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November 2012

China’s Big Bang

New leaders ready to revolutionise the financial system

As the West wobbles, Beijing eyes sweeping reforms in the next 3-5 years

Interest rates to be liberalised, the bond market to double in size...

...and the RMB to become convertible within five years

By Qu Hongbin, Sun Junwei and Ma Xiaoping

Disclosures and Disclaimer This report must be read with the disclosures and analyst

certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it



November 2012



As the West wobbles, all eyes have now turned East to see what China’s leaders will do to stimulate the

economy. While there’s little doubt that policymakers will gear up both monetary and fiscal easing, likely

leading to a modest recovery in the coming quarters, focusing on short-term stimulus misses a far more

important trend – a swathe of co-ordinated reforms which we believe will revolutionalise the country’s

financial system. In fact, there are clear signs that China’s new leaders, who will take power in early

2013, will make speeding up reform top of their policy agenda in the coming years.

This chain reaction will change the trajectory of the institutions and policies that are all intertwined –

banks, bonds, interest rates, the opening of the capital account and the convertibility of the RMB –

triggering a wave of deregulation that could happen much faster than many people think. We think

interest rates will be liberalised, the bond market will double in size and the RMB will become

convertible within five years. These changes would not only make capital allocation more efficient,

boosting the private sector, but also provide the middle class with greater choice about where to put their

money so they can earn a higher return and therefore spend more. This should help rebalance growth

from investment to consumption and lift the potential growth rate in the coming years.

This report looks at how this process will unfold over the next three to five years. Reforming China’s

financial system is unlikely to be a simple process. There will be bumps in the road and perhaps an

occasional diversion. But plenty of other countries have already gone down this route and we think

Beijing’s policymakers can learn from what was successful and avoid repeating some of the mistakes that

were made along the way.

Banks to bonds

The debt problems of local government financing vehicles reflect the pressing need for China to shift the

burden of distributing credit from banks to capital markets. The country has witnessed the largest and

fastest migration from the countryside to the cities in history, creating massive demand for investment in

railways, roads, bridges and other infrastructure projects related to urbanisation. Money is not an issue

given the country has a domestic savings rate above 50%, the highest in the world. Yet the absence of

long-term financing instruments means the projects have had to rely on bank loans for funding, resulting

in a big mismatch between the payback period of these projects and the maturities of bank loans.

To address this problem and meet future demand for funding urbanisation, Beijing is speeding up the

development of bond markets and other long-term financing instruments. Pilot programmes for municipal

and high-yield bonds have been introduced and the issuance of corporate bonds is also picking up. Given

the estimated RMB20-30trn of urbanisation-driven infrastructure investment in the next 10 years and the




November 2012


12th Five-year Plan’s goal to lift the ratio of direct financing to 15%, we expect the expansion of

municipal and corporate bonds to double the size of the domestic bond markets in the coming five years.

However, some daunting challenges remain, such as the unification of the fragmented bond markets, the

establishment of a single set of regulations governing new issuances and the development of a stronger

institutional framework for the market. We believe that allowing sophisticated global institutions to

participate can help improve market efficiency. A wider, deeper bond market will likely give the banks

much more incentive to focus on financing small and medium-sized enterprises (SMEs) and consumers.

And a pilot reform programme in Wenzhou should also help explore new options for funding SMEs, the

life blood of China’s economy; according to an industry body, SMEs account for 65% of GDP, 50% of

taxes and eight out of 10 jobs.

Liberalising interest rates

The latest move by the People’s Bank of China (PBoC) to widen the floating band of both deposit and

lending rates while cutting interest rates is a positive surprise. We see this as an indication of Beijing’s

determination to push forward interest rate liberalisation in the coming years. Consensus on the need to

liberalise interest rates was reached many years ago, but reform was delayed by concerns that financial

institutions were not ready. Today, all the major state banks have been restructured and are more

commercially-driven and the non-state sector takes nearly 60% of total investment. The time is now ripe

to free interest rates, especially given the pressing need to deepen capital markets. The recent adjustment

to the ceiling for deposit and lending rates by the PBoC is the first step and more moves will likely follow

in the coming years. Meanwhile, we also expect the PBoC to gradually create a single benchmark in the

next three years, leaving all other rates freely determined by the market.

Renminbi internationalisation is taking off

Since Beijing introduced a pilot scheme to expand the role of the RMB in cross-border trade settlement

and capital flows in 2009, the momentum has been much stronger than expected. The proportion of

China’s total trade settled in RMB has quadrupled, topping 11% in the first three quarters of 2012,

reflecting the pent-up demand for switching from issuing invoices in USD to RMB when trading with

China. In our view, this ratio is likely to reach 30% in the next three years. In volume terms, this would

make the RMB one of the top three global trade settlement currencies. This, of course, doesn’t give the

RMB the status of a real global and reserve currency, as this requires full convertibility. That said, seven

foreign reserve managers are starting to invest in RMB bonds and other assets, although the amount is

relatively small.

The currency is set to become fully convertible in five years

When it comes to capital account liberalisation China is likely to adopt a gradual approach. Yet Beijing is

now more confident than ever about speeding up the process, considering that: 1) China’s trade balance is

back on an even keel (the current account-GDP ratio has fallen below 3%) and the RMB is now close to

its market equilibrium rate; 2) domestic financial reforms have already made progress and will likely gain

momentum in the coming years; and 3) the role of the RMB in cross-border trade and investment should

continue to expand quickly. Further changes in the coming years are likely to include the further

expansion of the Qualified Foreign Institutional Investor (QFII) and the Qualified Domestic Institutional




November 2012


Investor (QDII) schemes, a gradual removal of limits on foreign currency purchases by both local and

foreign individuals and increased foreign access to domestic capital markets. Combined with China’s

policy of promoting both foreign and outward direct investment, these moves will make the RMB fully

convertible within five years, in our view. Although certain restrictions on capital inflows will likely

remain, full RMB convertibility would take China’s financial integration with global markets to a new

level and have a profound impact on both China and the world.

The challenges

The experiences of other countries show that the road to financial reform, especially capital account

liberalisation, tends to be a bumpy one. To stay on track and to avoid major distortions, China must get

the sequence of the reforms right, that is, to strengthen its domestic banking system, liberalise interest

rates and develop a functioning bond market before making the RMB convertible. Meanwhile, the

success of the financial reforms will also depend on Beijing pushing through changes in other areas,

including fiscal and legal reforms. As people in the investment world are well aware, the term “Big

Bang” refers to major reforms introduced in the UK in 1986 that transformed the country’s financial

services industry from a protected species into a global powerhouse. The increase in financial activity

completely altered the structure of the market. Now it’s China turn.




November 2012


China: Economic and financial reforms in the pipeline

Exchange rate reform

Why: As part of the plan to make the RMB a more international currency

China has pledged to make the exchange rate more market-oriented. In April

2012 it met this commitment by expanding the daily trading band against the

USD for the first time since 2007 to 1%, up from 0.5%.

Obstacles: Concerns that a widening of the trading band would increase

speculation about currency appreciation, triggering inflows of speculative

cash, appear to be fading. Some areas of the government – notably the

Ministry of Commerce – have opposed reforms that could lead to a stronger

RMB, which undermines the competitiveness of China’s exports.

What’s happening: With a wider trading band we can expect more two-way

volatility, less consistent appreciation, and faster internationalisation of the

currency. Total trade settled in RMB increased four-fold in 2011 to reach

RMB2.1trn (USD330bn), about 9% of China’s total trade last year.

Timeline: A managed-floating currency within five years.

Opening the capital account

Why: Liberalisation of China’s capital account would give foreigners greater

opportunity to invest in mainland capital markets and domestic investors the

option to invest overseas. Capital allocation would become more efficient as

China’s financial institutions are forced to compete for funds with overseas

counterparts. This would also increase pressure to introduce interest and

exchange-rate reform, as large cross-border capital flows make control of

these rates difficult to maintain.

Obstacles: The authorities believe that capital controls protected the Chinese

economy from the volatile international capital flows that hit its Asian

neighbours during the 1997-98 Asian financial crisis and again during the

2008-09 global financial crisis.

What’s happening: The PBoC, China’s central bank, this year released a

report outlining a potential roadmap to capital account reform ending with full

convertibility of the RMB.

Timeline: Gradual reforms over the next 3-5 years.

Interest-rate liberalisation

Why: Phasing out government control of interest rates would enable market

forces to play a greater role in capital allocation, allowing capital to flow to the

most dynamic sectors of the economy. This would also help shift the balance

of the economy towards consumption as higher bank deposit rates would give

households more spending power, while higher lending rates would reduce

excess investment.

Obstacles: The big state-owned banks profit from the guaranteed spread

between lending and deposit rates. State industrial firms also benefit from

access to cheap capital. These groups are likely to oppose reform.

What’s happening: Top central bank officials have said the time is ripe for

interest rate reform and that the government has a timeline for

implementation. Premier Wen Jiabao recently criticised “monopoly” profits by

large banks. But no concrete measures have been announced.

Timeline: Within three years but reform is likely to be gradual.

Opening monopoly sectors to private investment

Why: Allowing private firms to invest in the country’s railways, banking, energy

and healthcare sectors will boost the economy. The potentially lucrative

services sectors could help hard-pressed private firms shift from low-end


Obstacles: State industrial giants, which received the bulk of Beijing’s

massive spending package during the 2008-09 global crisis, have long

enjoyed favourable positions and they are reluctant to see more competition.

What’s happening: The State Council is making a fresh bid to open up

sectors dominated by state giants.

Timeline: The NDRC, the main economic policy body, has pledged to publish

details of its plan (called the New 36-Clauses) but how quickly reform will be

implemented remains uncertain.

Bond market reform

Why: A more developed bond market would increase the efficiency of capital

allocation. It would also help to reduce the current concentration of financial

risk in the banking system. The high-yield bond market and the privateplacement

SME bonds that China’s securities regulator are promoting should

widen credit channels for small, private firms which struggle to get access to

the state-dominated financial system.

Obstacle: Bureaucratic turf battles have prevented the unification of China's

two main bond markets and the establishment of a single set of regulations

governing new issuance.

What’s happening: China’s bond market development is hindered by the

fragmentation of the market. Different regulators oversee different types of

bonds, which also trade in different markets. However, a recent

announcement by the central bank indicated some progress towards greater

coordination among regulators.

Timeline: The private-placement SME bonds market was launched in June,

but unification of the regulatory structure will take longer.

Equity listings by overseas companies

Why: Shanghai's stock exchange is considering launching an international

board that will allow foreign companies and red-chip Chinese companies

(those incorporated and listed overseas) to list and give Chinese investors

direct access to foreign firms’ shares.

Obstacles: This is closely linked to capital-account and exchange-rate reform.

Regulators are still working out which currency the shares would be

denominated in, and currency conversion restrictions would have to be revised

to enable foreign companies to transfer capital raised in China for use in other


What’s happening: The regulator says it will launch the international board

when conditions “mature” but has given no timeline.

Timeline: 1-2 years.




November 2012


Fiscal reform

Why: A revised tax system would enable local governments to finance their

increased social spending obligations – healthcare, education, pensions, and lowcost

housing – without relying on land sales and financial help from the central

government. A property valuation or transaction tax would also help to reduce overinvestment

in property. Allowing local governments to issue bonds directly would

also decrease the need to use heavily-indebted local government financing vehicles

(LGFVs) to raise money.

Obstacles: The central government may be reluctant to cede revenue to local

governments. Property developers and current homeowners oppose new property

taxes, which could bring down the value of their assets.

What’s happening: Property-tax pilot schemes are under way in Shanghai and

Chongqing and may soon be expanded to Guangzhou and Nanjing. The cities of

Shanghai and Shenzhen and the provinces of Guangdong and Zhejiang became

the first local governments to issue local government bonds in late 2011, and the

Ministry of Finance expanded the quota for local-government bond issuance for

2012 to RMB250bn (USD39.6bn).

Timeline: This year for expanded property tax trial and local government bonds;

unknown for broader fiscal reform.

Resource pricing, taxes

Why: The NDRC has said it will accelerate reforms to its energy pricing

system, which aims to make domestic fuel and gas prices closer in line with

international rates. This would likely lead to more frequent changes in retail

fuel and power prices. Senior NDRC officials said in March that Beijing will roll

out tiered power pricing for residential customers by the first half of this year to

charge higher prices for heavy users.

Obstacles: Inflationary pressure could prompt authorities to hold off on

introducing reforms that would push up prices in the short term.

Timeline: Some changes are likely in the next few months.

Financial and commodity derivatives

Why: China is considering launching new financial derivatives linked to the

RMB exchange rate, foreign currencies, international bonds and Chinese bank

interest rates. Simulated trading of government-bond futures is under way on

the Shanghai-based China Financial Futures Exchange. Regulators have also

said they will gradually open up the country’s commodity exchanges to allow

foreign investors to trade futures.

Obstacles: A government bond futures trading scandal in 1995 is still fresh in

the minds of many officials and traders. Such fears are supported by the fact

that China’s tightly controlled interest and exchange rates offer domestic

financial institutions little experience in managing related risks.

Timeline: Individual products will be launched gradually.

Residence permit (Hukou) reform

Why: Since 2011 more than 50% of the population now lives in cities. The full

potential of urbanisation will not be unlocked until migrants are allowed to

settle in cities permanently. The hukou system prevents people from getting

access to healthcare and schools for their children.

