guide ................................................................................................................................... 22
HONG KONG 24
Monetary policy environment ............................................................................................................... 24Money markets and policy rate transmission.................................................................................... 27Interest rate derivatives........................................................................................................................... 29Bond markets ............................................................................................................................................ 31Fiscal policy and credit ratings.............................................................................................................. 34Fixed income instruments reference guide........................................................................................ 35Currency policy and foreign exchange markets................................................................................ 36FX reference guide ................................................................................................................................... 37
INDIA 38
Monetary policy environment ............................................................................................................... 38Money markets and policy rate transmission.................................................................................... 41Interest rate derivatives........................................................................................................................... 43Bond markets ............................................................................................................................................ 45Fiscal policy and credit ratings.............................................................................................................. 49Fixed income instruments reference guide........................................................................................ 51Currency policy and foreign exchange markets................................................................................ 52
FX reference guide ................................................................................................................................... 54
INDONESIA 55
Monetary policy environment ............................................................................................................... 55Money markets and policy rate transmission.................................................................................... 58Interest rate derivatives........................................................................................................................... 60Bond markets ............................................................................................................................................ 61Fiscal policy and the sovereign credit rating...................................................................................... 66Fixed income instruments reference guide........................................................................................ 67Currency policy and foreign exchange markets................................................................................ 68FX reference guide ................................................................................................................................... 69
MALAYSIA 70
Monetary policy environment ............................................................................................................... 70Policy rate transmission.......................................................................................................................... 73Interest rate derivatives........................................................................................................................... 75Bond markets ............................................................................................................................................ 77Fiscal policy and credit ratings.............................................................................................................. 83Fixed income instruments reference guide........................................................................................ 84Currency policy and foreign exchange markets................................................................................ 86FX reference guide ................................................................................................................................... 87
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PHILIPPINES 88
Monetary policy environment ............................................................................................................... 88Money markets and policy rate transmission.................................................................................... 90Interest rate derivatives........................................................................................................................... 91Bond markets ............................................................................................................................................ 92
Fiscal policy and credit ratings.............................................................................................................. 94Fixed income instruments reference guide........................................................................................ 95Currency policy and foreign exchange markets................................................................................ 96FX reference guide ................................................................................................................................... 97
SINGAPORE 98
Monetary policy environment ............................................................................................................... 98Policy transmission ............................................................................................................................... 102Interest rate derivatives........................................................................................................................ 105Bond markets ......................................................................................................................................... 107Fiscal policy and credit ratings........................................................................................................... 111Fixed income instruments reference guide..................................................................................... 112Currency policy and foreign exchange markets............................................................................. 113FX reference guide ................................................................................................................................ 114
KOREA 115
Monetary policy environment ............................................................................................................ 115Money markets and policy rate transmission................................................................................. 119Interest rate derivatives........................................................................................................................ 122Bond market........................................................................................................................................... 125Fiscal policy and credit ratings........................................................................................................... 130Fixed income instruments reference guide..................................................................................... 131Currency policy and foreign exchange markets............................................................................. 132FX reference guide ................................................................................................................................ 134
TAIWAN 135
Monetary policy environment ............................................................................................................ 135Money markets and policy rate transmission................................................................................. 138Interest rate derivatives........................................................................................................................ 142Bond markets ......................................................................................................................................... 144Fiscal policy and credit ratings........................................................................................................... 148Fixed income instruments reference guide..................................................................................... 149Currency policy and foreign exchange markets............................................................................. 150FX reference guide ................................................................................................................................ 152
THAILAND 153
Monetary policy environment ............................................................................................................ 153Policy rate transmission....................................................................................................................... 157Interest rate derivatives........................................................................................................................ 159Bond markets ......................................................................................................................................... 162Fiscal policy and credit ratings........................................................................................................... 167Fixed income instruments reference guide..................................................................................... 169Currency policy and foreign exchange markets............................................................................. 170FX reference guide ................................................................................................................................ 171
APPENDIX: USEFUL LINKS 172
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ChinaFI Strategist: Ju Wang +65 6308 2801; ju.wang@barcap.com
Monetary policy environment
Policy objectives Price and currency stability; relatively fast and stable growth;
full employment; balance in international payments.
MPC frequency and membership
The MPC meets quarterly, but policy decisions can bemade at any time. Decisions are recorded in "meeting
minutes; the PBoC can decide RRR and discount rate
changes on its own but State Council approval is required
for annual credit growth/money supply, interest rate,
exchange rate targets.
The MPC comprises the governor of the Peoples Bank ofChina and two deputy governors, a deputy secretary-
general of the State Council, a vice minister of the NDRC, a
vice finance minister, the administrator of SAFE, the
chairman of the CBRC, the chairman of the CSRC, the
chairman of CIRC, the commissioner of the NBS, the
president of the China Association of Banks and an
academic expert. (For details on the PBoC, seeAsia-Pacific
Central Banks: 2012 Guide, 4 November 2011).
Monetary policy tools
Policy rates: Both lending and deposits are regulated inChina. Policy rates are the 1y lending rate (Bloombergticker: CHLR12M) and 1y deposit rate (Bloomberg Ticker:
CNDR1Y). Since 2004, commercial lending rates have been
allowed to vary by 0.9-1.7 times the 1y lending rate for
commercial banks and by 0.9-2 times the 1y lending rate
for rural credit cooperatives. Deposit rates up to 5y are still
regulated. The spread between the lending and deposit
rates, a key source of banking system profits, remains
wide and largely unchanged 15 years after China began
the interest rate liberalisation process in 1996.
Open market operations: The PBoC began conductingopen market operations (OMOs) in October 1998. Cashbond trading initially was the most common tool, but was
replaced by bond-based repo transactions to avoid
affecting the bond market. The PBoC began auctioning
central bank bills to conduct OMOs in 2003, when it ran
out of government bonds issued by the Ministry of
Finance in the face of large FX inflows.
The frequency of OMOs has been kept at twice a week
(Tuesday and Thursday) since 2003. Currently, 52 primary
Summary table of monetary policy
ObjectiveMaintain price and currency stability, economic growth,
high employment, balance in international payments
Policy rate 1y lending and deposit rates
2011 monetary
targets
M2 growth of 16% and an implicit new loan target of
CNY7-7.5 trn
MPC
The PBoC's MPC is a consultative body for setting
monetary policy. Its responsibilities, composition and
working procedures are prescribed by the State Council
MPC frequency Meets quarterly
Policy toolsReserve requirement ratio, open market operations,
discount window, "window guidance"
The People's Bank of China (PBoC)
Source: PBoC
Policy rate, RRR, discount rate and inflation (%)
-2
0
2
4
6
8
10
2001 2003 2005 2006 2008 2010 2011
%
0
5
10
15
20
25
1y deposit rate 1y lending rate
CPI (y/y) RRR ratio (%, RHS)
Source: CEIC, Bloomberg, Barclays Capital
1y deposit rate and spread vs 1y lending rate
0
1
2
3
4
56
7
8
9
Jun-96 Jun-99 Jun-02 Jun-05 Jun-08 Jun-11
0
50
100
150
200
250
300
350
4001y lending - deposit rate spread (bp, RHS)
1y deposit rate
Source: CEIC, Bloomberg, Barclays Capital
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dealers participate in the bill auction process (most are
domestic commercial banks, but policy banks, securities
firms, insurance companies and asset management firms
are also included; two locally-incorporated foreign banks
have also been selected as PDs). The PBoC inquires about
the primary dealers interest (level and size) one day in
advance and announces the auction size (Dutch style) at4:30pm local time on that day.
Currently, instruments used for OMOs are 3m, 1y and 3y
PBoC bills. 1y bills are auctioned every Tuesday and 3m bills
on Thursday. The 3y bill is used to lock in liquidity for longer
periods and is seen as a powerful tool. Its issuance has
varied from weekly to no auction at all. The 1y bill auction
yield is widely seen as a leading indicator of the policy rate,
particularly in hiking cycles. Primary and secondary market
bill yields can diverge, depending on market expectations of
future rates and interbank liquidity conditions.
Other key OMO instruments are repos and reverse repos.
