Foreigners enter China's interbank bond market

Many foreign companies have long complained of the few channels at their disposal to use renminbi-denominated proceeds derived from cross-border trade with China. That has largely dampened their desire to retain local currency holdings.

Now this is changing – and it is all thanks to Beijing’s plan to boost the international profile of the renminbi.

The People’s Bank of China said on August 17 that it would allow three kinds of foreign financial institutions to trade on the mainland interbank debt market: renminbi-clearing banks in Hong Kong and Macau, foreign central banks involved in currency swap deals with Beijing, and international banks participating in renminbi settlements.

Under the pilot program, foreign participants have to apply for investment quotas and open trading accounts with Chinese lenders. They are also required to clarify funding sources and disclose their investment strategies. Beijing’s caution in designing the mechanism and the restrictions on participation reflect a desire to shield the market from speculators.

The initiative should encourage foreign investors to hold renminbi assets and further bolster China’s fledging capital market. Beyond that, it demonstrates Beijing’s intent to gradually liberate the currency market and capital account, and thereby lay the foundations for securities market reforms.

The value of renminbi-denominated cross-border settlement reached US$7.2 billion in the second quarter, bringing the total for the past 12 months to US$10.4 billion. The People’s Bank of China (PBoC) has signed currency swap deals with seven overseas counterparts – Singapore, Argentina, Indonesia, Belarus, Malaysia, South Korea and Hong Kong – valued at a total of US$117.6 billion since December 2008.

The mainland interbank bond market had a total US$2.1 trillion of debt outstanding as of June 30, including bonds issued by the central government, banks and companies.

That means that the domestic interbank market may feel any meaningful impact from the launch of the pilot scheme. Foreign investors also may need time to gauge the debt market before getting involved.

Although overseas banks are likely to grow more willing to hold renminbi assets amid the global economic slowdown, the program has more initial appeal for central banks rather than commercial lenders. In particular, the seven central banks that signed swap deals with China now have the option of diversifying part of their reserves into renminbi.

The decision to open up the capital markets represents a major step in Beijing’s quest to establish its currency on the international stage.

In the last few months we have seen the removal of the renminbi’s two-year-old US dollar peg, which improves currency elasticity, and the expansion of the cross-border renminbi settlement program to 18 more provinces, following a year-long trial in Shanghai and Guangdong. Allowing foreign participation in the interbank market takes the focus of renminbi internationalization beyond trade.

The interbank market is dominated by big financial institutions with little influence on individual investors. It is not prone to volatility, which makes it a good starting point in the drive to create more renminbi investment channels for overseas players.

The next step is allowing wider foreign participation in the A-share market. We have already seen the first domestic asset management company receive approval to set up a renminbi fund in Hong Kong that will invest in A-shares under the “mini-QFII” system. Renminbi deposits in Hong Kong climbed 4.8% in June to a record US$13.2 billion.

More foreign companies are expected to issue renminbi-denominated bonds in Hong Kong while overseas investment banks are likely to be permitted to underwrite corporate bonds in the mainland. There is also the ongoing issue of foreign firms listing on the Shanghai Stock Exchange, which could be resolved as early as next year.

As foreign engagement in China’s capital markets deepens, tight regulation should mollify concerns about financial and economic stability being threatened by undue overseas influence. The pace of reregulation will largely depend on how existing programs work – with provisions for a reversal of the reforms if concerns about macroeconomic stability emerge.

This means that it will take about a decade of cautious steps before the renminbi is fully convertible. In the meantime, domestic bonds should start appearing in the portfolios of overseas investors, but it is likely to be a minority share.