Obstacles: China’s leaders fear that a sudden influx from the countryside into

big cities could undermine social stability and create slums.

What’s happening: The government is taking small steps to overhaul the

system by launching pilot schemes in smaller cities.

Timeline: Unclear.

Source Reuters, Bloomberg, NDRC, HSBC.




November 2012



From banks to bonds 7

The world’s next big bond

market 14

How to set interest rates free 22

Going global 30

The rise of the redback 37

A convertible RMB within five

years 44

Learning the lessons 52

Disclosure appendix 59

Disclaimer 60




November 2012


From banks to bonds

Banks have dominated China’s financial landscape for decades;

this needs to change – the bond market must play a bigger role

The problem of local government debt could be resolved by a bond

for loans swap; this would give bonds a huge lift

A stronger bond market would offer a cheaper source of finance,

forcing banks to switch their focus to small companies

Too big for comfort

China’s state-owned banks are goliaths. It has

been 11 years since China’s accession to the

World Trade Organisation, when Beijing

promised to speed up the opening of its financial

markets, but the banks still dominate the

channelling of the nation’s vast savings into

different areas of investment.

Their true power was seen during the global

financial crisis. They made loans of RMB9.6trn in

2009 and RMB7.6trn in 2010 (up from RMB5trn

in 2008) as Beijing rolled out a massive stimulus

package to prop up growth. The outstanding bank

lending to GDP ratio jumped to 120% in 2010

from 97% in 2008.

At the end of 2011 bank assets topped

RMB113.3trn, three times the total in 2005, the

year that major state banks went public. Despite

slowing from the peak of over 40% at the end of

2010, bank loans are still growing at around 16%

y-o-y, faster than nominal GDP growth (around

10% in the first three quarters of 2012). The

M2/GDP ratio – which compares credit expansion

with economic growth – surged to 1.87 at the end

3Q 2012 from around 1.5 before the financial

crisis in 2008.

This needs to change. The problem is that reform

represents a formidable challenge for the big stateowned

banks which make huge profits from their

loan books. For example, any narrowing of the gap

between savings and lending interest rates will be a

major issue. The net interest margin – the

difference between the two rates – is the lifeblood

of China’s banks, on average representing around

80% of total operating income. They have a lot to

lose and may resist change.

In contrast to bank loans, financing through the

bond and equity markets has lagged behind. In

2011, total RMB bond issuance (including

treasury bonds and financial bonds issued by

policy banks) accounted for 46% of total

financing – bank loans, bonds and the stock

market – down from 57% in 2008. This ratio

dropped to 38% in the first three quarters of 2012

(see Chart 1.1).

This is much lower than in neighbouring countries.

For example, in South Korea over 85% of

financing was done through the bond market over

2010-11 (see Chart 1.2). In China, bond financing

as a percentage of total GDP has remained below

20% over the past two years; in Korea this ratio

was more than 33% over the same period.




November 2012


Chart 1.1 Fundraising in China {delete asterisk-Production}








(RMB bn)

Source: CEIC, HSBC

2006 2007 2008 2009 2010 2011 2012*

Equity (Lhs)

Bonds (Lhs)

Loans (Lhs)

Bonds as % of total financing (Rhs)

Chart 1.2 Direct financing in China needs to develop








Source: CEIC, HSBC 2010-11

Equity Loans Bonds



Chart 1.3. Loan growth and loans to GDP ratio







(%, y r)

1998 2000 2002 2004 2006 2008 2010 2012f

Source: CEIC, HSBC

Loan to GDP ratio (Lhs)

Loan grow th (Rhs)














Bonding with bonds

Beijing wants to “significantly lift the share of

direct financing” and “actively promote the

development of the bond market,” according to

the 12 th Five-year Plan (2011-15). More

specifically, in the financial sector’s 12 th Fiveyear

Plan announced in September 2012, Beijing

wants direct financing to total at least 15% by

2015, up from 14% in 2011.

Recent policy initiatives suggest things are really

starting to move. In January the influential

National Financial Work Conference, held once

every five years, stressed the importance of

building a standardised, unified bond market (see

China: National Financial Work Conference hints

further easing and reform, 8 January 2012).

Then, in April, the three bodies that oversee

different types of bonds – the PBoC, the National

Development and Reform Commission (NDRC)

and the China Securities Regulatory Commission

(CSRC) – put together a scheme for a coordinated

corporate bond market, a big step

towards ending the fragmented way bonds are

regulated. We see this as a signal that Beijing is

serious about developing the bond market.

Indeed, Guo Shuqing, the head of the CSRC, told

the official People’s Daily newspaper in June that

international experience shows that overreliance

on bank credit in a financial system can, under

certain circumstances, lead to systemic risk,”

adding that the bond market, “seriously” lags

behind the demands of the real economy (source:

Bloomberg, 12 June).

Since June, corporate bond issuance has started to

accelerate in tandem with efforts to stabilise growth,

such as monetary easing and the approval of a wide

range of infrastructure projects. The average

monthly issuance of corporate bonds topped

RMB173bn by September, more than 50% higher

than the monthly average of RMB113.8bn in 2011.




November 2012


Chart 1.4 The surge of corporate bond issuance

(RMB bn)








Jan-11 May -11 Sep-11 Jan-12 May -12 Sep-12

Corporate bond issuance

Source: CEIC, HSBC

Policymakers have good reason to believe that

bank lending, supported by the huge deposit base,

is an unsustainable form of financing. They

believe it can no longer meet the infrastructure

financing needs associated with rapid urbanisation

because of the funding limits and maturity

mismatches involved in bank lending.

First, the problem of mismatches between asset

and debt maturities has become pronounced.

While more than 50% of bank deposits are

demand deposits, the bulk of lending comes in the

form of mid-to-long term loans. This mismatch

has become more pronounced as banks keep

making more mid-to-long-term loans.

Second, the excessive lending triggered by the

massive stimulus package that Beijing rolled out

to weather the global economic crisis has

increased the risks of a rebound in nonperforming

loans, which have risen for three

consecutive quarters (although the NPL ratio is

almost flat). This is because the bulk of bank

lending went to LGFVs, large infrastructure

projects and state-owned conglomerates and some

of these government-led projects didn’t generate

enough returns to service the loans.

This underlines the need to change the financing

structure of China’s economy in the post-crisis

era because:

In the short term, the local government debt

problem shows that bank lending is not the

way to meet the huge and ever-growing need

for infrastructure investment. This is why it is

so important to accelerate the development of

the bond market.

In the long term, an effective financial market

would channel savings to where they are most

needed. A properly functioning bond market

would not only offer lower cost of financing

than the banks but also more effective capital

allocation as it can price risk in a more

efficient way. This would serve the financing

needs of businesses, big infrastructure

projects and different levels of government.

Bond for loans swap can fix

the local debt problem

It is high time to fix the problem of LGFVs to

minimise the loss to the banking system and avoid

another round of bail-outs. The main problem

facing local governments is liquidity. They cannot

service their bank loans because many of the

long-term infrastructure projects they borrowed

money to develop are not generating sufficient

returns. But there’s no sovereign risk, as there is

in some struggling European countries. Their

balance sheets, while often lacking transparency,

remain generally strong thanks to the

accumulation of valuable assets such as

infrastructure projects and land purchases.

In our view, the most feasible solution is a bond for

loans swap which, in turn, could be the catalyst that

triggers bond market reform (see China Economic

Spotlight: Time to restructure local government

debt, 29 July 2010; China Inside Out: Local debt:

Three options, 1 August 2011).

It would work like this. Between 2009 and 2011,

Beijing issued RMB200bn of bonds annually on

behalf of provincial governments to support local

projects and this year the amount was raised to

RMB250bn. The central government would now




November 2012


issue even more long-term construction bonds on

behalf of local governments, enabling them to repay

the loans they used to fund public work projects.

This would be easy to do as it does not require

any change in the fiscal arrangements between the

central and local governments. With the money

raised by the bonds, local government could either

finance the ongoing construction projects or repay

bank lending to avoid a default.

The central government would be able to issue

debt at a lower cost of funding than local

governments. Demand for these central

government bonds should not be an issue, given

1) the huge pool of funds sitting idle in individual

deposit saving accounts (RMB38trn); 2) demand

for this type of government debt from insurance

and mutual funds in China is rising.

More importantly, Beijing has allowed certain

prosperous local governments to issue their own

bonds to service existing debt and raise funds for

new projects. The obvious advantage of this

option is that each local government’s debt will be

priced by the market according to its own specific

set of credit ratings, effectively imposing market

discipline on local governments.

We expect more progress on this front but

expanding the scheme to the whole nation would

require an amendment to China’s budget law as

well as local governments adopting much higher

accounting standards, so it may take time. Clearer

delineation between local and central government

ownership rights of state assets is also needed.

The sale of state assets by local governments to

raise funds to repay loans could also help solve

the debt problem. Local governments still own

more than 20,000 state-owned enterprises (SOEs),

of which 70% are profitable. Local governments

also own toll roads, ports and other commercially

valuable assets. Selling these assets would help

them to repay their debts.

These sales are also necessary if local governments

are to shift their attention away from business

activities to public services – an important objective

for government reforms in the next five years.

Public listing of local SOEs would be the best way

to do this, but the real challenge here is how to

manage the sales of these assets transparently.

A bigger bond market needed

to finance urbanisation

The increasing lure of urban life also has major

implications for the bond market as more financing

is required by China’s cities and towns. For the first

time in the country’s history, more people now live

in urban areas than in the countryside.

At the end of last year, 51.3% of the population

were city dwellers, up from 20% 30 years ago

when China was just starting to open up its

economy. This implies that an average of 10m

people have left the countryside each year, a trend

that is likely to keep accelerating as China catches

up with developed countries. As Chart 1.6 shows, it

may take at least another two to three decades for

China’s urbanisation rate to match that of the US.

Chart 1.5. The rise and rise of urbanisation









1950 1960 1970 1980 1990 2000 2010

Source: CEIC, HSBC

Urban population as % of total (Left ax is)






Percentage points change ev ery 5 y ears (Right ax is)




November 2012


Chart 1.6. Urbanisation: Following in the footsteps of the US



1970 1990 2010







Rural population as % of total

1840 1860 1880 1910 1930 1950 1970 1990 2010


China (upper scale)

Source: US Census Bureau, CEIC, HSBC

This means huge demand for infrastructure

investment. If history is a guide, for every new

urban citizen migrating from the countryside

investment of at least RMB100,000 in urban

infrastructure is needed (source: the China

Development and Research Foundation, a

government think tank). If we assume that an

average of 15-20m people a year settle in cities, a

number consistent with the last 10 years, this will

require annual investment of RMB2-3trn per year

(taking into account modest inflation) in the next

decade, or around 4.3-6.4% of GDP in 2011.

So, how will this be financed? The bond market is

the best way to meet the needs of the

infrastructure boom because:

The funds that banks have available to lend are

limited by the 75% loan to deposit ratio and

other regulatory requirements. A deep, liquid

bond market would be able to accommodate

financing on a much larger scale.

Long-term bonds are a much better way to

fund multi-year infrastructure projects than

bank loans as they remove the problem of

duration mismatches in the banking system.

They would also meet demand from

institutional investors like long-term debt


The cost of lending is lower than bank loans.

The role of banks will change

As the bond market develops and the financial

markets become more competitive, banks should

be prepared to shift their focus away from big

projects and SOEs to retail customers and SMEs.

For some, this has already started. It can be seen

by the increase in the percentage share of the

assets of small and medium-sized banks (SMBs)

within the banking system (Chart 1.7). SMBs are

doing more and more business with SMEs, a trend

that is likely to continue in the coming years as

the reform process accelerates.

Banks have also widened their range of services,

selling different types of wealth management

products, which are short-term investments that

offer customers better returns than deposits.

Chart 1.7. Small and medium-sized banks gaining market







2003 2004 2005 2006 2007 2008 2009 2010 2011

Source: CEIC, HSBC

Small and medium-sized banks' asset as % of total

The Wenzhou experiment

Beijing has launched an important programme of

pilot reforms in Wenzhou, a city in China’s eastern

Zhejiang province where many small businesses ran

into serious credit problems (see box). This city of

8m has a strong tradition of entrepreneurship, so it is

not surprising that private business represents a

remarkable 82% of the local economy. The aim of

the reforms is to standardise and regulate the

development of private financing and small-scale

financial institutions. Local residents are also

being allowed to make overseas investments.




November 2012


According to local media, Wenzhou’s local

government has submitted a proposal to the State

Council to implement Beijing’s plan. It wants to

increase the number of micro-finance companies

that lend small amounts of money.

There are around 35 today and the plan is set up

another 30 next year and a further 30 in 2013,

taking the total to about 100, enough to cover

Wenzhou and neighbouring towns. At the same

time, local branches of commercial banks would

set up special departments for small companies,

the reform of rural co-operative financial

institutions should be finished by the end of this

year and village and township banks and their

subsidiaries should cover every county by 2013.

This type of financial deregulation is taking place

in other regions too. Huge cities such as

Shenzhen, Shanghai and Tianjin have introduced

similar reforms and smaller places such as Li Shui

in Zhejiang province have received permission to

press ahead with change. More will follow,

setting the stage for major changes in China’s

financial landscape.

The PBoC is also playing a role in the Wenzhou

experiment by measuring lending activity. Its

Wenzhou branch has started to record the

percentage of lending made by local private lending

institutions on a monthly basis. It is using data from

30 rural co-operatives, 28 micro-lending companies,

30 guarantee companies, 50 pawn shops (which

include property among the assets they lend cash

against) and other financial services institutions.

