By Leo Zhang
For a long time, Shanghai has been trailing behind regional financial centers like Hong Kong and Singapore in cross-border banking services due to strict regulatory control over capital flows imposed by mainland authorities.
As a result, only a select batch of domestic banks was allowed to be engaged in offshore banking business while foreign lenders faced quite a few limits in terms of offering international banking services on the mainland.
However, the industry landscape will likely be changed after the Chinese central government gives the green light to Shanghai, the country's financial capital, to start a new wave of reforms in a pilot free trade zone.
The State Council, China Cabinet, has officially approved the set-up of the zone in late September, with an aim to accelerate financial system innovation under the premise of ontrollable risk.
In November, the communiqué of the third plenum of the 18th Communist Party Central Committee also highlighted that accelerating the construction of the free trade zone and relaxing investment access and promoting economic openness. It is widely regarded as a general guideline for China reforms over the coming years to 2020.
As part of a long-term plan, the new zone will allow free yuan convertibility under the capital account, interest rate liberalization and cross-border yuan usage. Apart from establishing new outlets, foreign banks will also be allowed to form joint venture banks with private capital in the zone.
As for private banking and wealth management, the new Shanghai FTZ will bring investment opportunities for foreign investors, due to further opening of business scope. For example, in order to achieve full convertibility of the yuan and build Shanghai into an international financial center, China may speed up the liberalization of its capital account within the FTZ.
Based on the general guidelines, foreign individuals employed in the zone will be allowed to set up non-resident individual accounts with securities firms to carry out investment in domestic securities market, while individuals employed in the zone can also invest in foreign securities market. This will definitely create new business for foreign banks and asset management companies in the area of wealth management.
High hopes from participants Although detailed rules governing the banking sector in the FTZ are set to be unveiled in the middle of next year, a majority of Chinese and foreign banks have pinned high hopes in operating in the zone in terms of business innovation, especially in those cross-border sectors.
So far, more than a dozen of lenders have been approved to set up sub-branches in the new FTZ. Senior executives are upbeat about offering high-quality international financial services in the zone. Almost all domestic and foreign banks have plans to provide offshore banking services in the FTZ.
He look forward to operating in the FTZ. Expected to open early 2014, our sub-branch in the pilot zone will further extend our banking network. Our presence in the FTZ will enable us to leverage global financial expertise and tap into a new spectrum of opportunities, said Helen Wong, Deputy Chairman, President and CEO with HSBC China.
He will look to fulfill customers growing demands for cross-border financial services and innovative financial tools, particularly relating to the yuan as it develops into a global currency, she added.
Andrew Au, CEO of Citi China, echoed the view, noting that the US bank is ready to connect the free trade zone with the rest of the world. e have been working with many of our global clients to promote the free trade zone, and we will provide our full range of services to our clients to help them take advantage of what the free trade zone has to offer, he said.
Chinese mainland banks, including the country Big Four state-owned lenders, have already been approved to set up branches in the FTZ. Their major business is expected to include offshore banking, capital settlement, investment and wealth management, overseas financing, and bond issuance.
Bank of Communications, China fifth-biggest lender, also received the approval for a new branch and a financial subsidiary specifically for leasing aircraft and ships in the FTZ. Trust, fund management and insurance units of the financial group will open branches in the zone at the ppropriate time, the bank said.
Qian Wenhui, deputy president of BoCom, said that ross-border yuan business will be the focus of the new zone branch, and it one of our strongest strengths.
Larry Chen, China country head for Fidelity Worldwide Investment, one of the world largest fund managers, said that The opening of Shanghai free trade zone will bring about changes in finance, tax, trade and general government policies.
To facilitate trades and investments, we strongly believe that financial services companies including asset managers should have a key role in the overall development of the zone in order to create a strong and sustainable eco-system, he said.
Nora Wu, Global Board Member and Shanghai Senior Partner with PwC, pointed out that the FTZ may change the way Chinese and foreign companies manage their business can capital.
raditionally, Chinese enterprises, both state-owned and privately owned, would use an overseas business management platform in Hong Kong, Singapore or even in particular European countries as their investment platform for offshore financing and management of funds, Wu said. f the FTZ could create conditions comparable to these overseas platforms, it would be regarded as a new destination for Chinese companies to consider establishing their global headquarters.
For many multinational companies operating in China and for those who have regional headquarters based there, a relaxed financial and foreign exchange environment could help their regional funds management and settlement, Wu said. This would enhance the functionality and scope of influence of their China-based headquarters, she added.
