Thanks to China's continuedefforts in deepening financialreforms, the offshore RMBmarket has continued toexpand rapidly, as revealed by a recentreport by Deutsche Bank.
　　2014 marks the five-yearanniversary of RMB cross-borderbusiness. The report analyzes the keydevelopment milestones in the offshoreRMB market in 2014 and expects arobust growth in 2015.
　　Five milestones of offshoreRMB market
　　According to the report, the yearof 2014 witnessed five key developmentmilestones in the offshore RMB marketin the following areas.
　　(a) Liberalizing RMB cross-border flows: Deregulation is one of thekey structural reforms, and China hasimplemented many new rules in themanagement and regulatory oversightof RMB cross-border flows in 2014; forexample, the introduction of "negativelist" management in the SHFTZ,the simplification of regulatoryapproval for RMB cross-border flows,and the establishment of a RMBcross-border payment informationmanagement system. These policieshave greatly facilitated cross-bordertrade and investment settlement flows:during Jan-Nov 2014, RMB cross-border settlement flows amounted toRMB 6.8trn, up 52.5% from 2013.RMB trade settlement flows (YTDNovember) accounted for 21.32% ofChina's global trade volume, exceedingthe prior forecast of 20% for 2014.RMB has become the seventh globalpayment currency by SWIFT (with1.59% global share).
　　(b) Opening up,apital accounts,The greatest progress in 2014 has beenin liberalizing two-way capital accountflows, with the launch of the Shanghai-Hong Kong Stock Connect program;the expansion of the RMB QFIIprogram to more offshore centers inEurope, North America, the MiddleEast, and Australia-and the expansionof the total quota from RMB 400bnin 2013 to RMB 770bn currently;the expansion of interbank bondmarket access to foreign investors; theremoval of the PBoC's quota controlover the RMB QDII program; theexpansion of the RMB cross-bordercash pooling program nationwide;and the liberalization of RMB cross-border financing in the SHFTZ. Thesekey policies have not only broadenedinvestment channels for foreigners toaccess the onshore market and domesticinvestors to access the offshore market,allowing corporations to access cheaperoffshore financing, but also improvedthe RMB cross-border circulationmechanism and boosted the supply ofRMB liquidity to the offshore RMBmarket.
　　By the end of November 2014,about 98 foreign institutions hadreceived RMB QFII licenses withan investment quota of about RMB298bn. About 173 foreign institutionshave access to the onshore interbankbond market, with a total quota ofapproximately RMB 600bn accordingto the estimates. 　　RMB direct investment (ODIand FDI) settlement flows duringJanuary-November 2014 rose to RMB879bn, up 111% from 2013. RMBFDI accounted for over 31% of China'stotal FDI (excluding FDI by financialinstitutions), and RMB ODI accountedfor about 4.3% of China's totalcorporate outbound direct investments.
　　(C) Accelerating interest rate andexchange rate reforms: The wideningof the RMB vs. USD spot FX tradingband to +/-2%, the launch of directtrading between RMB and majorglobal currencies (NZD, GBP, EURand SGD), RMB demonstratingincreasing two-way volatility, and therecent deposit rate liberalization are keysteps in laying out a policy frameworkwith the objective of moving towardsRMB convertibility. Such liberalizationpolicies will drive the adoption ofRMB for trade and investmentpurposes. Moreover, they reafiirm ourexpectation that China will completeinterest rate liberalization reformstowards the end of2016 and makeRMB fully convertible in 2020.
　　(d) Strengthening offshore RMBinfrastructure and boosting globalfinancing cooperation. To assist theexpansion of RMB business to moreoffshore centers, the PBoC designedseven new RMB Clearing Banks in2014 and signed RMB swaplines withsix central banks. The PBoC currentlymaintains RMB cross-currencyswaplines with 28 central banks with atotal notional amount of RMB 3.1trn.Currently about 30 central banks andsovereign wealth funds have includedRMB in their official reserves andRMB has become the seventh globalreserve currency. The HKMA hasrefined its RMB liquidity facilityto ensure sufficient RMB liquidityprovision in the CNH market andto support the liquidity needs of theShanghai-Hong Kong Stock Connectprogram.
　　(e) Steady growth in the offshoreRMB liquidity pool and offshore RMBproducts.
　　Offshore RMB deposit base:Thereport estimates that the offshore RMBmarket deposit base stood at RMB2.2trn by the end of October 2014,up 35% from 2013's RMB l.63trn.Relative t0 2013, RMB depositsgrowth this year has been particularlystrong in Taiwan (up 40%), Macau(+42%), Singapore (+32%), Seoul, andEuropean centers. The slowdown inoffshore RMB deposit growth in Q4 isattributable to the broad USD strengthand rising volatilities in the CNH spotand forward markets.