The ratio was 20.4% in September, or 5ppts lower

than the peak in August 2011, suggesting that

demand for loans has slowed, as is the case in the

rest of the country.




November 2012


Why Wenzhou is so different

Some say it is the mountainous terrain that has kept

the place isolated; others point to the area’s distinctive

dialect. What ever the case, Wenzhou has always been

a bit different from the rest of the country.

Wenzhou and Guangdong’s economic model is more

market-driven than Chongqing’s

For decades it has been known as a hotbed of

entrepreneurship and grey-market lending. The

city’s thousands of small businesses make, amongst

many other things, most of the shoes, eyewear and

cigarette lighters produced in China. It’s known as

one of the richest cities in the country.





But Wenzhou recently became famous for another

reason – its private companies were starved of credit

Source: HSBC

by banks as the PBoC tightened monetary policy through three rate increases and six RRR hikes in 1H 2011.

This led to businesses turning increasingly to unregulated shadow banking channels. When the economy

slowed and interest payments piled up, many went broke, threatening the financial stability of the region

late last year.

That was when Beijing stepped in. Premier Wen Jiabao visited Wenzhou and said the city would be the

testing ground for breaking the monopoly of the big state banks, which will help cash-starved private

enterprises get timely access to capital. The pilot project that is just getting started may one day become a

cornerstone of nationwide financial sector reforms.

Wenzhou’s financial model is much closer to that of the southern province of Guangdong, the economic

powerhouse that neighbours Hong Kong, than the government-led, debt-driven Chongqing model that

attracted negative headlines earlier this year (see China Inside Out: The Guangdong way is China’s

future, 30 April 2012).




November 2012


The world’s next big bond


China’s bond market has lagged behind the country’s spectacular

economic growth

With a wider range of products and a growing pool of investors, it

is set for rapid expansion

We expect market capitalisation to double in the next 3-5 years,

making it one of the world’s top three bond markets

Ready for take-off

From market regulation and product innovation,

to the scale of bond issuance and the growing

investor pool, it is clear that China’s bond market

is moving into a new era. We expect its market

capitalisation to double in the next 3-5 years,

lifting it into the world’s top three bond markets.

Our confidence is based on the pace of recent

developments to deepen and broaden the market

and the growing need to fund China’s rapid

urbanisation, as millions of people continue to

move to the city from the countryside every year.

In the past there has been limited co-operation

between competing regulators but there has been

progress in a number of different areas, including:

The expansion of local government bond

issuance (the Ministry of Finance has issued

RMB250bn on behalf of local authorities this

year, up from RMB200bn in the previous

three years) and a pilot programme allowing

local governments to issue new municipal

bonds, with the option of longer maturities.

A regulatory scheme led by the PBoC to

improve co-ordination between the different

parts of the corporate bond market.

The rapid growth of credit bonds issued by

LGFVs (although Beijing is trying to make

sure this is kept under control).

The launch of private placement SME bonds

and the expected relaunch of Treasury

bond futures.

The opening up of the bond market to

overseas investors and granting quotas to

foreign central banks.

The need to play catch-up

China’s bond market needs to catch up fast. The

world’s second-largest economy represents over

10% of world GDP, while the country’s outstanding

bonds represent 5% of the world total (3.6% if

policy bank bonds are excluded). The gap between

China’s bond market and GDP is huge compared

with other large economies (Chart 2.1).




November 2012


Chart 2.1 China’s bond market needs to catch up

Chart 2.3. China’s bond market lags Asian peers










(As % of w orld total)







(As % of GDP)


Bonds outstanding


Gov ernment


Source: ADB, World Bank, HSBC 2011 data. China bonds excl. policy bank bonds

Source: ADB, HSBC. EEA stands for emerging East Asia. Data as of 2Q 2012

Over the last three decades China has maintained

spectacular growth averaging 10%. Half of this is

driven by investment – roads, rail, factories and

skyscrapers– which runs at around 20% y-o-y in

nominal terms despite the recent slowdown.

Despite this the financial landscape remains

dominated by banks. Bond market capitalisation

accounted for 45% of GDP in 2011 (Chart 2.2),

less than half the outstanding loans to GDP ratio

(116%), down from 125% in 2010 when it was

inflated by the effects of the stimulus package.

Chart 2.2. Bond market cap dwarfed by bank lending










2002 2004 2006 2008 2010 2012f

Bond market cap as % of GDP

Source: CEIC, HSBC estimates

Outstanding loans as % of GDP

The bond market is not only small but lacks

variety. It is dominated by treasury bonds and

other policy bonds and is light on local

government and corporate bonds. As of mid-

October 2012, 35% of total outstanding bonds

were financial bonds (mainly issued by policy

banks and state-owned banks), followed by

treasury bonds (30%), mid-term notes (11%) and

enterprise bonds (7%), see Chart 2.4. Put together,

government-backed bonds represent nearly 75%

of China’s outstanding bonds.

Chart 2.4 Government-backed bonds dominate








Corporate Gov ernment

Source: ADB, HSBC. EEA stands for emerging East Asia. Data as of 2Q 2012

China’s bond market also lags its neighbours in

Asia. According to the Asian Development Bank,

the country’s bonds outstanding to GDP ratio

(44.8% in 2Q 2012) was 8.2ppts lower than the

average for emerging East Asia and more than

30ppts below Singapore, Malaysia and South Korea.




November 2012


Chart 2.5. A snapshot of China's bond market (outstanding)

PBoC bills CPCorporate

5% 4% 2%











Source: Wind, HSBC. MTNs refers to mid-term notes; CP refers to commercial paper

Market structure

China’s bond market has three segments: the

national interbank market, the exchange market

and the bank counters market. It has a centralised

trust and clearance system provided by China

Government Securities Depository Trust and

Clearing Company.

1) The interbank market handles over 90% of total

daily business. Established in 1997, this is also the

country’s largest over-the-counter (OTC) market.

Bond transactions are made through inquiry and

independent negotiations. As it is the most liquid

market, this allows the central bank to conduct

open market operations through central bank bills

and repos.

The interbank bond market has opened its door to

foreign banks on a trial basis, a key step towards

internationalising the RMB (see China: Onshore

RMB bond markets open up a crack, 17 August

2010). Some 20 foreign institutions can now

invest in China’s interbank bond market. These

include foreign central banks – for example, the

Bank of Korea has a quota of USD3.2bn and the

Bank of Japan USD10bn.

In addition, Shanghai’s municipal government

aims to establish itself as global centre for RMB

trading, clearing and pricing by the end of the

12th Five- year Plan (2011-15). This means that

the expansion of the interbank market is likely to

be faster than expected.

2) The exchange market is open to various

(basically non-bank) investors on an automatic

matching trade system. Trading volume is limited

due to the lack of participation by banks. This

could change as commercial banks are to be

allowed to participate on a trial basis, according to

a joint circular by regulators.

3) Banks’ OTC market serves individual investors.

Treasury bonds (mainly certificate bonds and bookentry

bonds) are sold to individuals and companies.

There are four types of bonds: treasury bonds,

PBoC bills, financial bonds and credit bonds (see

Asia-Pacific Rates Guide 2012, 14 December 2011).

Treasury bonds, commonly referred to as

onshore Chinese government bonds (CGBs), are

issued by the Ministry of Finance (MoF) as the

government’s main debt instrument. Maturities

typically range between 1-year and 10-year but

are increasingly available in longer-term tenors

(e.g. 15-, 20-, 30- and 50-year).

PBoC bills are issued by the PBoC to manage

liquidity and sterilise FX operations. Available

maturities range from 3 months to 3 years. Active

trading in PBoC bills makes it a useful benchmark

for money market rates.

Financial bonds are issued by financial

institutions and underwritten by banks and leading

securities firms. The main type of financial bonds

are policy bank bonds that are issued by three

policy banks backed by the government (China

Development Bank, Export-Import Bank of China

and Agricultural Development Bank of China) for

financing key national projects that are not

covered by the national budget.

Credit bonds in the interbank market include

enterprise bonds, commercial paper (CP),

medium-term notes (MTNs) and super and short-




November 2012


term commercial paper (SCP). CP maturities are

typically 9-months and 1-year. Maturities of

MTNs vary according to business needs and

typically range between 2 and 10 years. Enterprise

bonds maturities range from 3 to 30 years. In

addition, since the end of 2010, Shanghai Clearing

House (SCH) also launched SCP with maturities

of less than 270-days. Long-dated bonds are held

mostly by insurance companies and liquidity is

limited. Only short-tenored credit bonds have

decent liquidity.

Table 2.1 Bond products in China

Type of bond

Treasury bonds

Policy bank financial bonds

PBoC bills

Local government bonds

Enterprise bonds

Corporate bonds

Commercial paper and mid-term


Convertible bonds, bonds with


Source: HSBC

Issuing entities

Ministry of Finance

Policy banks, i.e., China

Development Bank, Agriculture

Development Bank, EXIM Bank


Ministry of Finance on behalf of

local governments

Unlisted enterprises

Listed companies

Non-financial firms

Listed companies

Local government financing

China’s local governments are deeply in debt –

RMB10.7trn (23% of 2011 GDP) by the latest

conservative estimates. How did they get into this

situation when the economy has been booming for

so long? It’s a long story.

In the early 1990s, Beijing launched a major fiscal

reform programme aimed at centralising tax

revenue. This resulted in the central government’s

share of total fiscal revenue rising from less than

30% in the early 1990s to more than 50%, at the

expense of local governments.

The problem is that local governments still

shoulder a large part of the burden of funding

infrastructure. With insufficient revenue, most

local governments, which are not allowed to

borrow directly from banks, chose to access credit

from the banking system through what are known

as LGFVs. It is no surprise that most LGFVs have

been accumulating debt since the early 1990s, and

the pace has accelerated since the financial crisis.

Bank loans to LGFVs are made under the name of

the company responsible for the construction

project. They generally have the explicit or

implicated guarantee of local governments – i.e.

local governments are responsible for their debts.

The Shanghai Securities News reported in

February that at least 65% of these loans were

fully covered by cash flows.

As we mentioned in the previous chapter, to help

stimulate the economy in 2009 Beijing started

issuing RMB200bn of bonds annually on behalf

of provincial governments to support local

projects (raised to RMB250bn this year, with the

option of a longer maturity period).

While this will help local governments in the

short term, it won’t fix the problem completely.

However, Beijing may have found another

solution. In 4Q 2011 it started a municipal bond

trial programme, which allowed the wealthy cities

of Shanghai and Shenzhen, along with prosperous

Guangdong and Zhejiang provinces, to issue a

total of RMB22.9bn municipal bonds with 3 or 5-

year maturity.

We believe this trial programme is likely to be

rolled out in other parts of the country in the

coming quarters. All this sends a strong signal that

Beijing sees these new local government

municipal bonds as the way to solve the liquidity

problem facing LGFVs, while at the same time

providing long-term financing for public housing

and infrastructure projects. This is particularly

important at a time when the economy is slowing

and there are calls for additional easing measures.




November 2012


The surge of LGFV bonds

Apart from bank loans, the local governments

have found another way to get themselves into

financial difficulties – LGFV bonds. Strictly

speaking, local governments are not allowed to

issue bonds but they found a way round the

regulations. LGFVs started to issue mainly credit

bonds in the late 1990s (for example, the

RMB500bn Pudong construction bond to build

the subway in Shanghai in 1999).

The volume of bonds issued by LGFVs has grown

rapidly. In 2009, urban infrastructure construction

investment companies issued bonds totalling

RMB233bn, up from RMB60bn in 2008.

Despite Beijing’s efforts to start cleaning up local

government debt in 2H 2010, bond issuance

bounced again in 2011 and is up 160% y-o-y in the

first half of 2012 as market confidence was restored

after the last-minute bailout of Shandong Helon.

This debt-laden fibre company almost became the

first company in China to default on a corporate

bond, pushing up high-yield spreads to record

levels (see Default dynamics, 7 March 2012).

LGFV bonds are usually only thinly traded in

comparison with mainstream products such as

government bonds, central bank bills and debt

issued by large corporations. They also tend to

trade at high yields, given the concerns over the

risk of default.

Chart 2.6. LGFV bond issuance since 2009

(RMB bn)







2002 2004 2006 2008 2010 2012*

Source: Wind, HSBC * As of end Oct 2012

Corporate bonds need a boost

The corporate bond market is very

underdeveloped in both the primary and

secondary markets.

Broadly speaking, there are three types of

corporate bonds. They are regulated by different

authorities and trade in different markets.

Enterprise bonds: Mainly issued by unlisted

companies regulated by the NDRC, the main

economic policy body. First issued back in

the early 1980s, these bonds are mainly issued

by SOEs but private enterprises are

increasingly using them to raise funds. Most

enterprise bonds are traded on the interbank

market, with the exchange market handling

the balance. Insurance companies,

commercial banks and mutual funds are the

main investors.

Corporate bonds: Issued by listed

companies regulated by the CSRC and traded

on the exchange market. Their market cap is

much smaller than enterprise bonds (about

25% of enterprise bonds). Investors are

mutual funds, insurance companies, enterprise

annuity funds and commercial banks.

Corporate mid-term notes and commercial

paper: Regulated by the National Association

of Financial Market Institutional Investors

(NAFMII), a PBoC agency, and mainly

traded in the interbank market. The approval

process is easier than for enterprise and listed

companies bonds (a credit rating is needed

but there is no requirement for a bank

guarantee). These bonds were first issued in

2008 and have proved to be very popular.