Tony Cheung, Partner with KPMG China, said that he pilot content of the zone will gradually extend to the free exchange of the yuan and the liberalization of interest rates, which will promote the capital turnover of enterprises and bring about the formation of a new northeastern Asian, or even Asia-Pacific level, offshore financial center.
Even world-renowned offshore financial centers have shown interest in the FTZ. During a recent visit to Shanghai, Guernsey Chief Minister Peter Harwood said that the island has interest in operating in Shanghai new FTZ. He had a meeting of Tu Guangshao, Vice Mayor of Shanghai, who has recognized the quality and stability of Guernsey financial services industry.
As well as recognizing our achievements in financial regulation and development, the Vice Mayor also reiterated that Guernsey and China have shared great cooperation with each other in recent years, said Harwood. his relationship is something we are both eager to build on in the future, particularly at a time when Shanghai has taken the decision to establish a pilot free trade zone in the city. The pilot free trade zone formed a major part of our discussions and presents a great opportunity for Guernsey businesses.
As well as Deputy Harwood, the Guernsey delegation comprised Deputy Kevin Stewart, Guernsey Commerce and Employment Minister; William Mason, Director General of the Guernsey Financial Services Commission (GFSC); Fiona Le Poidevin, Chief Executive of Guernsey Finance the promotional agency for the Island finance industry internationally; and Wendy Weng, Guernsey Finance Representative in Shanghai.
Le Poidevin added: he trip was also very timely as changes in China, such as the pilot free trade zone in Shanghai and further liberalization of the Chinese economic system in general, are presenting increased opportunities for inward and outward investment. This is something Guernsey is perfectly placed to take advantage of as a leading international finance centre that can act as a gateway between China and the wider capital markets.
Lesson from Eurodollar market Although the reforms in the FTZ will likely make the yuan an increasingly important currency in the global foreign exchange market, some worry that the establishment of the FTZ will undermine the development of offshore yuan markets.
Such fear is unwarranted, said Nathan Chow, an economist with DBS Bank. ooking at the Eurodollar market could help shed light on how offshore market grows in spite of onshore deregulation.
During the 1960s, changes in US regulations such as reserve requirements, interest rate restrictions, and borrowing limits made offshore banking more attractive to local banks. Consequently, US dollar liquidity migrated to London, where non-US banks were not subject to regulation by the Federal Reserve. The Eurodollar market grew rapidly as a result.
In the late-1980s and early-90s, most of the regulations were eliminated. For instance, the Fed lowered reserve requirements on large-denomination domestic deposits to zero; in effect removing that ax on local intermediation. But the Eurodollar share of global dollar banking had grown from 10% in 70s to 20% in 90s and over 30% in mid-2000s. Non-US residents continued to hold the majority of their dollar offshore, and so did the official holders of dollar reserve (mostly overseas central banks). During the 2000s, more than 70% of official dollar reserves was placed outside the US. And interestingly, LIBOR is the benchmark for today US corporate borrowing.
Chow believed that the sustainable growth of the Eurodollar market can be attributed to a number of factors. Most characteristically, it has served as an efficient intermediary between non-US lenders and non-US borrowers of dollars (also known as third-party intermediation).
For example, the central bank of UAE deposits US$10 million in a London bank, which then lends the funds to a Mexican oil importer. In this case, the dollars might go through one or more offshore interbank transactions that could take place in London or other banking centers. But it does not require either sourcing funds or deploying funds in the US. Indeed, a significant portion of offshore dollar banking corresponded to such third-party intermediation.
As of June 10, of the US$4.9 trillion total claims booked offshore, US$2.7 trillion (or 55%) were claims on non-US residents. Convenience factors such as regulatory environment, accounting standards, and time zone difference might explain the market participants preferences for offshore transactions.
Chow pointed out that another motive is to separate currency risk from country risk. In September 2001, for instance, the trading of US Treasury securities was interrupted due to terrorist attacks. But overseas central banks with dollar securities held in European depositories were still able to carry out normal operations. That reminds official reserve managers the potential benefits of having diverse trading and custodial locations.
Therefore, Judging from the dollar experience, global investors prefer to transact in a particular currency through the offshore markets. ith respect to the yuan, the offshore market in Hong Kong and in other financial centers can be expected to evolve along the paths of the Eurodollar counterpart, Chow said. pecifically, there is always a demand for separating currency risk from country risk amid concerns over concentration of infrastructure or operational risk in one jurisdiction.
The fortunes of Hong Kong, Singapore and London After the set-up of the FTZ in Shanghai, a government body in Hong Kong recently called on the city financial regulators to rev up reforms in order to keep its competitive edges as a premier offshore yuan center.