Compared to bills, repos have shorter terms and are used for
fine-tuning liquidity purpose. In repo transactions, which
are held on Tuesdays and Thursdays without prior notice, the
PBoC sells securities to the market with an agreement to buy
them back at a specified date. Repos take liquidity out of the
system, which is returned when the contract matures.
Reserve repos have the opposite impact on market liquidity.
They are rarely used and are conducted only with select large
banks when liquidity is deemed as too tight. The interest rate
charged by the PBoC for reverse repos tends to be
significantly higher than bill and repo rates to discourageover-reliance on the central bank to provide liquidity.
Reserve requirement: The reserve requirement ratio(Bloomberg Ticker: CHRRDEP) is the percentage of
deposits banks are required to place with the central bank.
Only cash is acceptable. The PBoC currently pays 1.62%
on required reserves, 0.72% on excess reserves and 0% on
foreign currency reserves. Banks adjust their reserves with
the PBoC on the 5th, 15th, and 25th of every month
depending on their deposit base and RRR levels.
On 25 April 2004, the PBoC adopted a system of
differentiated reserve ratios. Different required reserve
ratios were applied to financial institutions according to
their capital adequacy ratio and asset quality, with weaker
institutions subject to higher RRRs. In an effort to sterilise
FX inflows and fight inflation in 2011, the PBoC hiked the
RRR to a historical high of 21.5% for big banks and 19.5%
for small banks. In September 2011, PBoC broadened the
RRR deposit base to include margin deposits for bank
acceptances, letters of credit and guarantees, absorbing
Monthly OMO drains and injections (CNY bn)
-1400-1200-1000
-800-600-400-200
0200400
600800
10001200
201420132012201120102009
Maturing bi ll s Maturing repo Issued bi ll s Issued repo
Source: CEIC, Bloomberg, Barclays Capital
Policy deposit rate, PBoC bill auction and secondary market
yields (%)
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
Jul-
09
Nov-
09
Mar-
10
Jul-
10
Nov-
10
Mar-
11
Jul-
11
Nov-
11
1y PBoC bill secondary market rate
1y deposit rate
1y PBoC bill auction yield
Source: CEIC, Bloomberg, Barclays Capital
Monthly FX inflows, RRRs and net OMOs (CNY bn)
-1200
-800
-400
0
400
800
1200
20112010200920082007200620052004
RRR (incl. margin deposits RRR) Net OMOs FX inflows
Source: CEIC, Bloomberg, Barclays Capital
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an estimated CNY900bn of liquidity. On 30 November
2011, the PBoC cut the RRR for all banks by 50bp,
reversing the tightening trend.
Rediscount and relending rates: The rediscount raterefers to the rate at which the PBoC discounts bills for
financial institutions while the relending rate is the rate atwhich the PBoC relends to financial institutions on an
outright basis. Rediscount and relending rates are not
changed as frequently as policy rates. The last move was
on 30 December 2010 when the PBoC raised the
rediscount rate by 45bp, to 2.25%, and 1y relending rate
52bp, to 3.85%. Due to structurally high excess liquidity
and concerns about raising regulatory attention, banks in
China rarely resort to the PBoC for relending or
rediscounting funds.
Credit quota, M2 and total social financing: Creditinstruments are the most important policy tool in China,
including loan targets and administrative measures such
as window guidance to guide the pace and sometimes
direction (industries or regions) of bank lending. Over the
past 20 years, the implementation of credit policies has
become more indirect to avoid distortion. The PBoC
targeted M2 growth of 16% for 2011 and new loans of
CNY7.0-7.5trn.
However, the PBoC has increasingly monitored total social
financing, a broader indicator of the financial system that
includes banks off-balance-sheet lending and direct
financing, as well as bank loans.
In October 2011, the PBoC expanded the definition of M2
to include deposits at non-depository financial institutions
and social housing funds. Given the rapid development of
nonbank financing activity, the PBoC is still considering a
creating a broader money supply measure, M2+.
Administrative measures: The government also usesadministrative measures to control inflation, which is an
increasingly important policy objective in China.
Rediscount rate vs. policy deposit rate (%)
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11
Rediscount rate 1y deposit rate
Source: CEIC, Barclays Capital
Credit and money growth trends
5
10
15
20
25
30
35
2001 2003 2004 2006 2007 2009 2010-200
200
600
1000
1400
1800New loans (CNY bn, RHS)
M2 y/y
Source: Bloomberg, Barclays Capital
Total social financing (CNY trn)
0
3
6
9
12
15
2011(Q1-Q3)
2010
2009
2008
2007
2006
2005
2004
2003
2002
New yuan loan Loan in foreign currencyEntrusted loan Trust loanBank acceptance Corporate bondEquity financing Others
Source: CEIC, Bloomberg, Barclays Capital
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Money markets and policy rate transmission
Interbank and repo market yearly turnover (CNY trn)
0
20
40
60
80
100
120
140
20112009200720052003200119991997
Bond repo Interbank
Source: Bloomberg, Barclays Capital
Term structure of national interbank borrowing (CNY bn)
Overnight 1w 2w 3-4w 1m 2-3m 4-12m
2002 202 852 - 100 29 11 12
2003 642 1,456 189 57 44 10 3
2004 283 1,041 64 28 19 9 3
2005 223 896 46 61 30 7 2
2006 635 1,290 147 38 19 12 1
2007 8,030 2,178 274 50 34 35 7
2008 10,651 3,500 474 111 114 45 19
2009 16,167 2,135 598 102 205 54 6
2010 24,486 2,427 506 65 161 47 20
2011 26,089 3,924 906 215 269 109 31
Note: *Figures are total trading volume over certain period.Source: CEIC, Barclays Capital
Interbank market participants by volume (November 2011)
Overview
The money markets in China underwent drasticdevelopments towards the end of the last century when
the country started to liberalise its interest rate system.
The major money markets include interbank lending and
borrowing, the repurchase market, the securities markets
and the bill market. The bond repo market is the largest
with a current daily turnover of CNY400-500bn. The PBoC
manages reserve requirement ratios and conducts OMOs
in the interbank market to influence the monetary base to
achieve its monetary targets. The correlation between
OMO interest rates and money market rates has been
strengthened. However, as interest rates offered by
commercial banks on deposits and loans are still subject to
control, the transmission between the policy and money
market rates remains weak.
Interbank lending and borrowing
A unified national interbank market was formed in Chinain 1996. It arranges non-guaranteed financing among
financial institutions, which is settled through the CFETS
trading system. Various terms are available: 1d, 7d, 14d,
21d, 1m, 2m, 3m, 4m, 6m, 9m and 1y. The majority of
borrowing is overnight and within one week.
Starting in June 1996, financial institutions were allowed tofix rates for interbank lending and borrowing. These rates
(Chibor) are published regularly. However, Chibor, which
is based on transacted rates, has failed to become
established as a useful benchmark in China.
On January 4 2007, the PBoC formally launched the Shibor(Shanghai interbank offer rate; Bloomberg Ticker: SHIF1W)
aiming to develop a benchmark market rate for the rapidly
growing bond and money markets. Shibor is a simple,
non-guaranteed, wholesale interest rate calculated by
arithmetically averaging all the interbank RMB lending
rates offered by the price quotation group of banks with a
high credit rating. Currently, Shibor consists of eight
maturities, overnight, 1w, 2w, 1m, 3m, 6m, 9m and 1y.
The National Interbank Funding Centre is responsible for
the Shibor calculation and fixing disclosure at 11:30am
each trading day. The price quotation group of Shibor
consists of 16 commercial banks. These quoting banks are
primary dealers for open market operations or market
makers in the FX market, with robust information
disclosure processes and active RMB transactions in
China's money market.
Share
holding
commercial
bank
44%
City
commerical
bank
16%
State-
owned
commerical
bank
18%
Foreign
funded or
joint funded
insititution
9%
Other
financial
institution
12%
Rural
commerical
bank and
cooperative
bank
1%
Source: CEIC, Barclays Capital
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Relative to Chibor, Shibor is a more market-sensitivebenchmark as it is based on quoted rates, with maturity
extending to one year. However, Shibor is less liquid than
the repo market and carries a higher credit risk premium as
it is uncollateralised. As no actual transactions are needed to
set reference rates, Shibor fixing is at risk of manipulation.