　　Offshore RMB fixed incomemarket: Gross supply in the offshoreRMB market reached RMB 560bnin 2014, up 46% from 2013. The sizeof the offshore RMB fixed incomemarket is up 31% from 2013 to RMB760bn: the offshore RMB bond marketgrew 40% to RMB 500bn, while theCD market grew 7%. It is expectedthat 2014 net issuance in the offshoreRMB market is about RMB 190bn,wellbelow the forecast of RMB 300bn.It is believed that the slowing pace ofbond and CD supply in 2014 reflects: (a)rising concerns about CNH exposure asCNH has depreciated by over 2% YTDvs. the USD; (b) corporate fundingcosts having become less attractive sinceApril as a result of tightening CNHliquidity conditions; and (c) tighterregulation over trade financing and theUSD rally having cooled demand fortrade financing, thereby reducing thedemand for CD issuance. 　　Regionally, in Taiwan, RMBFormosa bond issuance rose 96%,bringing the total RMB Formosa bondmarket to RMB 31.4bn. In October2014, the British government becamethe first (other than China) to issueRMB sovereign bonds in the offshoreRMB market. In terms ofissuers,supranationals and a number of foreignstates have become more active in theCNH bond market in 2014.
　　CNH credits have underper-formed Asia IG USD bonds. The totalreturn of the CNH bonds tracked byS&P and DB's CNH Bond Index is3.07% in CNH and 0.79% in USD.In USD terms, the CNH bonds haveunderperformed the Asia IG bonds(which have returned 9.2% YTD); thereport notes this is attributable to theCNH depreciation against the USDand underperformance of CNH creditsby Chinese names (the credit sub-indexyield has risen 87bps YTD).
　　Regionally, in Taiwan, RMBFormosa bond issuance rose 96%,bringing the total RMB Formosa bondmarket to RMB 31.4bn. In October2014, the British government becamethe first (other than China) to issueRMB sovereign bonds in the offshoreRMB market. In terms ofissuers,supranationals and a number of foreignstates have become more active in theCNH bond market in 2014.
　　CNH credits have underperf-ormed Asia IG USD bonds. The totalreturn of the CNH bonds tracked by S&Pand DB's CNH Bond Index is 3.07% inCNH and 0.79% in USD. In USD terms,the CNH bonds have underperformedthe Asia IG bonds (which have returned9.2% YTD); the report notes that thisis attributable to the CNH depreciationagainst the USD and underperformance ofCNH credits by Chinese names (the creditsub-index yield has risen 87bps YTD).
　　Propect of continuous growth
　　In 2015, the report expects continuedrobust growth in the offshore RMB market,reaping the benefits of favorable policy andmarket infrastructure, and the consolidationof RMB as an increasingly internati-onalized currency.
　　Specifically, the report expects thefollowing developments and policies in2015.
　　(a) Expansion of the Free Trade Zoneto more regions to support RMB cross-border business. Progress made in theoffshore RMB market in SHFTZ wasunderstandably slow in 2014, as the newpolicy framework to open up the domesticmarket remains in the development andexperimentation stages. On December 12,2014 the State Council decided to expandthe FTZ to include Guangdong, Tianjin,and Fujian, with Shanghai the leading FTZin policy experimentation. The report viewsthis announcement as very positive becausehaving four FTZs should accelerate the paceof policy reforms with regard to liberalizingcross-border investment, trade, financialmarkets, and opening up the service sector(with up t0 28 reforms). In 2015 the reportauthors expect growth in RMB cross-border financing (in loans and bonds) andinvestment settlement flows in these FTZ. 　　(b) RMB clearing banks in LatinAmerica and possibly other regions.The RMB clearing banks are critical infacilitating RMB cross-border settlement,especiallyin supporting Chinese companies"going out". With RMB clearing'-bankshaving expanded to most financial centersin Asia, Europe, and the Middle East, andto Canada, the report authors expect moreRMB clearing banks to be appointed inthe Americas in 2015, most likely in SouthAmerica (in Brazil, for example).
　　(c). Expansion of two-way RMBinvestment schemes. During January-November 2014, about RMB 140bn RMBQFII quota and about USD 16bn QFIIquota were granted, plus approximately aRMB 150bn quota under the interbankbond market direct access program, A-shareinvestment under the Northbound tradingof the Stock Connect is about RMB 60bn.The report authors expect the ShenzhenStock Connect to be launched in the secondhalf of 2015, with roughly half of the quotaof the Shanghai Stock Connect program.The likely expansion of China's StockConnect program implies that the demandfor additional RMB QFII quota for HongKong (the RMB 270bn quota has been fullygranted) will be low.
