From trade to investment: riding the RMB wave

by David Olsson - China Practice Consultant

On the eve of the issue of the interim report by Australia’s Financial System Inquiry, it is timely to reflect on why the internationalisation of China’s currency is so important to Australia and how the RMB can drive competitive business advantage.

But first, some context.

A decade ago, the RMB was used only in mainland China and Hong Kong. Today, despite restrictions on capital flows in and out of China, the RMB is the second most traded currency in the world¹and increasingly used for trade and investment purposes.

This remarkable result has been the result of a very clear two track strategy: first, the internationalisation of the RMB under the current account, through the RMB cross-border trade settlement scheme², and secondly the development of RMB offshore markets to overcome the constraints on the capital account.

Chinese authorities are now actively promoting greater financial openness or ‘capital account liberalisation’ as a third track to bring about full convertibility of the RMB and greater integration of the currency into the global markets³.

It is this third track that is set to be a game-changer. Since the 2008 global crisis there has been a relaxation of controls in several areas. Investment quotas for the existing schemes governing foreign currency portfolio (equity and bond) inflows and outflows have been increased, while new channels for inward RMB portfolio investment have been introduced⁴. Pilot schemes have also been set up, introducing less stringent capital controls in specific locations in China⁵.

China’s size means that any substantial loosening of its capital controls will have a global impact. The process, if successful, will lead to more balanced and sustainable growth in China. It also means that any movements in capital flows — both into and out of China — are likely to be of a scale that will have significant implications for the global financial system and economies across the world.

Australia has more at stake than many other countries from a relaxation of China’s capital controls and must be ready to deal with the potentially massive capital flows out of China in the decades ahead.

Existing financial links between China and Australia

Behind the scenes, the Australia government has been working hard for some years to ensure that the right policy settings and systems (the so-called “financial architecture”) are in place to support a deeper institutional and business relationship with China. Significant policy initiatives include:

Swap agreement between RBA and PBOC

In March 2012, the Reserve Bank of Australia (RBA) and the People’s Bank of China (PBOC) established a reciprocal three-year, AUD/RMB currency swap line. In the unlikely event that a generalised shortage of offshore RMB liquidity emerges that poses a financial stability risk, the RBA will have the capability to draw RMB up to the value of RMB200 billion or A$30 billion under the swap facility in order to make this available to eligible banking institutions in Australia.

This swap line serves as a back-stop liquidity facility, providing market participants with greater confidence regarding the availability of RMB liquidity in Australia, particularly during times of stressed market conditions. In turn, this greater confidence should help build a solid platform for the growth in the RMB market in Australia.

Direct trading between the onshore RMB and AUD

In April 2013, the RBA announced that direct trading between the renminbi and the Australian dollar in the Chinese onshore market. At the time there were only two other major currencies – the US dollar and the Japanese yen – for which onshore direct trading with the renminbi was possible. The UK Pound, Singapore Dollar, New Zealand Dollar and Euro have all since followed.

The advantage of direct trading is that it allows RMB to be directly converted into AUD without the use of an intermediate currency, thereby eliminating transaction costs and simplifying payment procedures.

Investment of foreign currency reserves

In April 2013, the RBA announced its decision to invest up to 5 per cent. of its foreign currency assets in Chinese sovereign bonds.

This is an important move, reflecting the positive view that the RBA takes of the role that the RMB will play in the global money markets. It provides greater diversification of Australia’s investments and will help with our understanding of the Chinese financial markets.

Sydney as an offshore RMB centre

Together, these initiatives form the building blocks that underpin a robust financial relationship. They have provided Australia with a first mover advantage over other nations for some time, but such is the pace of change and the hunger of other nations to ride the RMB wave, that it is now more important than ever for businesses to put in the hard yards to stay ahead of the game.

The impetus for this may well come from the moves to promote Sydney as an offshore RMB hub.

During his recent visit to China in March 2014, Prime Minister Tony Abbott announced the possibility of an RMB clearing bank being based in Sydney. Further work remains to be done to formalise this, but if concluded it would establish Sydney as the next offshore RMB hub, boosting confidence in the market, attracting liquidity and supporting Sydney’s ambition to be a major regional financial centre.

We can only hope that this announcement occurs without delay. In the last few months, China has announced or formalised arrangements for similar appointments in London, Frankfurt, Luxembourg, Paris and Seoul.

Competition between offshore RMB hubs around the world undoubtedly benefits the RMB internationalisation process, but the market will over time determine the specific role of each centre. That requires each centre to define its own value proposition and to leverage its key strengths.

Hong Kong’s relationship with China and the sheer size its RMB deposit base mean that it is likely to remain the dominant Asian offshore RMB centre for the foreseeable future.