Outstanding mid-term notes stood at

RMB2.7trn as of October 2012, more than the

combined amount of enterprises and

corporate bonds. Commercial banks and

mutual funds are the main investors.




November 2012


We believe corporate bonds should play a larger

role in direct financing. They provide long-term

capital at a lower cost than bank loans and unlike

equities bonds don’t dilute the shareholders’

interests. And, more importantly, they will help

broaden the financing channels for SMEs. Today,

corporate (and enterprise) bonds account for only

9% of outstanding bonds, excluding mid-term

notes and commercial paper. The market is still

dominated by SOEs and large companies.

However, two recent policy initiatives suggest the

pace of development is speeding up.

For the first time Beijing set up a

consolidation scheme (led by the PBoC

working with the CSRC and NDRC) in April.

Few details are available but this move is

expected to eventually lead to the

consolidation of China’s bond market, which

should boost liquidity and issuance.

The Shenzhen Stock Exchange launched

private placement SME bonds from June

2012. This should help to ease financing

difficulties for SMEs.

Asset securitisation still


China launched the first asset backed security (ABS)

in 2005. Development has been very slow due to: 1)

a lack of co-ordination among policymakers; 2) the

fragmented nature of the interbank and exchange

markets; and 3) the ABS market was suspended

during the global financial crisis.

ABS issuance resumed in 2012 when three

financial regulators – the PBoC, the China

Banking Regulatory Committee and the Ministry

of Finance – issued a joint notice to promote ABS.

Banks are allowed to issue up to a combined

RMB50bn in these types of securities. China

Development Bank (CDB) made the first ABS

issuance of RMB10.2bn, marking the resumption

of this process. However, outstanding ABS

represented just 0.1% of total outstanding bonds

as of end October 2012.

Chart 2.7 Outstanding asset-backed securities still minimal

(RMB bn)








2005 2006 2007 2008 2009 2010 2011 2012*

Source: Wind, HSBC * As of end Oct 2012

Plenty of demand

Demand for bonds is not a problem. Insurance,

pension and mutual funds as well as the large pool

of household savings are all looking for long-term

investment instruments. China’s households and

companies have generally high savings rates,

which require effective investment channels. The

bond market provides long-term investment

instruments with fixed returns, a sharp contrast to

the more volatile and riskier equity market.

Further development of the bond market will

provide the middle class with greater choices

about where to put their money so they can earn a

higher return and therefore spend more.

Moreover, the number of institutional investors is

on the rise. By the end of September 2012, there

were 411,711 institutional investor accounts on

the Shanghai A-share market compared with

around 200,000 in early 2005. Fund management

companies, securities companies, insurance

companies and social security funds are all

important investors.




November 2012


Second, the market is increasingly open to foreign

investors. By the end of September 2012, 188

institutions had received QFII licences with an

investment quota of USD30.8bn. China is now

planning to lower the entry barrier for foreign

institutional investors as part of reforms to add depth

to the country’s capital markets. The government

will cut the minimum requirement on assets under

management to USD500m from USD5bn for

companies seeking a QFII licence, the CSRC

announced on 19 June 2012 (source: Bloomberg).

The regulator also said it will allow the QFII

funds to invest in the country’s interbank bond

market. Under the new rules foreign investors will

be required to have at least two years of

operational experience, compared with the current

minimum of five years. The CSRC hopes that

introducing more long-term funds from abroad

will help improve market confidence and promote

stable growth in China’s capital markets.

Chart 2.8. QFII investors expanding











04 05 06 07 08 09 10 11 12

No. of institutions approv ed (Lhs)

Approv ed inv estment accumulated (Rhs)

Source: CEIC, HSBC

But a stronger institutional

framework is needed

An efficient, well-supervised bond market would

reduce transition costs and lower risks in the

financial system. We believe corporate

governance, the legal framework and regulatory

supervision all need to be improved. We think the

following are needed to build the right

institutional framework:






Information disclosure: Better transparency

is needed to accelerate the development of the

local government bond market. The balance

sheets of many local governments lack clarity

and need higher accounting standards. The

current accounting law only applies to

companies – it should also be applied to local

governments. This will help price the risk of

local government bonds.

A credit evaluation system: A proper credit

ratings system is vital, especially in a market

which has a short history (the four major

domestic rating agencies are inexperienced)

and lacks statistics on default ratios.

Consolidation of the fragmented bond

markets, but this will take time. The current

segmentation splits liquidity and prevents the

formation of a complete yield curve.

Improving yield curves: A properlyfunctioning

yield curve provides the benchmark

for pricing risk. China’s yield curves need

further improvement through: 1) the

strengthening of market makers; 2) more

diversified products and maturity; 3) deeper

liquidity; and 4) interest rate liberalisation.

Bringing in global players

would help

There are many ways Beijing can strengthen the

institutional framework of China’s bond market –

enhance regulation, increase co-operation with

overseas exchanges and regulatory authorities and

nurture domestic investors and rating agencies.

But for us the best option would be to attract top

global institutional investors who are more

capable of identifying, pricing and managing risks.

Their active participation would encourage

companies to improve the quality of disclosure

and help domestic rating agencies raise their

standards to international levels.




November 2012


This can be achieved by expanding the current

QFII and RQFII schemes and further opening

bond markets to foreign central banks and

international organisations. There are signs that

this is already starting to happen.

On top of the increase in the QFII quota from

USD30bn to USD80bn, as mentioned earlier the

CSRC is considering further relaxing QFII’s

investment rules. This includes allowing QFIIs to

invest in the interbank bond market and changing

the rule that “no less than 50%” of QFII

investment must be in equities. Meanwhile, the

fact that Bank of Japan and Bank of Korea have

recently received approval to invest in the

interbank market is another positive sign (see the

chapter: A convertible RMB within five years).

Increased participation by sophisticated global

investors will accelerate the pace of building a

more transparent and liquid bond market – one

that matches China’s rapid economic growth.




November 2012


How to set interest rates


The governor of China’s central bank says the time is ripe for

liberalising interest rate policies

The powerful state-owned banks stand to lose the most from

reform, but there is little they can do to buck the trend

In our view, liberalising interest rates will be a step-by-step

process that could be completed within three years

Ready for action

Zhou Xiaochuan, governor of the central bank, the

PBoC, made his point very clearly. Writing in the

March issue of China Finance magazine, he

stated that conditions were “basically ripe” for

liberalising domestic interest-rate policies. His is a

powerful voice – he has held that important job

since 2002.

Interest rate liberalisation lies at the heart of

China’s financial reforms and much needs

changing. Under the current system the PBoC sets

a ceiling for bank deposit rates and a floor for

lending rates, creating a high spread that generates

fat bank profits. It also means that the returns

savers earn on their deposits are below the level of

inflation, so they are effectively losing money. As

The Economist magazine put it recently: “A

bank’s depositors, in effect, pay the bank to

borrow their money from them.”

This, in turn, works against the government’s

policy to make consumption a bigger driver of

economic growth. Consumption in China was

51.6% of gross domestic product in 2011,

compared with about 70% in the US.

Chart 3.1 Real interest rates in China

5 %








00 01 02 03 04 05 06 07 08 09 10 11 12




Source: CEIC, HSBC

Real interest rate

Long-term av erage

Reformers like Mr Zhou believe that liberalising

interest rates is vital for other reasons too – it

would help to develop the bond market and make

it easier to lift capital controls and internationalise

the RMB. Importantly, interest-rate liberalisation

is now official government policy as it is part of

China’s 12th Five-year Plan, which runs from

2011 to 2015. Mr Zhou believes it should be

possible to make considerable progress during this

period for a number of reasons, including:




November 2012


The process of financial restructuring and

listing the major domestic commercial banks

is largely complete. The banks should be able

to stand on their own feet.

The ability of financial institutions to price

interest rates and manage risk has improved


The central bank has become more proficient

at adjusting market interest rates through open

market operations (buying and selling

government securities to expand or contract

the amount of money in the banking system).

The Shanghai Interbank Offered Rate

(SHIBOR) is now an established benchmark

for pricing financial products.

A deposit insurance system and a “survival of

the fittest” mechanism to weed out weak

financial institutions are being established.

However, the problem is that reform in China is all

about timing and the order in which changes should

be made. Beijing likes to test the water by rolling

out pilot schemes in certain cities or provinces. But

this is not practical for interest rates and that’s why

they were not part of the Wenzhou reforms. With

the global economy still weak and China facing the

risk of an economic slowdown at home, liberalising

interest rates cannot be rushed. We think it will be a

step-by-step process that can be completed within

three years.

Our confidence is based on a number of factors.

Firstly, Mr Zhou is not a lone voice. In October, it

was announced that three bodies that regulate

banks, equities and insurance would all be led by

former PBoC vice-governors; Shang Fulin at the

China Banking Regulatory Commission (CBRC),

Guo Shuqing at the CSRC and Xiang Junbo at the

China Insurance Regulatory Commission (CIRC).

They are proven reform-minded problem solvers and

protégés of former premier and economic reformer

Zhu Rongji, who did much to change China in the

late 1980s and early 1990s. For more details see

China Investment Atlas, Issue 37, The market’s

driving forces in 2012, 18 November 2011.

Then, in January, the powerful National Financial

Working Conference (NFWC), that meets every

five years, came out strongly in favour of a string

of broad based financial reforms.

More evidence of change came in February with

the release of the China 2030 report by the World

Bank and the Development Research Center, a

think tank with links to the State Council, the

country’s top executive body. This presented a

sweeping reform agenda, including interest-rate

liberalisation and limits on the power of SOEs.

Then came Mr Zhou’s comments in March. In

addition, Premier Wen Jiabao has also stated

China’s road to reform cannot be changed and

separately called for the power of the state banks

to be reined in.

So what happens next? In the next three years or

so we think the pace of deregulation will be

guided by a series of small changes that make

both lenders and borrowers more responsive to the

cost of funding.

An assessment by the PBoC suggests that all

commercial banks and rural credit units already

have interest rates pricing systems based on cost

of funding and risks in place, ready to be rolled

out. China’s financial institutions appear to be

ready for the complete liberalisation of

benchmark lending and deposit rates.

Indeed, China’s Banking Association is working

on setting up a mechanism to decide benchmark

deposit and lending rates. We think the sector is

preparing for the final push towards interest rate

liberalisation. It is likely to start with rates for

long maturity, large deposits before moving to

short- term small deposits.




November 2012


As the Asian Wall Street Journal reported on

20 March 2012, the PBoC’s Mr Zhou and others

are also calling for the creation of a government

deposit insurance system, similar to the US and

other developed countries. This would put China’s

banking system on a more solid footing and

ensure that depositors’ money would be safe even

if some banks shut down because of the

increased competition.

The next steps

Mr Zhou has laid out a widely reported two-stage

roadmap for liberalising interest rates by 2015.

First, four preconditions must be met, followed by

a six-step reform process. The preconditions are:

1) China has a competitive financial market with

diversified financial institutions that can price

market risks at different levels depending on their

funding costs and financial strength. Current

status: Some of the stronger commercial banks

already have pricing power.

2) Commercial banks, which operate in a tougher

environment than policy banks, are to be given

more price setting power. Current status:

Competition has strengthened since the banks

were restructured and floated.

3) China’s banks still see market share as the most

important factor when it comes to competition.

This mindset needs to change. Current status:

Commercial banks are becoming increasingly

focused on promoting financial services.

4) Commercial banks need to reduce their reliance

on interest rate income. Prices of other financial

services also need to be deregulated. Current

status: The contribution of interest rate income at

the big four banks has declined significantly in the

past few years.

Where are we now

China, like many developing countries, has kept

interest rates artificially low to increase industrial

output growth and reduce financing costs for large

state-run companies. The net interest rate margins

for China’s banks were negative during the

majority of the first two decades of economic

development (1978-1996).

The downside is that this “financial repression”,

as it is known, has slowed the development of

financial services and reduced the efficiency of

allocating funds to businesses. In simple terms,

credit does not always get to where it is needed

most. For example, it is easy for big SOEs to get

credit while many SMEs are starved of funds.

The aim is to establish a market-oriented structure,

with money market rates acting as the benchmark

based on supply and demand. This would mean that

the central bank becoming less dependent on

administrative policy measures such as loan quotas

and the reserve requirement ratio to influence the

system. Experiences from other countries suggest

that the pace and sequence of reform will determine

the impact liberalising interest rates will have on the

financial system and whether the real economy

would suffer a negative shock.

Interest rate liberalisation is not a new concept in

China – the phrase first appeared in official

documents way back in 1993. Today, after years

of step-by-step deregulation and reforms (see

Table 3.6) much progress has been made. This

gradual approach has safeguarded the banks’

profit margin, while giving businesses and

households time to adjust.

Here is what’s happened so far:

Capital market rates

Money market and bond market interest rates

In a market-oriented system, inter-bank interest rates

are liberalised first, followed by bond market rates.




November 2012


In 1996 the central bank abolished the upper

limit on inter-bank lending rates. It only took

from 1996-99 to fully liberalise interest rates

on the inter-bank market and bond markets.

FX and local currency lending and

deposit rates

Lending rates

The foreign currency market uses

international rates as a benchmark; lending

rates of all foreign currencies were

deregulated from September 2000.

For RMB loans the upside floating limit for

SMEs was expanded from 110% of the policy

rate to 120% in 1998 in an effort to support

small business.

