RMB Offshore Bond Market

Introduction

The first RMB bond was issued offshore in July 2007. By October 2011, the value of bonds

issued in RMB offshore markets rose to RMB167 billion. RMB bond issuance outpaced the

dollar denominated bond issuance in Hong Kong in 2011. Appreciation expectation for renminbi

is playing a key role in the offshore RMB bond market. Supply lagged demand and so issuers are

able to raise funds in RMB offshore market at lesser yields compared to RMB or dollar markets

onshore. The very unusual characteristic of RMB offshore market is the dominant presence of

domestic players unlike in other offshore markets. The market structure is also shifting to

corporate and banks from sovereigns.

The gap in supply and the dearth of non-Chinese issuers paved the way for corporate with weak

credits to raise funds at lower rates offshore. Besides demand-supply gaps, the appreciation

expectations and the lack of demand for RMB loans from offshore borrowers contribute to the

lower yields on offshore RMB bonds. The appreciation expectations are clearly reflected in the

tenor of the issues. Most of them are less than three years which clearly show the intentions of

the investors to capitalize on currency appreciations. In addition, the absence of alternatives for

offshore RMB investments has caused investors to hold their positions. So the liquidity in the

secondary bond market is very low.

Majority of the issuances are not rated, but as most of the issuers are public listed companies,

investors can judge the credit worthiness based on the available information. As most of the

offshore issues have no credit rating, there is a risk of mispricing. To this extent, the authorities

plan to expand the Treasury bond issuances which can establish a benchmark risk-free rate and

offer critical support for market development.

Chinese banks are permitted to remit the proceeds onshore and are also allowed to pay

principal and interest in RMB subject to approval. It forms an important channel for funds to be

transferred onshore. The developments in infrastructure widened the investor base. Earlier

local CMU(Central Moneymarkets Unit) used to be the only settlement system, but now bonds

can be settled via Euroclear/Clearstream ( international settlement systems)

The development of RMB offshore bonds also saw the fading of once popular renmindi-

denominated but dollar-settled synthetic bonds.

Eligible issuers Not everyone is allowed to issue bonds in the offshore RMB market. The eligible issuers include

The Ministry of Finance, PRC-incorporated financial institutions and any non-PRC incorporated

entities. About 70% of the issuers are expected to be from mainland while the remaining 30%

from multinational companies, foreign banks and corporate this year. The mainland issuers

need to get approvals from onshore authorities for bond issuances offshore. As proceeds from

offshore bond issuances are likely to be brought onshore which in turn will drain offshore

liquidity, approval procedures for this type of issues will be lengthy. Also the issues from

onshore entities are longer in tenor compared to issues from offshore entities.

Issuing route for Chinese companies

As PRC-incorporated corporate are not allowed for direct issuance, they have the following

options:

1. Issuing via an offshore affiliating company that usually has offshore assets to back the

issuance

2. Issuing via an offshore subsidiary with debt issuance backed by guarantee of onshore

parent

The former option has been the preferred option for quite a long time while the latter is new

which was possible because of a circular from SAFE on administration of external guarantees

provided by domestic companies. The new route enables Chinese companies that do not have

sufficient offshore assets with affiliated entities to back the issuance to issue bonds in the

offshore market. The attractive route and not so rigorous requirements could attract more

Chinese companies to raise funds offshore but the restriction on proceeds remittance onshore

restricts the number of offshore issuances. The capital acquired by the debtor cannot be

transferred back to China directly and the parent company has to ensure that the capital is used

for overseas production and operations of the offshore subsidiary.

Remittance Channels

The remittance channels currently available are

1. Through liberalized current account transactions for trade and services related items.

2. As FDI. It takes the form of Shareholders’ loan or equity.

3. Approval for proceeds remittance during the application for bond issuance. It is possible

with PRC-incorporated financial institutions and Ministry of Finance.

4. Investment in onshore interbank market

Very tight remittance procedures might suppress the development of offshore market while

very liberal procedures might fuel arbitrage opportunities on offshore rate differentials

resulting in offshore liquidity drain.

Risks

Currently bonds of sub-investment grade quality account for 14% of the total outstanding

bonds and CDs. Also very few high yield issuances came with ratings in the recent past. The

research coverage on this new and emerging space is still not comprehensive. So credit risks are

very much real and market participants are not fully armed to deal with these risks. Different

investors have different appetites for market risks. The average differential between offshore

RMB high yield and high grade bonds in 2011 was 3.57 %, a touch higher than that seen in the

Asian Euro dollar market.

Pricing

Theoretically, credit products should be priced by adding credit risk premium to risk-free rate.

However, due to strong currency appreciation expectations, offshore RMB bonds are priced off

comparable credits trading in the Eurodollar market by adjusting for currency differentials. US

interest rates are currently playing a bigger role than the domestic interest rates in the offshore

RMB market.

As offshore markets evolve and the impact of currency appreciation expectations weakens, the

offshore bonds’ prices will depend on risk free rate and credit risk premium. The lower than

Eurodollar yields should not lead to the conclusion that credit risks are insufficiently

compensated in this market. In fact the lower yields on renminbi bonds result from lower risk

free rates (because of currency appreciation expectations). To compensate for the same

amount of credit risk, a lower risk free interest rate requires lower spread to account for credit

risk. For example a credit spread of 100bp on 10% interest rate would be considered tight

while the same 100 bp spread would be considered wide on 1% interest rate.

Future Outlook

The demand-supply gap might ease in the future as supply of bonds in the offshore market

increase to match the increasing demand. This increase in supply will be fuelled because of

tighter onshore liquidity, potential take-off of Overseas Direct Investment (ODI) and

development of offshore FX market which facilitates broader use of currency for general

purposes (currency swaps and conversions etc).

The offshore market could exceed in the next few years the onshore exchange traded amount –

only portion accessible to QFIIs. The onshore exchange offers better yields but offshore market

has better accessibility, broader investor and issuer base