Sydney has a strong case as Australia’s leading financial capital, but a smart move would be to work closely with Melbourne to capitalize on the strengths of both centres. The value proposition is yet to be clearly articulated but, for Australia, the embedded skills, scale and sophistication of Australia’s superannuation and funds sectors and the ability to develop wealth management and investment products to meet the increasing demand from Asia’s burgeoning middle class and institutional investors are compelling distinguishing features.

Discussions are also underway between PBOC and RBA in relation to the allocation of an R-QFII⁶allocation to Australia. If granted, this would Australian fund and asset managers more opportunities to invest in the mainland market.

RMB cross-border trade settlement

Globally, RMB is growing rapidly as a trade settlement currency. All Australian traders can now settle their trades, both exports and imports, in RMB.

Participation in this scheme by Australian companies is still low, partly due to lack of awareness but also because of concerns (in the case of exporters) about lack of investment opportunities for surplus RMB funds and (in the case of importers) about the availability and price of RMB funds.

Recent surveys point, however, to a rapid pick-up in RMB usage with a host of hedging products and new investment products now available. In fact, virtually every RMB related service or product that is on offer in Hong Kong is available in Australia.

Australian exporters that have started to conduct trade in RMB report that they have not only improved pricing but also gained new business opportunities.

There are also welcoming signs that Australia’s major mining houses are taking steps to invoice some shipments in renminbi⁷. If that trend continues RMB deposits and liquidity will be boosted significantly.

Bilateral investment flows

The less well understood but increasingly important element in the developing bilateral relationship is the increase in bi-lateral capital flows, including direct investment, portfolio investment and banking flows.

If China’s financial walls are lifted, some of its vast pool of domestic savings will migrate into global capital markets, including Australia’s, providing a significant boost to liquidity, new sources of capital and a massive new investor base.

The potential size of this outflow is unprecedented. An ANZ report⁸ predicts that China could overtake the US and Britain, and become the main source of foreign direct investment into Australia over the next two decades.

In 2010, about 2.5 per cent of the value of China's Foreign Direct Investment (FDI) was invested in Australia. If that proportion were to remain unchanged, the stock of Chinese FDI into Australia could be worth up to A$200 billion by 2030, which would be a ten-fold increase from 2012 levels.

While these flows have historically been denominated in United States dollars, China’s capital flows are likely to be increasingly renminbi denominated.

They bring with them tantalising opportunities – managing funds for foreign investors and creating Australian created RMB-denominated wealth management, insurance and other financial products for sale to Chinese and Asian investors under the Asian Regional Funds Passport scheme⁹, the emerging Shanghai – Hong Kong Stock Connect Scheme and other distribution channels that may emerge from a concluded Free Trade Agreement.

Funding the massive infrastructure needs of Australia and the region is a G20/B20 and national priority. Australia has always been a net importer of capital. With traditional European and US markets now constrained, tapping the capital reserves of China is both logical and increasingly practically possible.

Offshore RMB bond market

With growing pools of offshore RMB deposits, financial institutions and a number of multi-national companies are now regularly issuing RMB denominated bonds in the offshore (CNH) RMB markets.

Hong Kong has been the primary place of issue of these bonds (including by some of Australia’s banks), but the issue location has expanded to other offshore RMB centres, with listings on over 10 stock exchanges around the world.

The recent issue of bonds in the Sydney market listed on the ASX, by Bank of China, Sydney Branch¹⁰points to the potential for increased RMB bond issuance activity in the Australian market.

Australian companies with regional operations and RMB liabilities and State Governments looking to pay for imported Chinese infrastructure can now add RMB bonds to their list of fund raising options.

Going forward, RMB bond issuance can play an important role in supporting the development of Australia’s domestic bond market. Greater participation by superannuation (pension) funds, sovereign wealth funds and the State/Territory and Federal Governments will help increase liquidity and market growth.

Industry driven initiatives

Market and industry-led initiatives are complementing government policy initiatives.

Banks in Australia play a critical role in building the bridges between the onshore and offshore RMB markets. They invest heavily in developing their skills and capabilities and provide their customers with a growing range of products and services (including treasury and payment services).
Legal advisers and banks also work closely with corporates to provide thought leadership and insights into the developing legal and regulatory environment and to help navigate the environment effectively.
At an industry-wide level, the Australia – Hong Kong RMB Trade and Investment Dialogue held in Sydney in April 2013 led to the creation of an industry RMB Working Group¹¹. This Working Group has provided focus and leadership in raising market awareness of the RMB opportunities, product availability and need to develop RMB capabilities. Delegates at this year’s second annual Dialogue held in Hong Kong in April, committed to maintaining focus around corporate awareness, skills development and preparing business for increased RMB investment and capital flows.
Market participants and academia contribute significantly to the body of knowledge on the topic. An important research report by the Centre for International Finance and Regulation¹² provided some extremely helpful background information about the RMB international process, implications and opportunities, as well as the results of an industry wide survey on awareness of RMB invoicing opportunities.