Over 1998-2003 the floating limit of lending

rates for RMB loans expanded to 30%, rising

to 170% from January 2004.

The upper limit of lending rates for RMB

loans was abolished in October 2004. Only

the lending rate floor – 90% of the policy rate

– was kept in place.

Deposit interest rates

FX rates for large deposits of over USD3m

were liberalised in September 2000.

The number of foreign currencies subject to

deposit rate regulation was reduced from seven

to four (USD, EUR, JPY, HKD) in July 2003.

Interest rates for all small FX deposits with a

maturity of more than one year were

liberalised in November 2004.

The ceiling of RMB-denominated deposit

rates has been controlled since October 2004.

Problems areas

These include:

The 1-year deposit rate, the central bank’s

benchmark interest rate, acts as an important

reference for the rating of bonds. China’s

single tender, fixed bid system has distorted

the bond market and does not give a true

reflection of supply and demand. That’s why

interest rates for bonds are usually higher than

the benchmark deposit interest rate.

Having regulated interest rates limits the

issuing of bonds to the central government,

central bank, state-owned banks, big SOEs

and policy banks. This has hindered the

expansion of the bond market. Financial and

corporate bonds issued by policy banks and

large SOEs account for 50% of the total bond

market (this includes 40% of short-term

financing bills and medium-term notes). Most

local governments, which have great

difficulty in raising funds for local

infrastructure development, are not qualified

to issue bonds. The exceptions are Shanghai,

Shenzhen, Guangdong and Zhejiang which

were allowed to issue bonds late last year as

part of a pilot scheme.

A lack of development of related products

such as interest rate futures. Regulated

interest rates deprive market players of risk

management tools. Put another way, in

China’s bond market there’s no interest rate

risk other than policy risk.

There’s no benchmark yield curve, weakening

the market’s gauge of short-term rate trends

and inflation.

The PBoC still regulates 29 types of interest rate,

including preferential interest rates for export

credits, deposit rates for small FX deposits and

loans for anti-poverty purposes (see Table 3.3).




November 2012


Chart 3.2 Regulated interest rates are still the market







04 05 06 07 08 09 10 11 12

Source: HSBC, CEIC


3-month time deposit rates (LHS)

Shibor: 3 month

Inter-bank 3 month money rates

The main obstacles

The benefits from marginal changes in interest rates

in terms of improvements in banking efficiency and

allocating financial resources have come to an end.

In other words, the easy part is over.

Powerful vested interests have a lot to lose from

change – especially the big banks. Experiences

from many other countries show that the net

interest margin (NIM) tends to narrow after

lending and deposit interest rates are liberalised.

This is because banks have to compete with each

other – they attract deposits by raising deposit

rates and cutting lending rates to win business

from valued (normally big) clients.

This squeezes interest rate income and that’s why

China’s commercial banks are the main group

objecting to reform. NIM income represents 70-

80% of the banking sector’s profits, so it is







understandable that the banks will try to postpone

reform for as long as possible. Market driven

interest rates would force them to grow their

businesses in other areas, particularly fee income.

Chart 3.3 Banks’ interest rate margin has stayed between 3-







90 92 94 96 98 00 02 04 06 08 10 12


Source: HSBC, CEIC

Interest rate margin

1-y r time deposit rates

1-y r lending rates

But interest rate liberalisation is not just about

deregulation. It is also about power. China’s

government-controlled banking system has long

provided the financial resources that have made the

country the economic powerhouse that it is today.

Fully-liberalised interest rates would certainly

diminish the level of government control.

During the 2008-09 global financial crisis the

state’s control of the banking sector helped

China’s strong economic recovery. In 2009 the

banks pumped RMB9.6trn of new loans into the

economy as Europe and the US floundered. We

believe it is this deep-seated fear of the

diminution of power that is the biggest obstacle to

be overcome.

Table 3.3 Interest rates currently under PBoC regulation

Interest rates

Numbers of rates under regulation

Deposit rates Deposit rates (demand deposit, 3-month, 6-month, 1 year, 2 years, 3


years, 5 years), negotiated deposits (upper limit restriction), savings for

personal housing funds and other small deposit accounts

Lending rates

Lending rates (6-month, 1 year, 3 years, 5 years, more than 5 years),


personal housing loans

Preferential lending Export credits (China Import and Export Bank), anti-poverty 8


Small foreign currency Deposits with maturity of less than 1-year deposits of USD, EUR, JPY,




Total 29

Source: PBoC, HSBC




November 2012


We suggest policymakers think about this in a

different way – financial repression and the

misallocation of financial resources could

ultimately threaten the sustainability of China’s

economic growth.

It would be far better if commercial banks can

work together at an industry level to build a coordinated

mechanism to set a benchmark interest

rate. This, under the supervision of the central

bank during a transition period, could help

cushion the potential nasty shock of free interest

rates on the sector and, in turn, the real economy.

China’s Banking Association, which works under

the CBRC, is already researching the best way to

set up this mechanism.

As Yi Gang, the PBoC vice governor, wrote in his

2009 book On the Financial Reform of China,

only when a market-oriented benchmark interest

rate is properly pricing lending and deposits will

the PBoC be able to exit its role of setting

benchmark interest rates.

Chart 3.4 Around 70% of total bank loans were lent at

interest rates higher than the central bank benchmark







08 09 10 11 12

Source: HSBC, Wind

Below benchmark, 10%

Abov e benchmark, 10% up to 170%

SHIBOR, an emerging benchmark

Before the PBoC can give up its role of setting

interest rates a market-oriented benchmark

interest rate needs to be in place.

The Shanghai Interbank Offered Rate (SHIBOR),

introduced in January 2007, already acts as a good

reference for short-term (less than 3-month)

money supply and demand. SHIBOR is now

widely accepted as the benchmark rate for

discount bills, wealth management products and

asset management.

However, there is still too big a difference between

offer and transaction prices for more than threemonth

funding, which suggests that factors other

than supply and demand are at work between

market counterparties. There’s more work to do to

enhance SHIBOR’s role as a pricing benchmark.

Chart 3.5 SHIBOR, an emerging RMB rate benchmark

9 %






00 01 02 03 04 05 06 07 08 09 10 11 12


Source: HSBC, CEIC

Latest developments

China took another step towards liberalising

interest rates on 8 June when it cut borrowing

costs for the first time since 2008 and loosened

controls on banks’ lending and deposit rates. The

one-year lending rate was lowered 0.25ppts to

6.31% and the one-year deposit rate fell the same

amount, to 3.25%. Banks could offer a 20%

discount to the key lending rate after the move, up

from 10% previously. They will also for the first

time be able to offer savers deposit rates that are

up to 10% higher than the benchmark.

Currently around 70% of total bank loans are lent

at interest rates higher than the central bank

benchmark (see Chart 3.4), implying that Beijing

thought it was a good time to expand the floating

range as it eliminates the risk of irrational

competition between financial institutions.




November 2012


Less than a month later the PBoC acted again,

asymmetrically cutting the benchmark 1-year

lending rate by 31bps to 6% and the 1-year

deposit rate by 25bps to 3%, effective 6 July. The

central bank has also announced it was further

reducing the lower limit from 80% to 70% of the

benchmark lending rate. This change is not

applicable to mortgage rates as the central bank

reiterated that property tightening measures would

stay in place.


Interest rate liberalisation lies at the heart of

China’s financial reforms. Given the latest move

on 6 July, we expect the process to accelerate

along with reforms in other areas such as the

RMB exchange rate and capital account

liberalisation. We expect the full liberalisation of

interest rates to be completed within three years.

By cutting the lending rate more aggressively than

the deposit rate, and allowing a higher discount

against benchmark lending rates, the authority is

trying to lift private sector investment demand

amid the current economic downturn.

The next steps

In September the State Council approved the 12th

Five-year Plan for Financial Sector Development

and Reform, jointly formulated by the PBoC, and

other key regulators. According to the plan,

market-based interest rate reform will progress

during the 12 th Five-year Plan (2011-15). We

expect to see the following measures:

Further expansion of the floating band for

lending and deposit rates.

The number of lending rates categories under

regulation to fall from five to three and finally

to only one – the benchmark lending rate.

The reduction of regulated deposit interest

rate categories from seven to five or fewer.

The long-term deposit rate is likely to be

liberalised first and the demand deposit rate,

which accounts for about 50% of total

liabilities in the banking system, last.

Eventually, the ceiling on the interest rate for

deposits will be removed, letting bank rates

float freely.




November 2012


Table 3.6. Interest rate liberalisation milestones in China

Category Year Event

Money market interest rate and bond market

interest rates

1996 PBoC abolishes upper limit on inter-bank lending rates.

1996 MoF adopts interest rate and yield bidding in treasury bond

issuance (exchange platform).

1997 Liberalised repo rates in interbank markets.

1999 MoF issues treasury bonds in the interbank market for the first


Lending rates 1998 Upside floating limit for SMEs expanded from 10% to 20%;

lending rate upper limit for rural credit units increased from

40% to 50%, while limit for bid enterprises unchanged at 10%.

2003 Pilot scheme for reforming credit unit launched. Upper limit of

lending rates for rural credit units included in the scheme

expanded to 200%.

2004 Removed ceiling for all lending rates, except interest rates for

housing mortgage loans, and credit units for urban and rural

areas (upper limits were increased to 230%).

2012 Lending rate floor lowered from 90% to 70% of benchmark.

Deposit rates 1999 PBoC allowed negotiated wholesale deposits for insurance

company clients.

2000 FX lending rates fully liberalised; deposit rates freed for

USD3m deposits

2003 PBoC expands number of institutions that can apply to

negotiate wholesale deposits.

2004 Floor for all deposit rates removed.

2004 All FX deposit rates with maturity above 1-year liberalised

2012 Deposit rate ceiling was expanded to 110% of benchmark.

Source: PBoC, HSBC




November 2012


Going global

China’s ODI is set to double in the next 3-5 years…

… as Chinese companies venture overseas to acquire natural

resources, markets and technology

The firms will require sophisticated financial services; domestic

banks need to raise their game if they want to keep their business

Banks face big challenges

China’s companies are going global. Faced with

tougher competition in domestic markets and slow

growth in the developed world, they are exploring

new markets, acquiring advanced technology to

sharpen their competitiveness and securing muchneeded

raw materials.

The result has been a spectacular rise in China’s

overseas direct investment (ODI) since 2002, when

the government encouraged businesses to “go out”.

China is now the world’s sixth biggest source of

ODI; its non-financial ODI 1 totalled USD68bn in

2011 and this figure is likely to double in the

coming 3-5 years. By 2011, there were over 13,500

Chinese companies and institutions making ODI in

more than 18,000 foreign companies across 177

countries and regions.

This has important implications for China’s

banks. As more Chinese enterprises extend their

global reach they will need an increasingly wide

range of sophisticated financial services. The

banks need to follow in the footsteps of their

clients. Chinese enterprises now have investments

in more than 170 countries but the focus of the

country’s banks remains overwhelmingly

domestic in terms of networks, assets, business

models and human capital. The large state banks

will have to raise their game if they want to keep

pace with this surge of overseas investment.

1 There are two categories of China ODI: financial and

non-financial. The former refers to domestic financial

institutions’ investment in overseas financial

institutions; the latter refers to domestic non-financial

institutions’ investment in overseas non-financial





November 2012


Chart 4.1 China’s outward direct investment










(USD bn)

1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011









China's annual ODI flow s (Lhs)

China's annual ODI flow s as % of w orld total(Rhs)

Bank loans and debt issuance in

offshore markets.

Table 4.2 Chinese banks’ overseas presence (end 2011)

Bank name

Number of overseas


Total assets


Overseas assets


Overseas assets/total


Bank of China (BOC) 96 2,165 429 19.8%

Industrial and Commercial Bank of China

31 2,396 125 5.2%


China Construction Bank (CCB) 13 1,902 69 3.6%

Agricultural Bank of China (ABC) 10 1,808 19 1.1%

Bank of Communications (BoCoM) 12 714 51 7.2%

China Merchants Bank (CMB) 6 433 8 1.9%

China Development Bank (CDB) 3 968 145 14.9%

Total 158 10,386 846 8.1%

Source: Annual reports

Domestic financing alone will no longer be able

to meet the increasing funding needs of these

adventurous Chinese companies. More crossborder

funding will be needed and credit could be

much cheaper on international markets and in

currencies such as the USD. The domestic banks,

long used to funding the big state-owned

companies, lack experience on the global banking

stage and will find it difficult to provide all the

services these companies need.

For example, demand for the following crossborder

banking products will increase:

M&A advice: According to Dealogic, China

leads M&A activity in Asia, representing

nearly 7% of global M&A over the past three

years. In 2011, 37% of China’s ODI flows

went to M&A.

Transaction banking for payments and cash

management, trade finance, supply chain and

securities services.

FX risk management: The increasing global

presence of Chinese companies implies rising

demand for currency settlement and risk

management. This demand will be

strengthened as RMB internationalisation

gathers pace; eventually it will be crosstraded

against most other global currencies.

Playing catch-up

China’s banks are still very much domestic

businesses. While this was helpful during the




November 2012


2008-09 global crisis, the country’s financial

sector lags far behind manufacturing when it

comes to operating comfortably in today’s

globalised world.

A few big state-owned banks have started to respond

to the “go out” strategy, led by China Development

Bank (CDB) and Industrial and Commercial Bank of

China (ICBC). At the end of 2011, CDB was

providing USD187.3bn in loans to Chinese

companies in over 100 countries and regions.