Banks have the incentive to set the fixing higher as to priceShibor-linked loans at higher rates. Floaters, rediscount
rates, and short-term bills are linked to Shibor.
Repo market
Bond repo transactions first started in China in 1991 andwere carried out via the Shanghai Stock Exchange. At the
beginning of 1997, the PBoC ordered commercial banks to
transfer repo trading from the stock exchange to the
interbank bond market. Compared with interbank
borrowing, repos are more active and the interest rates
more stable, and represent the full liquidity of the financial
market. Pledged repos are the dominant format. Largestate-owned banks tend to be the main suppliers of liquidity
in the repo market, while smaller banks, insurers, securities
firms and fund managers are net recipients.
Pledged repos are a financing act in which a borrower(positive party) pledges bonds to a lender (reverse repo
party) in return for funds. The two parties also agree that
when the positive repo party returns the borrowed funds,
calculated at the specified repo rate, the reverse repo party
lifts their rights over the pledged bonds. Terms for pledged
repos range from 1 day to 365 days but overnight
transactions are dominant and actual deals longer thanthree weeks are very rare.
Based on data from the trading system, volumes and prices
for pledged repo transactions are publicly released
according to 11 term periods: 1d, 7d, 14d, 21d, 1m, 2m, 3m,
4m, 6m, 9m and 1y. Trading hours are 9:00-12:00am and
1:30-4:30pm, excluding Chinese statutory holidays.
Market participants include commercial banks, rural credit
cooperatives, urban credit cooperatives and other deposit-
taking financial institutions, insurance companies, securities
companies, fund management companies, financial
companies and other non-bank financial institutions withbond trading licences, and foreign-funded financial
institutions that conduct RMB business. The two trading
parties, at the specified deal termination date, handle the
gross settlement of funds at their own risk in accordance
with the deal sheet. Depository bond settlement is carried
out through the China Central Depository & Clearing Co.,
Ltd, while funds settlement is conducted through the China
National Automatic Payment System of PBC.
Collateralised and noncollateralised market borrowing rates (%)
-5
0
5
10
Oct-06 Oct-07 Nov-08 Nov-09 Dec-10 Dec-11
-10
10
30
50
bp7d Shibor7d repo7d Shibor - 7d repo (RHS)
Source: CEIC, Barclays Capital
Interbank bond market daily turnover (CNY bn)
0
100
200
300
400
500
600
700
800
900
1000
Dec-11Aug-11Mar-11Nov-10Jul-10Mar-10
Spot Pledged repo Outright repo
Source: CEIC, Barclays Capital
Pledged bond repo borrowing term structures (by trading
volume)
14y
4%
1m-1y
1%
21d
2%
1d
75%
7d
18%
Source: CEIC, Barclays Capital
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Pledged repo market participants by volume (Nov 2011)
Share
holding
commercial
banks
17%
State-
owned
commercial
banks
17%
City
commercial
banks
24%
Rural
commercial
and
cooperative
banks
9%Foreign
funded or
joint funded
institutions
2%
Other
financial
institutions
31%
Source: CEIC, Barclays Capital
Bill discount rate vs. other money market rates (%)
0
2
4
6
8
10
12
May-08 Jan-09 Oct-09 Jun-10 Mar-11 Nov-11
Rediscount rate
6m bank note discount rate
7d repo
3m Shibor
0
2
4
6
8
10
12
May-08 Jan-09 Oct-09 Jun-10 Mar-11 Nov-11
Rediscount rate
6m bank note discount rate
7d repo
3m Shibor
Source: CEIC, Barclays Capital
Policy rate, PBoC bill auction yield, monetary market rate and
interest rate paid by PBoC on excess reserves (%)
-
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
Jan-07 Oct-07 Aug-08 Jun-09 Apr-10 Feb-11 Dec-11
7d repo1y PBoC bill (primary market)Interest paid on excess reserves1y deposit rate
Outright repos refer to a bondholder (positive repo party)selling bonds to a buyer (reverse repo party), which the
former will repurchase from the latter at a specified future
date and at a predefined price. Terms for outright repos
range from 1 day to 91 days. Based on data from the
trading system, volumes and prices for outright repos are
published according to seven terms: 1d, 7d, 14d, 21d, 1m,2m and 3m. Trading hours, market participants and
settlement procedures are the same as for pledged repos.
The daily repo fixings use the median of all repo pricestransacted via the China Foreign Exchange Trade System
(CFETS) between 9:00 and 11:00. Most trades occur in the
morning session, and all trades must be transacted over
CFETS. The overnight repo (R001), 7d repo (R007), and
14d repo (R014) is posted on the CFETS website at 11:00
am on each trading day. The 7d repo fixing includes all
trades with 2-7d tenors (inclusive). The 7d repo fixing is
also used as a benchmark for the IRS curve (BloombergTicker: CNRR007).
Bills market
The commercial paper market, including bankacceptances, bills of exchange, discount and rediscount
bills, has developed rapidly since the late 1990s. Typical CP
maturities are 9m to 1y. Since December 2010, short-term
commercial paper (SCP) with maturities of less than 270
days were launched by the National Association of
Financial Market Institutional Investors (NAFMII).
In China, the cost of issuing bills is determined by the
market, hence bills are seen as superior for financingcompared with controlled short-term lending rates.
FX deposits and swaps
Banks, non-bank financial institutions, non-financialenterprises or their authorised branches that have FX
interbank lending business licences, can all take FX
deposits. Lending transactions for USD, EUR, HKD, JPY,
GBP are allowed.
Policy rate transmission
As commercial banks interest rates on deposits and loansare still subject to control, there is a loose relation betweenthe policy deposit rate and the interbank rate.
Instead, the PBoCs quantitative tools (RRRs, OMOs) havemore impact on interbank rates. Compared with OMOs,
where participation is voluntary, RRR changes are a
stronger tool, as they are imposed on all banks and can
squeeze the smaller banks, which tend to be net
borrowers. Source: CEIC, Bloomberg, Barclays Capital
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The PBoC achieves its monetary aggregate targetsthrough adjusting its degree of sterilisation of FX inflows
via changes in reserve requirements or open market
operations as well as credit quotas. This sets the basic
tone for market liquidity. However, government fiscal
spending patterns, seasonality in currency in circulation,
regulations on banks loans and deposits as well as fundflows such as IPOs/bond issuance/state company
dividend payments also influence liquidity from time to
time. Fluctuations in money market rates tend to be more
visible when excess liquidity is low (for more details see
the What drives financial system liquidity in China?
section).
Banks hold PBoC bills as part of their liquid assets, andhigher bill auction rates increase the opportunity cost of
lending funds to other banks. Therefore, PBoC bill rates
tend to guide money market rates particularly when
liquidity is tight. The 1y bill auction yield is seen as aleading indicator of the policy rate. However, when
liquidity is extremely flush, money market rates can trade
much lower than policy rates and only find a bottom at the
interest rate paid on excess reserves (72bp currently) by
the PBoC.
The high volatility in the Chinese money market points to anunderdeveloped system. In particular, policy rates do not
necessarily reflect the true cost of funds. And there is a
shortage of efficient balancing mechanisms for interbank
liquidity. The PBoCs discount window is rarely tapped, as
access is limited to commercial banks and policy banks withthe right to participate in lending and bill financing activities,
whereas borrowers are concerned about negative
regulation implications. The PBoC conducts reserve repos,
but they are expensive and infrequent.
Factors affecting liquidity (CNY bn)
-2000
-1500
-1000
-500
0
500
1000
1500
2000
2500
3000
Dec-11Oct-11Aug-11Jun-11Apr-11Feb-11
OMO drain RRR tightening Fiscal impact
Change in liquidity Maturing OMO FX inflows
-2000
-1500
-1000
-500
0
500
1000
1500
2000
2500
3000
Dec-11Oct-11Aug-11Jun-11Apr-11Feb-11
OMO drain RRR tightening Fiscal impact
Change in liquidity Maturing OMO FX inflows
Source: CEIC, Bloomberg, Barclays Capital
Factors affecting liquidity - Currency in circulation, changem/m (CNY bn)
-1500
-1000
-500
0
500
1000
1500
2000
Jan-07 Feb-08 Mar-09 Apr-10 May-11
Source: CEIC, Bloomberg, Barclays Capital
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What drives financial system liquidity in China?