Clearing and settlement arrangements

Currently, Hong Kong has been the primary clearing hub outside mainland China. However, new offshore mechanisms are developing, and China is also developing its own clearing markets.

It is not yet clear how this will evolve, but Australia has been active in creating practical options for RMB settlement.

In April 2014, the Australian Securities Exchange (ASX) and the Bank of China agrees to provide Australian and Chinese financial markets with RMB settlement services. The arrangement provides the backing of China's largest bank and the institutional backing of the ASX's settlement service, Austraclear, and when it becomes operational in July will provide a near real time settlement service for RMB settlement.

Longer term, it will also provide the basis for the local development of other RMB denominated financial products in the Chinese currency such as offshore RMB-denominated bonds.

The anticipated appointment of an official RMB Clearing Bank in Sydney will complement the ASX/BOC platform and create another option for direct settlement with mainland China.

Conclusion

As China moves steadily toward full RMB convertibility and pushes ahead with its reform agenda, the global influence of the RMB can only increase.

Many Australian companies have deferred taking action as there has been no immediate need nor perceived business advantage.

This stance, however, misses the fact that markets are changing rapidly and demand attention of boards and senior management. We know for a fact that:

China will be the growth engine of the world for decades to come
RMB will increasingly be used in international transactions
RMB will be widely traded
China can be expected to continue to de-regulate its financial markets and allow the market to play a more dominant role in the development of the currency’s cross-border market.

Failure to respond to the growing desire of trading partners to transact and invoice in RMB, and to be alert to the opportunity to accept and deploy RMB for investments or to issue or manage RMB denominated investment products, could put organisations at a competitive disadvantage. Conversely, whoever has a better understanding of these issues will do better in the future.

Nationally, the rise of the renminbi presents major strategic opportunity for Australia. We might debate the timing of full RMB convertibility and its rise to reserve currency status, but the process has started and it is almost inconceivable that it will slow down.

It is unquestionably in Australia’s national best interests to build on our existing strong economic relationship and partner with China and our regional counterparts as this process unfolds.

Sydney has long aspired to be a strong regional financial centre, but has struggled to implement the necessary policies and framework. China’s financial reform process brings with it both opportunity and a commercial imperative for government and the private sector to push ahead boldly, and with confidence, to achieve Sydney’s aspiration to become a major regional financial centre.

¹As cited by global transaction services organization SWIFT, Q4 2013

² Launched in 2009 this scheme allows all cross-border trade transactions to be conducted in RMB with simplified approval, processing and payment arrangements.

³This was an explicit goal of the Chinese government’s twelfth five-year plan in 2012 and was reaffirmed during the Third Plenum (a policymaking conference) in November 2013.

⁴For example, the Qualified Foreign Institutional Investor (QDII) scheme for foreign investment into listed mainland bonds and equities, the Qualified Domestic Institutional Investor (QDII) scheme allowing domestic institutions to covert RMB into foreign currency and invest in overseas equities, the R-QFII scheme allowing RMB raised offshore to be invested in mainland bonds and equities and a program to allow qualified foreign institutions to invest RMB in the Chinese inter-bank market.

⁵These include the Pilot Shanghai Free Trade Zone and the cross-border scheme between Qianhai and Hong Kong.

⁶R-QFII is a policy initiative which allows qualified foreign institutions the ability to channel RMB funds raised offshore into investments into mainland securities markets.

⁷In March 2014, Rio Tinto and Baosteel settled a sale of over 170,000 tonnes of iron ore in RMB, valued at over RMB114 million.

⁸ANZ Research: “Caged Tiger: The Transformation of the Asian Financial System”, March 2014

⁹ The Asia Region Funds Passport is an APEC initiative which aims to create a regulatory arrangement for the cross-border offer of collective investment schemes in participating economies. When operational in 2016 it is expected the passport will enable fund operators in passport member economies to offer eligible schemes to retail investors in other member economies under a streamlined process.

¹⁰ In April 2014, Bank of China, Sydney branch issued RMB 2 billion bonds. Reports indicated that the two-year bonds, with a coupon rate of 3.25 per cent, were well-received in the market, oversubscribed 1.45 times. Apparently 27.5 per cent of the bonds were subscribed by local investors.

¹¹ The Industry Working Group comprises representatives of the major Australian and several of the Hong Kong and international banks, with the active support of the RBA, Australian Treasury, HKMA, PBOC and King & Wood Mallesons.

¹²CIFR: “Internationalisation of the Renmimbi: Pathways, Implications and Opportunities”, 2014

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