In a document titled, "Proposals to advance the development of Hong Kong as an offshore renminbi centre," the Financial Services Development Council (FSDC) suggested that Hong Kong should develop its own policies to sustain its first-mover advantage.
To ensure Hong Kong's first mover advantage, some of the recommended measures include relaxing remittance restrictions on Hong Kong residents for yuan trade, allowing onshore companies to lend yuan to their offshore counterparts and attracting more companies from emerging economies of Brazil and India to issue bonds in Hong Kong's offshore yuan bond market, according to FSDC.
"The report recognises that Hong Kong is facing challenges arising from evolving global macroeconomic forces and emerging local threats, and that Hong Kong's leading position as an international financial centre is not entirely secure unless we work relentlessly to advance our competitiveness," Laura Cha, chairman of the FSDC, said.
In the past several years, Hong Kong has been competing with London and Singapore as well as mainland cities like Shanghai and Shenzhen in the financial services sector as mainland authorities gradually expands the internationalization of the yuan.
The yuan in Hong Kong as a proportion of total yuan in the offshore market declined to around 65 percent by September 2013 from a peak of nearly 90 percent in December 2011. Despite the rise of other offshore cities, Hong Kong remains China's top offshore yuan center by far. Offshore yuan deposits, including certificate of deposits, have reached approximately 1 trillion yuan, while the outstanding balance of yuan bonds issued offshore has exceeded 450 billion yuan.
Market observers believed that Shanghai has a long way to go to become a truly globalized financial center. According to AT Kearney 2012 Global Cities Index, Shanghai ranked 21st in the list while Hong Kong, Singapore, and London ranked 5th, 11th, and 2nd respectively. It suggests the mainland most prosperous city has yet to become a world-class city in terms of business activity, human capital, information exchange, and cultural experience.
In addition, foreign investors are also highly sensitive to changes of political atmosphere in the mainland, which is in transition towards a market economy amid fierce resistance from vested interest group, according to Chow with DBS Bank. Any severe domestic volatility has the potential to force sweeping governmental actions; including financial reform.
Against this backdrop, investors need alternative venues to diversify their yuan exposures. The growing appetite for Dim Sum bonds of overseas institutional investors (including central banks), some of whom already have access to the mainland bond market (through QFII scheme), can be seen as a result of such risk-diversification behavior.
Dim Sum bonds, notably, are being issued by not only mainland entities but also multilateral companies as well as international institutions, such as the World Bank and the Asian Development Bank. This underscores the fact that the offshore RMB market is, to an increasing extent, functioning as a platform for yuan financial activities conducted among non-Chinese residents.
Meanwhile, banks in Hong Kong are extending yuan credit lines to customers. The outstanding yuan loan stands at 88 billion yuan, from virtually zero three years ago. Such rapid growth of financing activities are the result of several encouraging policies, including allowing non-residents to borrow yuan and liberalizing banks yuan net open positions and statutory liquidity requirement.
The Treasury Markets Association also introduced CNH HIBOR fixing recently. This provides a benchmark to price loan facilities and facilitates the development of offshore yuan interest rate swap market. s the market deepens and a greater variety of yuan products become available, more yuan intermediation within the offshore markets will be seen, said Chow. dding to that is the less consistent appreciation expectation of the yuan. Non-resident borrowing in the yuan going forward will be less discouraged by the previous one-way expectations on the exchange rate.
Other offshore yuan centers also possess respective long term edges. Singapore, as a gateway to ASEAN and a commodities hub, could facilitate yuan-denominated trade across the region. For instance, an Indonesian mining company may settle its trade with a Malaysian customer in yuan as long as doing so enables them to lower transaction costs or manage currency risks better. In 2012, ASEAN surpassed Japan to become China No.2 importing region.
Besides, the yuan liquidity generated from trade flow, alongside the yuan acquired from swap lines signed with Beijing, could potentially be used in third-party transactions. Likewise, London, the largest handler of the world yuan payments outside mainland and Hong Kong, can develop a estern RMB hub by facilitating third-party use in the pan-European region. Given the significant difference in time zone, London role is complementary to Hong Kong and Singapore by allowing longer trading hours for businesses in EMEA (Europe, the Middle East and Africa) and beyond.
Historical experience has shown that onshore deregulation did not interrupt the growth of the offshore markets. Non-US residents, private and official alike, reveal strong preference for doing dollar business in the Eurodollar market. Such behavior prevailed even after US capital controls and key taxes were lifted, said Chow. hird-party intermediation has since become the norm for the Eurodollar market. An inference is that the offshore yuan markets will increasingly play a similar role of intermediating among non-Chinese residents. The benefit of such positioning can persist in the long term, even when the yuan becomes convertible. /span>