The PBoC achieves its monetary aggregate targets through adjusting its degree of sterilisation of FX inflows via changes inreserve requirements or open market operations, as well as credit quotas. This sets the basic tone for market liquidity.
However, government fiscal spending patterns, seasonality in currency in circulation, regulations on banks loans and
deposits as well as fund flows such as IPOs/bond issuance/state company dividend payments also influence liquidity from
time to time. Fluctuations in money market rates tend to be more visible when banks excess reserve ratios fall below 2%.
FX inflows and PBoC intervention have been the main drivers of growth in Chinas base money supply over the past 10years. On average, monthly inflows have been CNY200300bn since 2002, divided between trade surplus (50%), FDI
(20%) and hot money (30%) flows by our estimations. This translates into around CNY2-3trn expansion pa of the base
money supply.
The PBoC has frequently adjusted RRR levels and conducted OMOs to offset money expansion from such inflows. A 50bpRRR hike absorbs roughly CNY380-400bn of liquidity from the system. Changes in RRR levels are a powerful tool as the
impact on interbank liquidity is continuous given that banks need to tender additional reserves as long as their deposit
bases are growing. In particular, the impact on banks with weaker liquidity tends to be stronger compared with other
liquidity measures such as OMOs, where individual bank participation is usually voluntary.
In 1995. China passed a law banning fiscal overdrafts, hence government fiscal activities do not constitute base moneysupply. However, government spending patterns do have a significant seasonal impact on banks liquidity. Fiscal revenue
tends to be collected at the beginning of the year and each quarter, while payment for spending tends to happen at
quarter- and fiscal year-ends. Government spending results in a drop in the governments deposits with the PBoC but an
increase of its deposits with commercial banks. This increase in banking system liquidity is temporarily until government
bond auctions/tax collections take it out. On a separate note, the MoF occasionally auctions treasury cash deposits to
commercial banks (this activity totalled CNY400bn in 2011).
Currency in circulation also has strong seasonality in China, as demand for cash tends to be strong during holiday seasons,which sees money flowing out of the system and a tightening in interbank liquidity.
Banks have showed a tendency to move deposits into off-balance-sheet activities in recent years, which are not subject toreserve requirements. Each quarter end, banks would move deposits back onto their balance sheets to meet loan-to-
deposit ratios set by the CBRC. This pattern has tightened liquidity at quarter ends. To close this loophole, the CBRC
switched from quarterly monitoring to monthly at the beginning of 2011 and introduced a daily LDR monitoring system on
a trial basis in June. These measures are likely to make RRR more effective and reduce fluctuations in interbank liquidity.
Similar to other markets, large sized IPOs/bond issuance/dividend payments also cause temporary squeezes in liquidity asthese events tend to freeze large amounts of funds for short periods.
Liquidity in the financial system (CNY bn) Banks excess reserves with PBoC
01-Oct-11 01-Sep-11 01-Aug-11 01-Jul-11 01-Jun-11
Net OMOs 89 236 167 9 399
Regular RRR (incl.
snow ball effect)48 -157 -152 144 -794
Margin accountdeposit RRR
-225 -144 0 0 0
Fiscal impact -308 309 -84 -342 -27
FX inflows -25 247 377 220 277
Currency in
circulation114 -224 -62 -52 -17
Change in liquidity -307 267 246 -71 -112
PBOC announced
excess reserve ratio1.40% 0.80%
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Oct-11Oct-09Oct-07Oct-05Oct-03
CNY trn
0
1
2
3
4
5
6
7
%Excess reserves in banking system
Excess reserve ratio (RHS)
Source: CEIC, Barclays Capital Source: CEIC, Barclays Capital
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Interest rate derivatives
Monthly turnover of IRS of different fixings (CNY bn)
0
50
100
150
200
250
300
350
400
Nov
11
May-
11
Nov-
10
May-
10
Nov-
09
May-
09
Nov-
08
May-
08
Nov-
07
7d repo Overnight Shibor
3m Shibor 1y depoLending rate
Source: CEIC, Barclays Capital
7d repo fixing, 1y repo IRS and 1s5s curve slope (%)
-2.00
-1.00
-
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
2006 2007 2008 2009 2010 2011
-100
-
100
200
300
400
500
600
700
800
900
NDIRS 1s5s (RHS, bp) 7d repo 1y NDIRS
Source: Bloomberg, Barclays Capital
Shibor IRS, repo IRS, and spread (%)
-
1.00
2.00
3.00
4.00
5.00
6.00
Jan-07 Dec-07 Dec-08 Nov-09 Nov-10 Oct-11
-100
-
100
200
300
400
500Shibor-repo ND IRS spread (RHS, bp)2y Shibor IRS2y repo IRS
Overview
The CNY IRS market started in 2006 and has since grownsignificantly. The first three quarters of 2011 saw 16,925
swap transactions with a total notional value of
CNY2.15trn, up 170% compared with the previous year.
Tenors of 1y and below remain the most active part of the
market, accounting for 70% of all transactions. Repo IRS
remains the most liquid and popular format, accounting
for 56% of the market, but Shibor IRS is catching up,
taking 40% of the market (up from 13% in 2007, its first
year). Deposit and lending rates based IRS trade only
occasionally, and represent just 4% of the market.
Repo IRS
Fixing: CNRR007 Index; Bloomberg ticker: CCSWNI1(offshore) and CCSWO1 (onshore).
The main onshore participants are banks and securitiesfirms. Hedge funds and interbank dealers are significant
participants in the offshore market. Trade size tends to be
larger in the offshore market but onshore volume is larger.
Front-end repo IRS yields depend more on systemicliquidity, but back-end IRS yields are more influenced by
global risk appetite and the performance of A-shares
versus bonds.
Shibor swaps
Fixing: SHIF3M; Bloomberg ticker: CCSH1 (offshore) andCCSHO1 (onshore).
Shibor is uncollateralised, and market participants includesmall banks that tend to have weaker liquidity positions and
are the main borrowers in the interbank market. As such,
the Shibor curve is more influenced by banking system
liquidity compared with repos. Also, as Shibor is meant to be
a benchmark for Chinas money markets, most financial
instruments and rates, including floaters, rediscount rates,
and short-term bills are linked to Shibor. This has created
more hedging demand using the Shibor curve.
Depo IRS
Fixing: CNDR1Y Index; Bloomberg ticker: CCSDF2(offshore) and CCSDO2 (onshore); Very illiquid, but is
widely used to assess rate hike expectations. It is also used
by insurance companies to hedge their floating rate assets
linked to the deposit policy rate.
Source: Bloomberg, Barclays Capital
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Nondeliverable cross-currency swaps (NDS)
Fixing: USD Libor 6m; Bloomberg ticker: CCSWN1; largelytrades on CNY appreciation expectations.
Onshore CCS
Cross-currency swaps are also available onshore but arevery rarely traded. In early 2011, SAFE issued a Circular to
expand the use of cross-currency swaps beyond the
interbank market to allow CCS trading between banks and
their clients. The convention is quarterly fixed rate (Act/
365) versus 3m US Libor (Act/360) (Bloomberg Ticker:
CCUSWO1). Cross-currency basis swaps are also available.
Bond-IRS swaps
IRS is used in both bond hedging and speculation. TheIRS-bond spread is very directional, narrowing when rates
fall and widening when rates rise.
CNH CCS
Tenors up to 2y are frequently traded. Quarterly fixed(Act/360) versus 3m US Libor (Act/360) (Bloomberg
Ticker: CGUSSW1). Increasing access between onshore
CNY and offshore CNH market is likely to lead to gradual
convergence of onshore and off rates.