　　With about 80% of the Northboundtrading and about 94% of the Southboundtrading yet to be utilized, the authors expectthe pace of quota approval under variousRMB investment programs to be similarto that in 2014. In 2015, the authors expectboth corporate ODI investment flows andthe RMB QDII program to grow at a fasterpace than in 2014. The liberalization ofoutward RMB flows is intended to bothincrease RMB supply to the offshore RMBmarket and also neutralize the impact ofRMB investment into China to maintainthe BOP at a balanced level.
　　(d) Offshore RMB marketdevelopment forecast: In 2015, the reportauthors expect RMB trade settlement flowsto grow by 17% to RMB 7trn, supportedby the expansion of RMB business to moreoffshore centers and the liberalization ofRMB cross-border flows. RMB tradesettlement should account for 25% ofChina's global trade, up from 21% in 2014.It is expected that the average RMB spotand forward FX trading volume to rise toUSD 14bn/ day from USD 12.5bn/day in2014. It is estimated that the CNH CCSdaily turnover will average about USD lbnand CNH FX option daily trading volumewill average USD 5.5-6bn, vs. USD Sbn in2014.
　　The report authors expect the offshoreRMB deposit pool to grow 30% to RMB3.25trn by the end of 2015, boosted byRMB investment and diversificationdemand from corporates, institutions, andforeign central banks. The authors call forRMB 250bn net issuance in the offshoreRMB fixed income market in 2015, with80% of supply in the cash bond market.With CNH funding costs likely to easefollowing China's monetary policy easing,the authors are likely to see more supplyfrom Chinese local governments and localcorporates. The report forecasts theCNH bond market will deliver 4.5%total return both in RMB and USDterms in 2015, slightly higher thanin 2014 as the authors expect theunderperformance driven by recentcredit events to be corrected in Hl in2015. 　　(e) RMB continues to see two-way volatility and CNH CCS rates arelikely to fall. The RMB complex tradedsharply weaker recently, with bothUSD/CNY and USD/CNH breakingthrough 6.20 for the first time sinceJuly 2014, despite the stronger-than-expected USD/CNY fixing. The lasttime RMB faced significant weakeningpressure was in late February 2013.Back then, it was mostly due to thePBoC, which the report authors believewas trying to flush out speculativepositioning. This time, as the authorsexpected, the move is much moremarket-driven.
　　To be sure, some of this weaknesscan be blamed on the negative spillovereffect from the change in the repocollateral rules, which has caused asharp squeeze on rates. But the authorsbelieve the move is more broadly areflection of l) slowing growth andbroadening disinflation; 2) a pick-up incapitaloutflows; 3) credit de-leveraging;and 4) valuations approaching expensiveextremes. On point 2, the authorsbelieve the outflows are being driven bya) hedge adjustments by corporates; andb) the repayment of outstanding foreigndebt.
　　Over the next few weeks thecrunch time for the PBoC's reaction tothe weakening in the RMB complexmight come. The RMB risk sentimentindex has been lifting off sharply (abearish RMB signal). In the absenceof any significant fiscal stimulus orintervention, onshore USD/CNYspot could reach the top ofits tradingband. The PBoC will have two choices:intervene and push spot lower, orgradually start fixing USD/CNYhigher. The authors' view is that FXpolicy will be more "hands off" thistime, and will act only to smooth RMBvolatility. If so, moreyweakness shouldbe seen to come for USD/CNH.
　　CNH vol spiked once more andcame close to recent highs. In theauthors' view, CNH vol will likelyremain elevated in lQ15. Given themore restricted regulatory environmentgoverning the recommendationof Target Profit Forwards (TPFs)products, particularly in Taiwan, andongoing RMB weakness, the authorsbelieve the appetite of corporates andprivate banking clients for TPFs will belower than in recent years.
　　Trading strategy: Although thereport authors are yet to initiate a longUSD/RMB trade, they have beenrecommending buying USD/TWDor USD/KRW as proxy trades on thisreversalin RMB fortunes.
　　On the CCS curve, the authorsthink the CNH CCS rates areincreasingly attractive and investorsshould consider receiving for thefollowing reasons: (a) CNH liquidityriskis manageable; (b) there is a limitedimpact from the expansion of theRQFII scheme; (c) CNH bond issuanceswapping into USD is more cost-efficient for corporate borrowers thanalternative USD financing; (d) payinginterest on the CNH CCS curve forhedging over long-term cross-borderRMB lending is likely to weaken;and (e) the CCS curve has priced ina significant risk premium for USDstrength and higher USD rates. Theauthors have recommended receivingCNH CCS 3Y at 3% with a target of2.4% and a stop loss of3.2%.