ICBC has also realised how important it is to build a

global network and upgrade its services. It recently

acquired Bank of East Asia’s US arm, making it the

first China bank to complete an M&A deal in the

US. Back in 2007, ICBC acquired a 20% stake in

Standard Bank, the largest bank in South Africa, for

USD5.5bn. ICBC now has 244 sub-branches and

outlets in more than 34 countries/regions, up from

100 in 2004.

That said, Chinese banks still have a long way to go.

Today only a few banks have an overseas presence.

As shown in Table 4.1 the number of overseas

branches was less than 160 at the end of 2011 and

overseas assets totalled just USD846bn, only 8% of

these banks total assets. They lack staff with

overseas experience and hiring talent from countries

with sophisticated international banking cultures

will not be easy, given the huge differences in

culture, pay and corporate governance.

Meanwhile, China’s practice of separating

commercial and investment banking means most

big banks concentrate on commercial banking

rather than taking a universal approach to the

industry. The bottom line is that they may find it

difficult to match the needs and wants of

customers doing business overseas.

The future is competitive

So, what should Chinese companies do if

domestic financial institutions lack the networks

and expertise to serve them overseas?

They could choose to be patient and wait for

domestic banks to grow their international

services. This is unlikely as it could take years

and corporations will be reluctant to miss out on

good business opportunities.

Another option is to use foreign banks with global

operations. After all, time is money and Chinese

companies have to seize the moment when it

comes to expanding overseas, especially now that

there are bargains aplenty. Getting the best service

available will be the priority, no matter whether it

is from a domestic or foreign bank. There are

fears that this will slow the development of

domestic banks. They are not justified, in our

view. Increasing competition is the quickest way

to get the domestic banks to raise their game.

Just look at what happened in the manufacturing

sector. Instead of being squeezed out, the

domestic companies became more competitive by

using the technology and management skills

brought in by foreigners. In less than two decades,

the Chinese manufacturing sector has become the

most competitive in the world. As banking relies

on a very specific set of skills, strong competition

should help move the industry up the learning

curve at an even faster pace.

Deep pockets, broad horizons

There are plenty of reasons why Chinese

companies are expanding overseas. They include:

Resources: China is the world’s second

largest oil consumer (10% of global

consumption) and has to import over 50% of

its oil needs. To meet the rising gap between

domestic production and demand, stateowned

oil companies have been acquiring

stakes in oil fields around the world.

Technology and brand names: Chinese

manufacturers are buying well-known foreign

businesses to strengthen their competitiveness.

Examples include Lenovo acquiring IBM’s

PC business and Geely buying Volvo.




November 2012


New markets: As domestic competition

intensifies Chinese companies are creating

direct distribution networks to boost exports

and setting up factories to avoid trade barriers.

Money is not a problem. Chinese companies,

especially large SOEs are flush with cash – total

corporate profits topped RMB5.45trn in 2011, up

nearly 12 times from 2001. This implies an annual

growth rate of around 28%, outperforming GDP

growth of 10.4% during the same period. SOEs

represent nearly 30% of total corporate profits. At

government level, net dollar inflows remain

robust and Beijing is also sitting on huge foreign

exchange reserves.

Chart 4.3. Chinese companies’ total profits

Despite the rapid increase, as of 2011 China’s

ODI still only accounted for 4.4% of global FDI

flows and China’s cumulative ODI represented

just 2% of global total cumulative direct

investment. This doesn’t match China’s economic

status as the world’s second largest economy

(10% of world GDP). Put another way, China’s

ODI needs to double to match its economic power.

It seems the only way for ODI is up.

SOEs dominate

SOEs account for most of ODI. In 2011, around

90% of ODI flows came from big SOEs, while

private enterprises accounted for a marginal share.

In cumulative terms, SOEs have accounted for

around two thirds of total ODI.








(RMB bn)

Source: CEIC, HSBC

2001 2003 2005 2007 2009 2011

SOE (Lhs)

Non-SOE (Lhs)

Total profit as % of GDP (Rhs)





Non-financial ODI constitutes more than 80% the

of China’s total. In 2011 it was concentrated in

five sectors (in cumulative terms): leasing and

commercial services, mining, wholesale and retail,

manufacturing and transportation (Chart 4.5).

Manufacturing ODI rose to 10.3% in 2011 from

4.2-4.7% in 2008-09. Here the focus is on

transport equipment, machinery, textiles, special

purpose equipment, information and technology

and electronics.

ODI taking off

China is not just the world’s biggest exporter of

goods but also one of the top exporters of capital.

Annual ODI for non-financial companies has

surged more than 20 time between 2002 and 2011

and five times in the past five years. It even rose

11% y-o-y in 2009 during the global financial

crisis, a time when global ODI contracted 37%. In

2011 non-financial ODI surged 14% y-o-y to

USD68bn, up from just USD2.7bn in 2002,

implying an annual growth rate of 43%.

Chart 4.4. Sector distribution of non-financial ODI








(% of total)

2003 2004 2005 2006 2007 2008 2009 2010 2011

Leasing & Commercial Serv ice



Wholesale & Retail Trade

Source: CEIC, HSBC




November 2012


Chart 4.5. Top five sectors for China’s accumulative ODI








(% of total)

Leasing &


Serv ices

Source: CEIC, HSBC





2005 2011


Banking dominates financial ODI, with a share of

nearly 80%, followed by securities and insurance.

The overseas expansion of state-owned banks

started from 2006 when they were listed and

demand for overseas financial support from SOEs

surged. By 2011, state-owned banks hired 32,000

foreign employees in 32 countries/regions.

Asia the main target

By region, emerging markets remain the top

destination for Chinese funds (developed markets

account for only 11% of cumulative ODI by 2011).

More specifically, as of 2011 Asia represented

71.4% of cumulative ODI, followed by Latin

America (13%), Europe (5.8%), Africa (3.8%),

North America (3.3%) and Oceania (2.8%) .

Chart 4.6. Regional allocation of China ODI (2011 stock)









2003 2004 2005 2006 2007 2008 2009 2010 2011

Asia (Lhs)

LatinAm (Rhs)

Africa (Lhs)

Europe (Rhs)

North Am (Rhs)


Source: CEIC, HSBC






Hong Kong, with an overwhelming share in

Chinese ODI (47.8% of 2011 flow and 61% of

2011 stock), should be treated as an exception.

The top three industries are leasing and

commercial services, financial services and

wholesale and retail sales.

China’s direct investment into Hong Kong is

mainly due to its unique position as a gateway to

the Asia-Pacific region and the world. Aside from

being a logistics hub, Hong Kong’s developed

financial markets and advanced services industries

help Chinese enterprises establish an international

presence, build better regional distribution and

marketing channels, and enjoy easier access to the

region’s financial resources.

Within Latin America, the Virgin Islands and

Cayman Islands, both offshore tax havens, are the

top two destinations, accounting for a combined

12 % in cumulative total ODI by 2011, or over

92% in accumulative ODI to Latin America.

While Brazil is an attractive destination for

Chinese investors, its share of ODI was only 0.2%

in 2011 and 0.3% in cumulative terms. But it is

growing fast. In 2010 China became Brazil’s top

FDI investor (USD17bn, up from USD360m

accumulative FDI over previous years).

Within Africa, ODI is evenly distributed among a

handful of countries. In cumulative terms, by

2011 South Africa was the top destination,

accounting for 1% of total ODI, followed by

Sudan (0.4%), Nigeria and Zambia (0.3%).

Why emerging markets are so


Emerging markets are likely to remain the focus

of Chinese investors’ global expansion. They are

made for each other – China is the world’s largest

producer of manufactured goods, while emerging

countries have rich resources and commodities

that China needs to meet domestic demand.




November 2012


We believe Chinese companies will keep

expanding overseas for many years to come for

two reasons – they need new markets abroad and

raw materials at home.

1 New markets

China’s manufacturers need to explore new markets

because the economies in so many developed

countries, their traditional export destinations, are in

such poor shape. HSBC’s economics team forecasts

1.2% y-o-y and 1.2% y-o-y growth for developed

markets in 2012 and 2013, respectively, much lower

than the 4.9% y-o-y and 5.6% y-o-y for emerging

markets (see Global Economics Quarterly: Why

pump-priming isn’t working, 27 September 2012).

The robust recovery in emerging markets points to

new sources of export growth for China’s

manufacturers. Their exports to emerging markets

have outperformed those to developed countries

since 2005, resulting in a 6ppt increase in the

emerging market share of China’s total exports

(58.5% in the first three quarters of 2012).

Chart 4.7 Exports to emerging markets have outperformed

(%y r)








1996 1998 2000 2002 2004 2006 2008 2010 2012*

Dev eloped markets Emerging markets

Source: CEIC, HSBC * As of end September 2012

The nature of China’s ODI is also changing.

Besides setting up manufacturing plants in foreign

countries, more and more mergers and

acquisitions are taking place.

Tapping local markets and lifting market share are

the top considerations for Chinese manufacturers as

they expand overseas. Having local manufacturing

bases should give these companies better local

knowledge of and access to local markets. In many

cases they can also avoid any trade barriers and

make use of cheap labour and resources.

Examples of major Chinese enterprises expanding

internationally include white goods producer

Haier, which has built manufacturing bases in

South East Asia and North America, and domestic

car marker Chery, which plans to build a plant in

Brazil, the largest car market in Latin America.

2 Raw materials

China accounted for two thirds of the increase in

global demand for hard commodities over 2003-

07, and this share surged to over 100% during

2008-10. While tighter credit and the cooling of

the property market have led to a cyclical

slowdown in fixed-asset investment, China’s

structural growth story remains intact. So securing

the necessary supply of resources will continue to

drive Chinese ODI for the foreseeable future.

While there will be some roadblocks, Beijing’s

increasing investment in infrastructure in

emerging economies should help to clinch deals to

secure resources.

Led by SOEs such as Sinopec, PetroChina and

Chinalco, Chinese companies have speeded up the

pace of acquiring overseas mines. According to

the Chinese Academy of Social Sciences (CASS),

a Beijing-based think tank, over the past seven

years they have made over 91 overseas mining

acquisitions worth USD32bn.

As well as making acquisitions in Australia and

other resource-rich countries, China has been very

aggressive in building infrastructure in Africa as

well as co-operating with or sponsoring local

companies to jointly develop mining projects.

Chinese companies have also helped with

construction projects, including a gas turbine

power plant in Nigeria and the Souapiti Dam in

Guinea (source: World Bank).




November 2012


ODI is sometimes difficult. The upheavals in the

Middle East and North Africa have slowed

progress in that part of the world. For example,

there are over 50 projects still under construction

by Chinese companies in Libya, raising concerns

about the outlook for ODI in the region.

Despite this setback, the big picture remains

unchanged. China’s surging ODI in emerging

markets is part of a new recycling of trade

between China and the countries in which it is

investing. On top of the injection of revenue,

Chinese investment boosts the local economies.

The spill-over from industrial projects helps

increase local productivity growth and improve

infrastructure networks.

This, in turn, consolidates complimentary

comparative advantages. Chinese direct

investment strengthens emerging market

purchasing power and also increases the domestic

acceptance of Chinese manufacturing goods.

Meanwhile, China’s rapid domestic demand

growth allows huge imports of raw materials from

these countries, fortifying a benign trade cycle.

ODI and the RMB

China’s ambition to internationalise the RMB (see

The rise of the redback, 8 November 2010) has

resulted in faster-than-expected progress in RMB

international trade settlement (Chart 4.8) and an

acceleration in the pace of using RMB for crossborder

trade investment. This has several

implications for Chinese ODI.

First, the PBoC has started to allow domestic

companies to use RMB for ODI (see China:

PBoC starts trial for RMB direct investment

overseas, 14 January 2011). Chinese companies

can now make ODI and remit revenues in RMB.

This will not only make ODI more convenient but

also reduce the exchange rate risk. The expected

gradual appreciation of the RMB in coming years

should also benefit Chinese companies that

expand overseas.

Chart. 4.8: RMB trade settlement taking off








(RMB bn)

2009 2010 2011 2012e 2013f 2014f



Trade settled in renminbi (Lhs)

RMB trade settlement as % of China's total trade (Rhs)

Source: CEIC, PBoC, HSBC

Second, most of the increase in RMB trade

settlement is taking place in emerging countries,

paving the way for wider acceptance of the RMB

as an investment currency. This should encourage

the recycling of trade-related RMB funds for

offshore investment.

Third, Beijing policymakers are actively relaxing

restrictions on ODI. In February 2011, the NDRC

raised the threshold for ODI projects seeking

central government’s approval to USD300m from

USD30m for the resources category and USD100m

from USD10m for non-resources projects.

Approval procedures were also simplified.

Meanwhile, the pilot reforms in Wenzhou allow

local residents to invest in overseas non-financial

projects that have clear, clean sources of capital.

The quotas for ODI have been reported as: 1)

USD3m for an individual’s investment in one

project; 2) USD10m for a collective investment in

one project; 3) USD200m for an individual’s total

annual investment.

Even more reason for the banks to improve.








November 2012


The rise of the redback

We expect RMB trade settlement to account for over 30% of

China’s total trade in less than three years

Inbound and outbound RMB direct investment is also rising

The easing of capital controls is likely to further increase the

global importance of the currency in the coming years

Matching China’s rising

economic power

What are the key factors that turn a currency into

an international one? A number of empirical

studies 2 conclude that the international acceptance

of a currency goes hand in hand with the rise and

fall of a country’s economic power.