Depo IRS, repo IRS, and spread (%)
-
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
4.50
5.00
Jan-08 Sep-08 Jun-09 Feb-10 Nov-10 Jul-11
-150
-100
-50
0
50
100
1502y repo IRS - 2y depo IRS (bp, RHS)
2y repo IRS2y depo IRS
Source: Bloomberg, Barclays Capital
Bond yield, IRS yield and spreads (%)
-
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
4.50
5.00
Jan-07 Dec-07 Dec-08 Nov-09 Nov-10 Oct-11-100
-50
-
50
100
150
200
250
300
350
4005y IRS - bond spread (RHS, bp)5y repo IRS5y government bond
Source: Bloomberg, Barclays Capital
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Bond markets
Outstanding onshore RMB bonds (USD trn)
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Jun-98 Sep-00 Dec-02 Mar-05 Jun-07 Sep-09
Government Corporate
Source: Asian Development Bank
Outstanding onshore RMB bonds by type
Central
Bank bill s
51%
Treasurybonds
18%
Corporate
bonds
4%
MTN
5%
Commercial
paper
2%
Commercial
Bank bonds
2%
Policy Bank
bonds
18%
Source: CEIC
Book-entry treasury bonds issued since 2006, by tenor (CNY bn)
0
200
400
600
800
1000
1200
91d
182d
273d
1y
2y
3y
5y
7y
10y
15y
20y
30y
50y
2011 2010 2009 2008 2007 2006 2005
Overview
Chinas onshore RMB bond market started when thegovernment resumed bond issuance in 1981 and has
experienced significant growth over the past 10 years. By
outstanding amount, Chinas USD3.2trn bond market is
the largest in Asia ex-Japan. The main types of bonds are
government bonds, PBoC bills, local government bonds,
financial bonds, corporate bonds (divided into enterprise
bonds and listed-company bonds), medium-term notes
(MTNs), commercial paper, asset-backed securities,
convertible bonds and bonds with warrants. Compared
with government securities (eg, CGBs, PBoC bills and
quasi-government issues), the private sector bond market
is still underdeveloped, accounting for 23% of the total
outstanding at September 2011.
Currently, Chinas bond market consists of three mainmarkets: the interbank bond market, the exchange
market and the commercial bank OTC market. The
interbank market accounts for 90% of the total
outstanding and transactions, and is dominated by banks
and nonbank financial institutions (including some foreign
institutions). The exchange market consists of both
institutions and individuals, and the OTC market can be
viewed as an extension of the interbank bond market.
Bond categories
Treasury bonds (CGBs, issued by the Ministry of
Finance)
There are two types of treasury bonds: book-entry bondsand certificate savings bonds. Book-entry bonds are sold
through financial institutions via auctions. The Ministry of
Finance announces issuance plans at the beginning of the
year (details are released quarterly) and chooses a group
of underwriters to form a syndicate to auctions the bonds.
The syndicate usually includes commercial banks,
securities firms and insurance companies. Most of the
book-entry treasuries are issued in 3-10y tenors, but the
longest tenor available is 50y (the MoF has issued 50y
bonds since November 2009). On the other hand,certificate savings bonds are sold to retail customers and
are not tradable after the sale. Most treasury bonds are
fixed rate.
PBoC bills (issued by the central bank for OMOs)
For more details see the Monetary policy section.
Source: CEIC
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Breakdown of policy financial bonds issued by policy banks
ADBC
18%
EXIM
12%
CDB
70%
Source: CEIC, Barclays Capital
Monthly local government bond issuance (CNY bn)
0
10
20
30
40
50
60
70
80
90
100
Nov-11May-11Nov-10May-10Nov-09May-09
Source: CEIC, Barclays Capital
Financial bonds (issued by policy banks and financial
institutions)
More than half of all financial bonds are issued by policybanks. Among the three policy banks, China Development
Bank (CDB) is the largest issuer, but Agricultural
Development Bank of China (ADBC) and Export-Import
Bank of China (EXIM Bank) have been gaining share.
Commercial banks are allowed to issue tiered bonds,
which include senior, subordinated and hybrid tranches.
Local government bonds
According to the budget law adopted in 1994, Chinaslocal governments are forbidden from borrowing in capital
markets. As a result, local governments have relied on
government-owned entities to borrow.
Since 2009, the Ministry of Finance has issued bonds onbehalf of local governments. Issuance sizes were kept at
CNY200bn for 2009 and 2010.
In October 2011 the government allowed the localgovernments of Shanghai, Shenzhen, Guangdong, and
Zhejiang to sell bonds directly. These four governments
issued a total of CNY22.9bn of bonds in November at
yields lower than comparable central government bonds.
Corporate bonds
Enterprise bonds include corporate bonds issued byunlisted companies and bonds issued by enterprises that
are not incorporated in accordance with Chinas Company
Law. Most enterprise bonds are issued by large state-owned companies, such as the state railway and State Grid
Corp. All enterprise bond issuance is subject to NDRC
approval.
Publicly listed companies are allowed to issue bonds onthe exchange market.
Medium-term notes (MTNs)
In 2008, corporates were allowed to issue regularly viamedium-term note programmes without obtaining
regulatory approval in each case.
Commercial paper Securities firms and nonfinancial institutions are also
allowed to issue commercial paper for short-term
financing. Commercial paper is a key instrument in the bill
market with tenors mostly shorter than 1year.
Corporate bond vs. government bond yield (%)
0
1
2
3
4
5
6
7
Mar-06 Apr-07 Jun-08 Aug-09 Oct-10 Dec-11
0
100
200
300
400
500
Corporate - government spread (bp, RHS)10y fixed rate government bond10y fixed rate (AAA) corporate bond
Source: CDYC, Bloomberg, Barclays Capital
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Monthly CNH bonds issuance (CNY bn)
41
5
9
3
15
22
27
10
34
18
11 11
2
0
5
10
15
2025
30
35
40
45
2010
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
2011
Source: CMU, Barclays Capital
CNH bonds by issuer
Sovereign/
Quasi
16%
Corporates
35%
Financials
48%
Supranationals
1%
Sovereign/
Quasi
16%
Corporates
35%
Financials
48%
Supranationals
1%
Source: CMU, Barclays Capital
The offshore RMB market
The offshore RMB bond market (CNH, or dim sum) waslaunched in 2007, when mainland financial institutions
were allowed to issue RMB-denominated bonds in Hong
Kong. However, the market took off in July 2010 when
most restrictions on offshore RMB transactions were lifted.
Since then, multinational corporations and international
financial organisations have tapped the market. For
issuers, the dim sum bond market offers a low-cost source
of funding. Most bonds issued are less than 5y, given that
investor interest lies more in potential FX gains.
Restrictions on access to the mainland bond market foroffshore investors with QFII licences have increased
demand for CNH-denominated assets, where there are no
such restrictions. Despite fast growth, the supply of CNH
bonds has fallen short of the growth in the deposit pool.
The lengthy and strict regulatory process for remitting the
proceeds onshore is a key bottleneck, but the approval
process is likely to be speeded up, given Premier Lis
comments made during a visit to Hong Kong. (For details
of the offshore RMB market please see CNH Market
Primer: Food for thought, 8 November 2011).
Market participants for onshore bonds
Special members: Include the PBoC, Ministry of Finance,policy banks, and China Government Securities Depository
Trust & Clearing Co.
Banks: Banks hold about 70% of Chinese governmentbonds. The fact that banks are the dominant investors,subjects the bond market to the credit cycle. Banks have a
preference for bonds with tenors below five years.
Insurance companies: These companies hold 5% ofgovernment bonds and have a strong preference for
bonds with tenors longer than five years.
Pension funds: The National Insurance Law mandatesthat at least 50% of social security funds be invested in
bank deposits and government bonds, 40% in equities,
and 10% in corporate bonds.
Investment funds: The Securities Investment Fund Lawrequires that 80% of fund assets be invested in the equity
and bond markets, and at least 20% invested in treasuries.
As investment funds are profit-seeking investors, their
participation in the bond market has stronger correlation
with actual bond prices (see first chart in next page). They
are more flexible on tenor length.
Others: Credit unions, securities firms, individuals.
Onshore government bond holdings among major investors
0%
20%
40%
60%
80%
100%
120%
1999 2001 2003 2005 2007 2009 2011
Special member Commercial bankTrust Cooperatives Nonbank financial institutionSecurities company Insurance companyFund house
Note: * Special members: PBoC, Ministry of Finance, policy banks, the Exchange,
China Government Securities Depository Trust & Clearing Co.
Source: CEIC, Barclays Capital
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Foreign participation
QFIIs: Starting in late 2002, FIIs were allowed to invest ingovernment bonds, convertible bonds and corporate
bonds listed on the exchange market. A local custodian
and broker are required for QFIIs. So far, very few bond
QFIIs have been approved. IFC and ADB were allowed to
issue CNY-denominated bonds in China in 2005.
As part of the effort to internationalise the RMB, foreigncentral banks and selected commercial banks that are
involved in RMB trade clearance and settlement are
allowed to access onshore interbank bond market. A
quota is assigned by PBoC, but details are not disclosed.
The RMB QFII (mini-QFII) is likely to be finalised soon,with an initial size of CNY20bn.
CNH bonds: Not accessed onshore; foreign investors only.
Auction procedure The primary market for treasury bond issuance is largely
conducted through syndication. Government bonds are
typically underwritten by the four stated-owned banks,
and other commercial banks and securities companies
play active roles in forming a syndicate.
Bond settlement
Onshore settlement: China Government SecuritiesDepository Trust & Clearing Co. Ltd has responsibility as
the general custodian. Bonds typically settle at T+1.
CNH bonds: Via CMU or Euroclear or Clearstream; T+3.
Taxation
Onshore bonds: Government bonds are exempt from the25% income tax. A 5% sales tax is applied. The
government recently exempted local government bonds
from income tax and cut the income tax by half for bonds
issued by the Ministry of Railway.
CNH bonds: No tax is applied.Regulation
There are numerous regulators in Chinas onshore bondmarket, depending on the category of the bonds and
whether it is primary market or secondary. This has to
some extent created a heavy regulatory burden and
segregation of markets.
Bonds held by investment funds vs bond price index
-100%
-50%
0%
50%
100%
150%
200%
250%
Jan-04 Jan-06 Jan-08 Jan-10
-15%
-10%
-5%
0%
5%
10%
15%
20%Growth in bonds held by funds (y/y)
Treasury bond index (y/y return, RHS)
Source: CEIC, Barclays Capital
Chinese onshore bond markets and respective regulators
Primary market Secondary market
Treasury bonds MOF CSRC, NAFMII
PBoC bills PBoC NAFMII
Financial bonds PBoC, CBRC, CSRC NAFMII, CSRC
Enterprise bonds NDRC CSRC, NAFMII
Listed-company bonds CSRC CSRC, NAFMII
CP & MTNs NAFMII NAFMII
Interbank market PBoC
Exchange market CSRC
China Government Securities
Depository Trust & Clearing
PBoC, MOF, CBRC
*MOF: Ministry of FinanceCSRC: China Securities Regulatory Commission
NAFMII: National Association of Financial Market Institutional InvestorsNDRC: National Development and Reform Commission
CBRC: China Banking Regulatory CommissionSource: Barclays Capital
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Fiscal policy and credit ratings
Book-entry treasuries issuance and fiscal trends
0.0
0.5
1.0
1.5
2.0
2.5
2003 2004 2005 2006 2007 2008 2009 20102011E
-2.5%
-2.0%
-1.5%
-1.0%
-0.5%
0.0%
0.5%
1.0%
Yearly gross issuance F isca l % of GDP (bp, RHS)
Source: CEIC, Barclays Capital
Chinese governments estimated contingent liabilities
0%10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
% of GDP
Local government debt
China Development Bank
SOE debt (loan default est.)
Bank NPLs
Ministry of rail debt
Official public debt
0%10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
% of GDP
Local government debt
China Development Bank
SOE debt (loan default est.)
Bank NPLs
Ministry of rail debt
Official public debt
0%10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
% of GDP
Local government debt
China Development Bank
SOE debt (loan default est.)
Bank NPLs
Ministry of rail debt
Official public debt
Source: Barclays Capital
Fiscal policy
The Ministry of Finance sets fiscal policy in China. Thefiscal deficit as a percentage of GDP fell until 2007 as a
result of fast economic growth and an improving
government tax system. However, it picked up on the back
of the proactive fiscal policy initiated after the 2008 credit
crisis. Issuance of book-entry treasuries has been around
CNY 1.5-1.8trn per year since then.
The central governments balance sheet remains solid,with outstanding debt at just 19% of GDP, although the
number would rise to 80-90% if contingent liabilities
including local government debt were taken into account.
But the risk from government contingent liabilities would
appear to be lessened by the rapid growth in government
revenues (31.2% y/y in H1 11) and value of assets owned
by the government.
The government recently announced a series of measuresto ease concerns about rising local government debt,
including categorising Ministry of Railway bonds as
government bonds (instead of corporate bonds), cutting
the income tax for local government bonds and allowing
four provinces to issue bonds on a trial basis (the MoF has
issued CNY200bn bonds a year on behalf of local
governments since 2009). These measures were taken
positively by rating agencies.
Credit ratings Chinas long-term foreign-currency sovereign debt is rated
AA- (Stable) by S&P, A+ (Stable) by Fitch and Aa3 (Pos) by
Moodys.
Chinas long-term local-currency sovereign debt is ratedAA- by S&P, Aa3 by Moodys and AA- by Fitch. Moody's S&P Fitch
Aa3 (Nov 2010) AA- (Dec 2010) A+ (Nov 2007)
A1 (Jul 2007) A+ (Jul 2008) A (Oct 2005)
A2 (Oct 2003) A (Jul 2006) A- (Dec 1997)
A3 (Sep 1993) A- (Jul 2005)
WR (Oct 1992) BBB+ (Feb 2004)
Baa1 (Nov 1989) BBB (Jul 1999)
A3 (May 1988) BBB+ (May 1997)
BBB (Dec 1992)
Foreign currency debt - rating history
Source: Ratings agencies
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CNY nominal and real effective exchange rates
90
100
110
120
130
2008 2009 2010 2011
CNY NEER
CNY REER
Source: Barclays Capital Live
CNY spot and NDFs
6.0
6.2
6.4
6.6
6.8
7.0
7.2
7.4
2008 2009 2010 2011 2012
USD/CNY USD/CNY NDFs
Source: Bloomberg, Barclays Capital
PBoC FX reserves (USD trn)
1.5
2.0
2.5
3.0
3.5
2008 2009 2010 2011
Source: Barclays Capital
Currency policy and foreign exchange markets
FX Strategists: Olivier Desbarres +65 6308 2073 olivier.desbarres@barcap.com; Nick Verdi +65 6308 3093 nick.verdi@barcap.com
Exchange rate policy
On 21 July 2005, the PBoC revalued the CNY by 2.1% andmoved from a USD peg to a managed float based on
market supply/demand and with reference to a basket of
currencies. On 19 June 2010, the PBoC resumed reform of
the CNY regime to enhance exchange rate flexibility, after
about two years of a soft peg to the USD. The USD/CNY
daily trading band was widened to 0.5% around the
USD/CNY daily fix from 0.3% on 21 May 2007.
The government is promoting RMB internationalisation,through greater use of RMB in trade and investment. The
CNH market continues to thrive, helped by strong RMB
appreciation expectations. Regulation changes since mid-
2010 have largely reflected regulators preference for a
firm but measured pace of RMB internationalisation.
Further liberalisation of Chinas capital account is likely to
accelerate development of the offshore market (see CNH
Market Primer: Food for Thought, 8 November 2011).
Foreign exchange rate markets
Before the recent development of a deliverable offshoreRMB market, the offshore NDF market was the traditional
market for investors to hedge RMB exposures. The daily
spot fixing rate for NDFs is the same as the onshore PBoC
fixing. The USD/CNY forwards are nondeliverable and
dollar-settled against this fixing rate. The NDFs are driven
by supply and demand, which in turn are driven by RMB
appreciation expectations and are decoupled from the
interest rate differential between RMB and USD.
The deliverable RMB spot rate against the USD quoted inthe offshore market (for all practical purposes, Hong
Kong) is referred to as the USD/CNH spot rate.