In the 19 th century, 60-90% of international trade

was priced in British pounds. After eclipsing

Britain’s economy in the late 19 th century, the US

rose in economic power and turned into a net

creditor from a net debtor. Meanwhile, the dynamics

of economic power were reflected in the strength of

the US dollar, which overtook sterling as the

international reserve currency after World War II.

2 Bergsten, C. Fred., 1975, “The Dilemmas of the

Dollar: the Economics and Politics of United States

International Monetary Policy”, published for the

Council on Foreign Relations by New York University

Press, and Eichengreen, Barry, 1994, “History and

Reform of the International Monetary System”, Center

for International and Development Economics Research

(CIDER) Working Papers C94 -041 , University of

California at Berkeley.

The dominant role of the US dollar has seemed

unshakeable despite the challenge from the euro.

Although the recent financial crisis has

undermined investors’ faith in the US dollar to

some extent, the primacy of this currency in

international use should keep it as the top

international currency for the foreseeable future.

The internationalisation of the deutschemark,

which was the second-largest international

currency after the US dollar before the circulation

of the euro, can be attributed to Germany’s

economic power and the currency’s stability.

Germany became the third-largest economy after

the US and Japan in 1968, thanks to its remarkable

economic growth after World War II, which also

lifted its competitiveness in machinery exports.

Germany’s excellent trade record helped the

deutschemark appreciate against the US dollar

and British pound, while the liberalisation of trade

and capital paved the way for internationalising

the deutschemark. More importantly, the

Bundesbank, known as the most independent

central bank in the world, pursued a stable

currency as one of its most important objectives,

due to the fear of inflation.




November 2012


By limiting the growth of money supply, the

Bundesbank backed a strong and stable currency that

foreign investors and central banks chose to hold to

avoid exchange rate losses. Thus, the deutschemark

accounted for as much as 18% of the world’s foreign

exchange reserves by the early 1990s.

The internationalisation of the yen began in the

1970s, when Japan became the world’s secondlargest

economy after two decades of nearly 10%

growth. However, fearing some negative impact

from the yen’s internationalisation on domestic

financial markets, Japanese policymakers had not

actively pushed for yen internationalisation until the

Asian financial crisis and the launch of the euro.

Thus, the international use of the yen is not as

wide as it perhaps could be. This reflects: 1) the

initial passive attitude of the Japanese authorities

towards internationalising the yen; 2) the less

open domestic financial markets hindered

efficient yen internationalisation; 3) big swings in

the JPY/USD exchange rate have effectively

undermined the international use of the yen in

global trade and investment flows.

Long overdue

If history is any guide, the internationalisation of

the RMB is long overdue considering China’s

rising economic power relative to the limited use

of the RMB overseas. China’s nominal GDP

topped USD7.3trn at market exchange rates last

year, finally overtaking Japan as the world’s

second-largest economy.

Moreover, China is also probably the most

globalised of all the major economies, with the

value of its foreign trade growing at a pace of

21% per year over the last decade, more than

double the average growth rate of global trade in

the same period. China overtook Germany as the

world’s second-largest trading country in 2009.

From strength to strength

The RMB still has a long way to go before it can

match the influence of the country’s economy,

now the second largest in the world. But, as with

everything in China, things are moving very

quickly and the RMB is making giant strides

towards becoming a global currency.

For example, the pace of RMB trade settlement

has accelerated much faster than expected since it

was introduced in 2009. As Chart 5.1 shows, trade

volumes surged from a monthly average of

RMB18bn in 1Q10 to RMB173bn in 2011 and

RMB227bn in the first three quarters of 2012.

Cross-border trade settled in RMB accounted for

11% of total trade (exports and imports) in the

first three quarters 2012, a full percentage point

higher than in the same period last year. We

expect this to rise to above 12% by the end of this

year and well over 30% in less than three years.

This is much earlier than our initial expectation of

3-5 years.

HSBC’s survey of over 6,000 companies in 21

countries and markets showed that the RMB is

expected to overtake sterling to become the No 3

trade settlement currency in the coming months.

In mainland China, over a third of surveyed

companies expect to use RMB as a settlement

currency in the next six months, well ahead of the

EUR (24%). When the same survey was

conducted six months ago more businesses

expected to use EUR than the RMB.

We expect a further leap in RMB trade settlement

as trade with emerging economies continues to

increase (Chart 5.2).

Firstly, these markets represented about 70% of

China’s total imports in 2011, up from 52% in the

1990s. China’s exports to these countries account

for 53% of total exports, from less than 50% in

the 1990s. With growth likely to continue, we

expect at least half of China’s trade flows with




November 2012


Chart 5.1 RMB trade settlement is growing quickly

300 RMB bn







Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12

Value of renminbi trade settlement

Source: CEIC, HSBC

emerging market countries to be settled in RMB

in the next 3-5 years.

Secondly, as emerging markets supply China with

commodities and intermediate goods for assembly

before final shipment to the developed world, this

should further increase RMB trade settlement.

RMB trade settlement is triggering a chain

reaction in China’s capital markets. Rising

overseas demand for RMB is smoothing the path

for Chinese corporations to invest abroad using

RMB. As RMB trade revenue accumulates

outside China, it is smoothing the path for foreign

companies wishing to invest in China with RMB.

Chart 5. 2. Strong potential for RMB trade settlement with

emerging markets









1995 1997 1999 2001 2003 2005 2007 2009 2011

Source: CEIC, HSBC

EM ex ports as % of China total ex ports

EM imports as % of total imports

A three-stage process

Beijing sees internationalising the RMB as a

three-stage process:

1) Global trade settlement currency: The first

stage started in June 2009 with the RMB trade

settlement pilot scheme.

Table 5.1 Policy initiatives to internationalise the RMB


Policy initiative

April 14 2012 PBoC expands the RMB daily trading band from 0.5% to 1%.

June 21, 2011 A PBoC circular on cross-border RMB transactions states that FDI in RMB settlement business is at a pilot stage.

June 22, 2010 Pilot scheme for RMB trade settlement expanded to 20 provinces and municipalities. Overseas trade settlement rolled out

to rest of the world.

July, 2009

Six government departments jointly launch pilot programme for cross-border trade transactions.

April 2, 2009

PBoC signs bilateral currency swap agreement with Argentina.

March 23, 2009 PBoC signs bilateral currency swap agreement with Indonesia.

March 11, 2009 PBoC signs bilateral currency swap agreement with Belarus.

March 9, 2009 PBoC confirms that the State Council has approved a pilot scheme making Hong Kong the offshore centre for RMB trade


February 8, 2009 PBoC signs bilateral currency swap agreement with Malaysia.

December 25, 2008 The State Council allows cross-border trade between Guangdong, Yangtze Delta, Guangxi and Yunnan with Asian

countries to be settled in RMB. China signs bilateral currency settlement agreement with neighbouring countries, including

Mongolia, Vietnam, and Myanmar. This is considered a big step towards speeding up the regionalisation of the RMB.

December 4, 2008 Trade settlement between China and Russia to switch to their domestic currencies. The PBoC signs bilateral currency

swap agreement with the Bank of Korea, providing each other with RMB180bn in short-term liquidity.

July 10, 2008

PBoC sets up a new department responsible for exchange rate policy. One of its key functions is to "develop the offshore

RMB market in accordance with the evolution of internationalisation of RMB".

June, 2007

First RMB-denominated bond issued by the China Development Bank, worth RMB5bn, debuts on the Hong Kong stock

exchange, making it the first publicly-listed bond to be traded and settled in RMB. RMB bond issuance by mainland banks

totalled RMB 20bn by the end of 2007.

July 21, 2005

China moves to a managed floating exchange rate regime based on market demand and supply with reference to a

basket of currencies. The revaluation puts the RMB at 8.11 to the USD, an appreciation of 2.1%.

Source: PBoC, HSBC




November 2012


2) International investment/debt currency: The

launch of a new RMB products platform in Hong

Kong in July 2011 laid the groundwork for a wide

range of future offshore RMB investment vehicles

for foreign holders of China’s currency. An

announcement by the PBoC that it was rolling out a

pilot scheme for RMB direct investment will open

up an array of future onshore RMB investments.

3) An international reserve currency. This is still a

long way off. The RMB still lacks many of the

required characteristics of a reserve currency.

This step-by-step process is being closely

supervised by the PBoC. The imposition of

“trade-only” limitations, quotas and the

opaqueness of China’s onshore interbank bond

market serve as reminders that Beijing wants to

make sure that the internationalisation of the

RMB is both gradual and controlled.

How things got started

Making the RMB a global currency became a

major priority during the global financial crisis

when the value of the USD tumbled, putting at

risk Chinese assets worth USD1.8trn (this figure

had risen to USD3.3trn by the end of September

2012). The US Federal Reserve’s response, the

introduction of quantitative easing, caused

concerns in Beijing about inflationary risk

weighing on the value of the greenback, creating a

dollar trap.

This had major implications for Chinese exporters

and importers who used USD invoices. For more

details see From People’s banks to people’s hands,

8 March 2006, and Recycling China’s trade

dollars, 7 May 2007).

The first step was to increase the level of

acceptance of the RMB among neighbouring

countries. This was done through currency swaps

between the PBoC and other emerging economies.

For example, South Korea proposed a currencyswap

agreement with China in 2008 to bolster

market liquidity and confidence amid massive

capital outflows. At that time, a currency swap

deal using USD was not feasible given the

uncertainties created by the US sub-prime crisis.

Instead, China suggested a swap deal based on the

RMB, a proposal South Korea accepted.

Subsequently more countries entered RMB-based

currency-swap agreements with China (Table 5.2),

and many wanted to go a step further by using

RMB for trade and investment settlement.

Since then the internationalisation of the RMB has

surprised even the sceptics (see The rise of the

redback, 9 November 2010).

Table 5.2 Foreign currency swaps outstanding (as of September



Bilateral swaps


Expiry date

Amount Swap


Iceland 3.5 ISK-RMB 9-Jun-13

Singapore 150 SGD-RMB 23-Jul-13

New Zealand 25 NZD-RMB 18-Apr-14

Uzbekistan 0.7 UZS-RMB 19-Apr-14

Mongolia 10 MNT-RMB 6-May-14

Kazakhstan 7 KZT-RMB 13-Jun-14

South Korea 360 KRW-RMB 26-Oct-14

Hong Kong 400 HKD-RMB 22-Nov-14

Thailand 70 THB-RMB 22-Dec-14

Pakistan 10 PRK-RMB 24-Dec-14

UAE 35 AED-RMB 27-Jan-15

Malaysia 180 MYR-RMB 9-Feb-15

Ukraine 15 UAH-RMB 26-Jun-15

Source: PBoC, HSBC

From trade to investment

Apart from trade, it is also necessary to develop

offshore RMB products and expand investment

channels so foreign investors and businesses have

an incentive to hold, trade and invest RMB. To

become an international currency, the RMB must

be widely used for investment as well as for trade


This is happening in a number of different ways:




November 2012


RMB bonds in the Hong Kong offshore RMB

market (known as dim sum bonds) are

expanding rapidly.

Beijing started an R-QFII (RMB qualified

foreign institutional investor) scheme at the

end of last year, allowing offshore RMB to be

recycled back into domestic capital markets.

The R-QFII quota was increased from

RMB20bn to RMB70bn in April.

The domestic RMB market was further

liberalised this year, giving wider access to

foreign investors to the inter-bank bond

market and equity market.

Qualified China fund management companies

and Hong Kong branches of Chinese

securities firms can sell R-QFII products to

individual and institutional investors in Hong

Kong and use the RMB to invest in China’s

bond and equity markets. A total of 21

financial institutions were granted R-QFII

licences in December (nine fund management

companies and 12 securities firms).

HK as an offshore RMB centre

Hong Kong continues to play a leading role in the

RMB story. The city was responsible for 79% of

all cross border RMB trades, according to the

latest SWIFT report (Chart 5.3).

5.3. Hong Kong responsible for 79% of all cross-border RMB

trade settlement

Hong Kong China Other Countries

Jan-11 Apr-11 Jul-11 Oct-11 Jan-12


Source: SWIFT. Customer initiated and institutional payments, sent and received, base on value.

As of August 2012, total RMB deposits in Hong

Kong stood at RMB552bn, accounting for 8.6%

of total deposits in the banking system. Hong

Kong’s RMB bond market is valued at RMB74bn,

still a fraction of the RMB834bn that foreign

central banks can theoretically tap into through

outstanding FX swap contracts.

In an effort to broaden the offshore Hong Kong

RMB bond market, the NDRC in May released a set

of rules standardising the process for offshore RMB

bond issuance by onshore non-financial entities.

By setting minimum requirements even lower

than those for onshore bond issuance, the new rule

greatly expands the number of eligible offshore

issuers and paves the way for a material increase

in Chinese corporate bond supply over the

medium term. The main beneficiaries are Chinese

companies that do not already have substantial

offshore exposure.

Gross issuance of bonds and certificates of deposit

(CDs) totalled RMB103bn by 10 May 2012. Of

this RMB36.75bn (36%) was bonds, with

RMB8.5bn (8%) issued by Chinese companies.

(see Offshore RMB bonds: Standardised issuance

framework launched, 10 May 2012).

But Hong Kong is only part of the bigger picture.

To complete the on/offshore RMB circle, foreign

holders of RMB need to be able to retain and

invest RMB both inside and outside the mainland.