The CNH and onshore CNY markets are similar as the RMBis deliverable in Hong Kong. There are no requirements for
underlying trade activity to access RMB via this market.
But, if the RMB is to be repatriated to mainland China,
documentation supporting trade or an approved capitalaccount item is needed. The gap between CNH and CNY
spot rates reflects different fixing dynamics in these two
markets and expectations for CNY appreciation. Improving
access between the onshore and offshore RMB markets
and creation of a complete regulatory framework should
help keep the basis steady longer term.
The CNH FX market has seen significantly improvedliquidity and a broadening in key instruments, with
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tradable tenors now extending to three years, with the
average interbank deal size about USD10mn and daily
interbank liquidity estimated at USD1.2bn. Investors can
also access deliverable FX forwards and FX swaps.
CNH forward points closely track CNY NDF points and areinfluenced by NDF curves. RMB appreciation pressures andoffshore arbitrage activities tend to translate into a more
downward-sloping CNH curve. The CNH forward curve is
ultimately a function of: a) interest rate differentials
between offshore RMB and USD interbank deposits; and
b) RMB appreciation expectations. The divergence
between CNY and CNH forwards is likely to continue until
China fully lifts its capital account controls.
The CNH FX option market is still nascent but developingrapidly, with the increase in RMB liquidity in Hong Kong.
USD/CNH option-implied vols were lower than onshore
USD/CNY vols until September 2011. The Hong Kong
Treasury Market Association has published a daily
USD/CNH fix since 26 July 2011. However, the current
market convention for settling USD/CNH options is to use
the Tokyo 3pm USD/CNH rate (as per Reuters Screen) as
the option settlement fixing.
Restrictions: Only entities registered in China can tradeCNY onshore. Nonresident investors are limited to
offshore nondeliverable forwards (NDFs), CNH and swap
instruments. Repatriation of principal and proceeds
derived from CNY-denominated equity and bond
investments is subject to strict controls. Sales and
proceeds from B-shares denominated in USD and HKD
can be repatriated freely. In the onshore FX market, CNY
forwards and FX swaps are available to onshore
institutions to hedge FX exposure.
Banks are permitted to engage in FX swaps (CNY againstforeign currency) after registering for the record only if
they have had the qualification for RMB forward business
transactions for more than six months. The State
Administration of Foreign Exchange (SAFE), under PBoCs
supervision, enforces exchange controls.
CorporatesExposure for multinationals in China
Equity inflows: An overseas parent entity can hedge itsforeign direct investment (FDI).
Intercompany loans: Hedged by Chinese subsidiaries. Trade- and operations-related flows: Can be hedged by
Chinese subsidiaries; subject to State Administration of
Foreign Exchange (SAFE) classification.
Equity and dividend repatriation: Can be hedged by Chinesesubsidiaries; subject to tax bureau and regulator clearance.
Regulations governing transactions
Foreign direct investment: A parent entity can hedge itsinvestment in its Chinese entities. Investments fall under
the regulatory domain of SAFE and the Ministry ofCommerce under FDI regulations.
External commercial borrowing (ECB): A Chinese entitycan hedge loans from the parent company. Subject to
SAFE approval.
Trade receivables and payables: A Chinese entity can puton a hedge but needs to undertake Know Your Client
verification and provide proof of actual underlying exposure.
Repatriation regulations
Dividends: Companies may remit dividends overseas toforeign investors after they have been declared by the
board of directors. Companies may also hedge the FX
exposure on this dividend on behalf of foreign investors.
Companies can remit dividends to nonresident
shareholders after all applicable taxes are paid and tax
bureau clearance and SAFE approval is received.
Interest: A local entity is permitted to remit interest (onparent entity loan/bond) to its overseas parent, subject to
SAFE clearance.
Principal: Remittance of principal is allowed as per theoriginal loan agreement. Tax-clearance documentationmust be submitted for non-trade-related payments.
Recent change in regulations CNY hedging foroverseas corporates
The creation of the CNH market has significantly increasedthe use of CNY in trade transactions.
Advantages to multinational corporates: By virtue of CNHbilling, current legislation allows the transfer of currency
risk from Chinese subsidiaries to parent companies.
Potential cost savings for importers of Chinesegoods/services: Due to the significant interest ratedifferential between most G7 currencies and the CNY,
importers of Chinese goods/services can use the high
forward premium to achieve potential cost benefits by
billing in CNY and hedging the payables with a sell
USD/buy CNH forward contract.
Taxation
There is a 5% business tax on gains from FX transactions.
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FX reference guide
MARKET CHARACTERISTICS
Overview
CNY is a managed, nondeliverable currency with a +/-0.5% intra-day trading band on the USD/CNY cross. Banks bid/offer spread of USD/CNYon quotes to non-bank clients is also limited to 1% of the USD/CNY fixing rate, which is announced by the PBoC at 09:15 Beijing time every day.
Security
Liquidity
(daily volume)
Bid/Offer
spread
Tenor/
Maturity
Local open/
closing times Settlement
Reuters
page Additional information
OnshoreFX spot
USD20bn 5-10 pips Spot 09:30 16:30 T+2 CNY=CFXS
CN/CONT4
Available only to domestic corporates
and institutions. Must be executedwith a designated FX bank (DFXB).
DFXBs can square the net CNY positionin the China Foreign Exchange TradeSystem (CFETS).
Onshore
FXforwards
USD6bn 10-30 pips
(1-3m)
30-50 pips
(3m-1y)
Somequotations
beyond 1y
but poorliquidity
09:30 16:30 T+2 CNYFWD=
CN/CONT6
Previously, this market was restrictedto the four major state-affiliatedbanks and corporates hedging for
underlying external trades in goodsand services. On 2 August 2005, PBoC
expanded the participation to allpolicy banks, city and ruralcommercial banks, rural cooperative
banks and select foreign banks.
Onshore
FX swaps
USD3-5bn 10-30 pips
(1-3m)
30-50 pips
(3m-1y)
Up to 1y 09:30 16:30 T+2 CNYFWD=
CN/CONT6
In the onshore market, CNY forwards
and FX swaps are available to onshoreinstitutions to hedge FX exposure.
Onshore
FX Options
The onshore options market is in its infancy. Onshore corporates are only allowed to buy options from local banks, who are in turn
allowed to cover their risk with offshore banks.
Non-deliverable
forwards
USD2bn Depends ontenor and size
(20-130 pips)
Liquid to 2y;traded up to
10y
24 hours a day T+2 PNDF
PBOCA
SAEC
CHIBOR
The CNY nondeliverable forward isrestricted to foreign investors and the
offshore market only. Cross-border NDFneeds to be approved by the SAFE.
Non-deliverable
swaps
USD100mn 15-20bp (upto USD10mn),
50-70bp
(USD50mn)
Illiquidbeyond 5y
09:30 16:30 T+2 PNDS
PBOCA
SAEC
CHIBOR
The CNY nondeliverable swap marketis restricted to foreign investors and
the offshore market only. SAFE needsto approve cross-border NDS.
Security
Liquidity
(daily volume)
Bid/Offer
spread
Tenor/
Maturity
Local open/
closing times Settlement
Reuters
page Additional information
Non-deliverable
FX options
USD600mn 0.2-0.4 vol up
to 2y
No liquidity
beyond 5y09:30 16:30 T+2 PBOCA
SAEC
CHIBOR
CNHDeliverable
spot
USD1-1.5bn 10 pips forUSD20mn
Liquid to 2y;traded up to
5yr
09:30 16:30 T+2 CNHFIX= Most interbank deals are aroundUSD10mn.
CNHdeliverable
forwards
USD2bn forwhole curve
1y bid/offer30 pips forUSD20mn
Liquidityextends to3y
24 hours a day T+2 CNHFWD= Interbank liquidity has improvedsignificantly. Typical size is USD20mn.
CNH Cross-
currencySwap
(CCS)
Not liquid 1y CCSbid/offerabout 10bp
Most activetraded tenoris 1y; traded
to 3y
24 hours a day T+2 CNHUSCS=ICHK
No active interbank market.
CNH
FX options
USD100-
150mn0.8 vol Liquid to 1y 24 hours a day T+2 N/A
Source: Barclays Capital
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FX MARKET PARTICIPANTS IN CNY MARKET
Description
Corporates Corporates are allowed to engage in spot and forward transactions.
Banks Banks use spot, forward and swap transactions to hedge FX risk.
PBoC The central bank intervenes to maintain USDCNY in daily trading band of +/-0.5%.
Source: Barclays Capital
FX MARKET PARTICIPANTS IN CNH MARKET
Description
Clearing bank, the Bank ofChina (HK)
The clearing bank, Bank of China (HK), brings RMB from mainland China into Hong Kong. A participatingauthorised institution (AI) is allowed to hedge its trade-related flows with the clearing bank. So, if a corporatewants to hedge its exports denominated in USD or imports denominated in CNY, it will sell USD/CNY (at the
onshore USD/CNY spot rate) to a participating AI bank. The participating AI will, in turn, sell USD/CNY to theclearing bank ie, Bank of China (HK). The clearing bank hedges its risk through its branch in the mainland,thus bringing RMB liquidity into Hong Kong. Corporates are also allowed to buy USD/CNY from participating
AIs if they have relevant trade documents. The PBoC established a settlement quota for BoC (HK), initially set atCNY8bn per annum is 2010. This was later changed to CNY4bn for each of the first three quarters of 2011 and
then set at CNY8bn for Q4 2011 in response to increased market demand.
Hong Kong Monetary Authority
(HKMA)
The HKMA has a CNY400bn swap line with the PBoC valid until November 2014. If trade settlement flows
require more CNH than the quota with the clearing bank, the HKMA will use its CNH swap lines with the PBoC,allowing participating AIs to hedge their open positions with the former. Thus, the HKMA acts as anothersource of CNH liquidity in Hong Kong if the trade settlement flow exceeds the clearing banks quota.
Offshore-domiciled exporters Mainland importers that have trade settlement in USD can obtain approval to remit RMB out of China into
Hong Kong to buy USD for their import needs. Given the demand for RMB liquidity in Hong Kong, theseimporters are incentivised to not use their trade documents to buy USD in Hong Kong. These importers aresuppliers of RMB to the CNH market as they try to capture the differential between onshore CNY and CNH
markets, providing RMB liquidity in Hong Kong in addition to that provided by the clearing bank. Onshoreimporters then buy USD in the CNH market. However, the onshore importer is not permitted to buy USD in theoffshore market itself and pay the offshore exporter (although the onshore importer can set up a financing
entity offshore to meet its USD buying purposes).
Individuals Hong Kong citizens who might have accumulated RMB deposits with Hong Kong banks, provide the marketwith RMB liquidity. Other groups are investors and tourists from mainland China bringing in cash RMB, which
is a significant source of the Chinese currency in Hong Kong.
Multi-nationals FX hedging
Hong Kong domiciled importers Hong Kong domiciled importers (from mainland China) who settle trade in RMB will absorb RMB out of Hong
Kong and remit it back into mainland China.
Bond issuers Proceeds from RMB-denominated bond issues will most likely be repatriated to mainland China for investmentpurposes, thereby draining RMB from Hong Kong. RMB bond issuance has expanded rapidly since 2009. As of
July 2011 there was CNY150bn outstanding of such paper. Although this is a significant source of RMBdemand, it is still well short of the rapid growth of RMB deposits in Hong Kong.
CNH interbank participants More than 10 foreign banks (including foreign central banks) now have access to the onshore interbank bond
market. While the details have not been confirmed by the Chinese authorities, the quotas are likely to havebeen kept small to limit the near-term impact on the CNH market. Over time, the greater access to the onshore
market should promote the convergence of onshore and offshore rates, and FX levels.
CNH equity issuers Similar to bond issues, if equity issuance proceeds are transferred to mainland China, this takes RMB liquidity
out of Hong Kong. If the proceeds are not remitted to mainland China, the liquidity impact is temporary fromthe funds being locked up during the issue process. Hui Xian REIT became HKs first IPO denominated in RMB
when it raised USD1.6bn (CNY10.48bn) with a yield of 4.33%.
Source: Barclays Capital
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Hong KongFI Strategists: Rohit Arora +65 6308 2092; rohit.arora3@barcap.com; Ju Wang +65 6308 2801; ju.wang@barcap.com;
Kumar Rachapudi +65 6308 3383; kumar.rachapudi@barcap.com
Monetary policy environment
Monetary policy
Hong Kong Monetary Authority (HKMA) and thecurrency board1: The HKMA is responsible for achieving
monetary policy objectives in Hong Kong. The HKMAs
main objectives are: 1) currency stability, which is defined
as a stable value for Hong Kongs currency in terms of its
exchange rate against the USD, within a band of 7.75
7.85, and 2) managing the Exchange Fund (Hong Kongs
official reserves). The financial secretary is the ex-officio
chairman of the HKMA, which also has a chief executive
and an additional nine members appointed by the chief
executive of the SAR.
The Linked Exchange Rate System: Hong Kong operatesa linked exchange currency exchange rate system (a
currency board) instead of implementing policy via
interest rates (monetary policy committee). The system
was established in 1983. The structure of the monetary
system is characterised by a currency board arrangement,
which requires the monetary base to be at least 100%
backed by USD reserves held by the Exchange Fund.
Changes in the monetary base are matched by
corresponding changes in USD reserves held by the
Exchange Fund2 at the fixed exchange rate of 7.80.
Convertibility: Since September 1998, the HKMA hasprovided a clear undertaking to licensed banks to convert
HKD in their clearing accounts into USD. On 18 May 2005
the HKMA introduced a strong-side convertibility
undertaking (CU) to buy USD from licensed banks at 7.75,
and announced the shifting of the existing weak-side
convertibility undertaking from 7.80 to 7.85, to achieve
symmetry around the linked rate of 7.80. Within the
convertibility zone, defined by the levels of the
convertibility undertakings, the HKMA may choose to
conduct market operations consistent with currency board
principles with the aim of promoting the smooth
functioning of the money and foreign exchange markets.
Summary of monetary policy
Objective(i) Currency stability (USDHKD within a band of 7.75-7.85)
(ii) Managing the Exchange Fund
Policy rate Base rate (Bloomberg ticker: HKBASE Index)
Decision
making
Formula based: MAX (US fed funds target rate + 50bps, 5d
average of overnight and 1m Hibor)
Other
tools
(i) Open Market Operations (overnight and intraday repos,
issuing and buying EF paper, direct buying and selling in the
FX market;
(ii) Under the convertability undertaking, HKMA undertakes
to buy USD from banks at 7.75 (on strong side), and sell USD
at 7.85 (on weak side)
Hong Kong Monetary Authority (HKMA)
Source: HKMA
USD/HKD exchange rate
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
8.0
8.5
1974 1978 1982 1986 1990 1994 1998 2002 2006 2010
Linked exchange rate 1983 onwards
HKD during the floating
years (1974-1983)
7.60
7.65
7.70
7.75
7.80
7.85
2003 2004 2005 2006 2007 2008 2009 2010 2011
Spot USD/HKD 1y forward USD/HKD
Convertibility zone
Source for both charts: Bloomberg, HKMA
1 Currency Board: A currency board is a monetary authority that is required to maintain a fixed exchange rate with a foreign currency. This policy objective requiresthe conventional objectives of a central bank to be subordinated to the exchange rate target.2 Exchange Fund: The Exchange Fund's primary objective is to affect the exchange value of the currency of Hong Kong. The HKMA, under the delegated authority ofthe Financial Secretary and within the terms of the delegation, is responsible for the use and for the investment management of the Exchange Fund.
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The monetary base comprises: Certificates of indebtedness, which provide full
backing to the banknotes issued by the three note-
issuing banks: Bank of China, HSBC and Standard
Chartered.
Government-issued notes and coins in circulation. The aggregate balance, which is the sum of the
balances of banks clearing accounts maintained with
the HKMA for the purpose of clearing and settling
transactions among themselves, and also between
banks and the HKMA. The balance, therefore, varies
with the flow of funds in and out of HKD. Since there is
no reserve requirement for ban