Hong Kong’s comparative strength as an offshore

RMB centre lies in its ability to develop a wide

range of RMB-related products and services,

rather than simply creating depth in one product

(e.g. RMB bonds).

Hong Kong Exchanges and Clearing (HKEx), the

city’s securities and futures exchange, launched a

USD-RMB contract on 17 September to meet

investors’ hedging needs. This is the first futures

contract denominated in RMB. To broaden the

range of products, it also plans to launch RMB




November 2012


commodities derivatives to meet demand risk

management in mainland China.

All in all, a lot of progress has been made in the

past few months. We have seen wider remittance

channels (e.g. RMB foreign direct investment, R-

QFII), RMB cross-border trade settlement

expanded to the whole nation and banks given

greater flexibility to conduct offshore RMB

business (through two HKMA refinements

released in January and February).

Shanghai: An international financial

centre of the future

Shanghai’s municipal government has ambitious

plans for RMB business as part of its plan to

become an international financial centre by 2020.

As well as more cross-border trade settlement,

Shanghai is encouraging trial RMB settlement in

capital accounts, including using the currency for

overseas project financing and direct overseas

investment. RMB cross-border trade settlement in

Shanghai already accounts for nearly 16% of the

national total in 2011.

The PBoC is allowing Chinese enterprises to use

RMB in ODI on a trial basis. This opens another

offshore channel and will encourage more

investment of RMB offshore trade funds

outside China.

Shanghai is the first mainland city open for RMB

denominated FDI settlement. Inward RMB

investment in the domestic bond market by

foreign central banks and trade clearance banks is

already allowed (see China: PBoC starts trial for

RMB direct investment overseas, 14 January

2011). Seven foreign reserve managers are

starting to invest in RMB bonds and other assets,

although the amount is still small (the amount

disclosed is less than USD20bn).

combined, this represents nearly 20% of total crossborder

investment for the same period.

Chart 5.4 RMB FDI inflows picking up








RMB bn


av g.

Source: PBoC, HSBC


FDI outflow s



FDI inflow s

Onshore is important too





The faster than expected development of RMB

internationalisation also has important

implications for the onshore financial markets.

They include:

Domestic financial markets to be opened

further to offshore RMB investors: The

markets are increasingly open to foreign

investors. Institutional investors have been

allowed to invest in the interbank bond

market since December 2010; they are now to

be given further access to the domestic bond

and equity markets. By September 2012, 152

institutions had QFII licences with a quota of


Further RMB exchange rate reform: This

will become more pressing as the amount of

inward and outward RMB investment gets

larger and larger. Shanghai’s plans to be an

international financial centre also require the

RMB to be more flexible to reflect market

supply and demand.


For the first nine months of this year, RMB ODI by

Chinese companies totalled RMB22.1bn and RMB

FDI into the mainland reached RMB154.5bn;




November 2012


Acceleration of interest rate liberalisation:

A competitive financial market with

diversified financial institutions is a

prerequisite for liberalising interest rates.

Armed with a stronger pricing capability,

domestic financial institutions could offer

deregulated interest rates depending on their

own funding costs and financial strength.

New RMB daily trading band offers

greater flexibility

The PBoC announced the widening of the USD-

RMB daily trading band to 1% from 0.5%,

effective 16 April 2012. This is another step

towards a more flexible and market-driven regime

based on supply and demand (see Asian FX: RMB

band widening: even more flexibility, 14 April).

Greater RMB volatility will create more currency

risk, which will encourage the banks to develop

more risk management products, such as currency

forwards, swaps, options and other financial

derivatives to meet hedging demand. At the same

time, this will increase trading volumes, which

will in turn help to deepen and expand China’s FX

market, improving price discovery in the process.

We see the widening of the band as a strong signal

Beijing recognises that now is the right time to

push forward with financial reforms, including

capital account and interest rate liberalisation.

Chart 5.5 Trade is basically balanced

350 USD bn

% 10














-50 1990 1993 1996 1999 2002 2005 2008 2011 -4

Trade balance, USD bn

as % of GDP

Source: CEIC, HSBC

The widening of the trading band was done to

internationalise the currency and not because it is

significantly undervalued (it has strengthened

30% since 2005). We believe the currency is close

to its equilibrium level, as indicated by China’s

more balanced current account. A market

oriented-exchange rate mechanism, once

established, will help to pave the way for RMB

convertibility and capital account liberalisation.




November 2012


A convertible RMB

within five years

China is increasing the pace at which it is opening its capital


We think this paves the way for the RMB to be fully convertible

within five years

Expect greater foreign access to China’s capital markets and

more individual Chinese to be allowed to invest overseas

The time is ripe

Signs are emerging that Beijing policymakers are

going to speed up the opening of the country’s

capital account. We think the pace of progress in

the next few years will be much faster than many

expect and now believe that the RMB will

become a convertible currency within five years.

Making the RMB a fully convertible currency is

the ultimate goal of China’s exchange rate reform.

While the currency has been convertible under the

current account for 15 years, recent steps have been

taken to make the RMB more convertible through

the gradual liberalisation of the capital account.

Policymakers now see a window of opportunity to

further speed up the process, although debate over

the pace of reform continues. In our view,

conditions are ripe for further action. Consider the

following factors:

1 More developed domestic financial markets

The rapid development of the domestic financial

market has paved the way for further capital

account liberalisation. First, the debt-laden big

state-owned banks have been transformed into

listed companies with stronger corporate

governance and risk controls.

Second, after 20 years of development China’s

capital market has become much more

sophisticated in terms of financial instruments and

investor base, and the market cap of both the

equity and bond markets has reached nearly 100%

of GDP. This means the market can accommodate

increased participation by foreign investors who,

in turn, will strengthen and deepen the domestic

financial markets. Meanwhile, the growing pool

of domestic funds also points to the need for

domestic investors to be able to invest more

outside China.

2 More balanced capital flows

Capital flows have become more balanced for

several reasons. First, China’s trade surplus has

dropped to around 2% of GDP in 2011 from the

peak of 7.5% in 2007. Consequently, the current

account surplus to GDP ratio fell to around 3%,

well within the target band set during the G20

summit in 2010.




November 2012


The RMB exchange rate is also much closer to its

equilibrium level after appreciating 30% against a

basket of currencies since it was de-pegged from

the USD in 2005. Markets now have two-way

expectations for the RMB exchange rate;

previously investors were only betting on it

appreciating against the USD. In April, China

doubled the RMB’s trading band to 1% from

0.5%, the first widening since 2007. This signals a

move towards a more flexible and market driven

currency regime (see Asian FX: RMB band

widening: even more flexibility, 14 April 2012).

3 Fast development of RMB trade settlement

RMB trade settlement has taken off, a key

stepping stone to making the RMB a global

currency. A small pilot RMB trade settlement

scheme introduced in July 2009 expanded rapidly

to the extent that total trade settled in RMB

increased four-fold in 2011 to reach RMB2.1trn

(USD330bn), about 9% of China’s total trade last

year. And this is likely reach a new record in 2012

thanks to the nearly 20% y-o-y growth in the first

three quarters, when renminbi trade settlement

represented 13% of total trade in 3Q 2012. To

support the programme, China has signed bilateral

currency swaps with a wide range of countries

and regions worth RMB1.3trn (see Table 5.2 and

The View, April 2012).

What’s next?

China currently restricts some movements of

money flowing into the country – including

investments in real estate, stocks and bonds – to

prevent sudden inflows and outflows of capital

that could destabilise its financial system. These

controls protected China during the Asian

financial crisis of 1997-98 and helped the country

weather the global financial crisis in 2008-09.

Essentially, China’s capital account is partially

open. For example, foreigners have full access to

B shares but A shares are restricted by a quota

system; a Chinese investor can buy foreign stocks

via QDII funds but cannot make direct

investments in overseas markets. Liberalising the

capital account will involve a gradual relaxation

of capital controls that will allow Chinese and

overseas investors to hold cross-border assets and

engage in cross-border asset transactions, which,

in turn, would increase RMB convertibility.

We expect Beijing to take the following steps to

further liberalise the capital account:

Further expansion of the QFII scheme which

has opened China’s domestic equity markets

to overseas investors. The quota was recently

increased from USD30bn to USD80bn and

the RQFII, its RMB equivalent, from

RMB20bn to RMB70bn.

The lifting of restrictions on foreign investors

participating in the domestic bond market and

the futures market.

An increase in the quota for individual

foreign exchange purchases, which stands at

USD50,000 per year. There is no evidence

that there has been an increase in the risk of

money outflows despite a rapid rise in the

number of Chinese tourists. We think this

quota is likely to be lifted to USD200,000 in

the coming years.

Permission for domestic individuals to invest

in overseas markets. The pilot programme in

Wenzhou is likely to be extended to

other regions.

Permission for foreign companies to raise

RMB on onshore capital markets.

The RMB has been convertible for current

account items since 1996. China started its foreign

exchange reform in 1994 by unifying the dual

exchange rates and introducing a market-based

unified floating exchange regime. In reality, this

was a de facto USD peg for the majority of the

time after the Asian financial crisis.




November 2012


Schemes introduced in 1994 and 1996 that

required companies to surrender foreign exchange

earnings that exceeded their quotas to domestic

banks were finally phased out in 2002. Today,

Chinese companies are allowed to keep their

foreign exchange earnings and also hold accounts

overseas. This has helped to support the boom in

China’s foreign trade, which has expanded 12-

fold over the past 15 years.

It’s official policy

Senior officials have made it clear that Beijing

aims to continue the gradual opening of the

capital account during the 12 th Five-year Plan

(2011-15), a policy that goes hand in hand with

increasing the convertibility of the RMB.

Premier Wen Jiabao has spoken of promoting

RMB convertibility “in a steady and orderly

manner”, a sentiment echoed by PBoC governor

Zhou Xiaochuan. PBoC Vice Governor Yi Gang

put it this way in an interview with Caixing

magazine in 2010: “A convertible yuan remains

the ultimate goal for the nation’s currency

exchange rate reform.”

It is easy to see why. Foreign trade and

investment – an important driver of China’s

spectacular growth over the past two decades –

would benefit not least because of the high cost of

retaining restrictions on capital flows and the

difficulty of differentiating capital account from

current account transactions (many involve both).

At the same time, capital account controls are

normally aligned with a fixed exchange rate

policy, resulting in imported inflation (or

deflation), posing risks to economic growth.

Controls are less tough than

many think

Following a series of steps towards liberalisation,

China’s control of the capital account is not as

tight as many think. According to the PBoC,

between 2002 and 2009 China announced 42

reform measures in this area. These loosened

administrative controls and eliminated differences

in the way domestic and foreign-invested

companies, state-owned and private enterprises

and institutions and individuals are treated.

The result is that the RMB is now more

convertible under the capital account than many

may think. Only four of 40 items under the capital

account are non-convertible (institutional

investor participation in domestic money markets,

funds and trust markets and trading

derivative instruments).

Twenty-two are partially convertible, including

transactions in the bond market, stock market, real

estate market and personal capital transactions.

The other 14 are basically convertible, including

credit operations, direct investment and the

liquidation of direct investment (see Table 6.1).

Table 6.1 Restrictions on China’s capital account

Not convertible








Transactions in capital market and money market instruments 2 10 4 16

Transactions in derivatives and other instruments 2 2 4

Credit operations 1 5 6

Direct investment 1 1 2

Liquidation of direct investment 1 1

Real estate transactions 2 1 3

Personal capital transactions 6 2 8

Total 4 22 14 40

Source: PBoC, HSBC. Here “ partially convertible” means strict restrictions and quota controls on payment for capital account transactions, “basically convertible” means loose restrictions on

payments for capital transactions, “fully convertible” means no restrictions on payment for capital transactions – a status rarely achieved even in advanced economies




November 2012


Foreign Direct Investment (FDI)

China started to liberalise FDI in the 1990s and

investors have long been free to convert foreign

currency into RMB. According to a 2003 circular

issued by the State Administration of Foreign

Exchange (SAFE), overseas investors can invest

in foreign-invested companies with freely

converted currency. This covers imported

equipment, intangible assets as well other

categories approved by the foreign exchange

bureau. RMB profits are fully convertible.

FDI is mainly monitored by the Ministry of

Commerce (some “strategic” sectors are restricted)

but forex controls over FDI inflows focus on

investigating the genuineness of the transaction.

According to the United Nations Conference on

Trade and Development (UNCTAD), China has

been the top FDI destination in the developing

market since the middle of 1990s. The country’s

FDI has surged 2.5 times over the last 10 years to

USD116bn last year.

In addition to the capital flows into manufacturing

sectors (which represented over 55% of total FDI

before 2007), China’s FDI has been

increasingly driven by the opening up of the

services sector (including banking, retailing

and telecommunications).

Chart 6.2 Strong FDI growth despite modest decline this year


(USD bn)








1998 2000 2002 2004 2006 2008 2010 2012*

Source: CEIC, HSBC * As of end 3Q 2012

There has been a modest decline in FDI this year

(down by 3.8% y-o-y as of end 3Q), which mainly

reflects the cyclical slowdown of investment

growth, the correction in the property market and

impact of the EU debt crisis. According to

UNCTAD, China surpassed US as the largest

recipient of FDI in the first half this year, with the

US experiencing a 39% y-o-y decline.




November 2012


Table 2.2 Summary of China’s rules about major capital account transactions -- Production please improve spacing between columns

Stock market

Bonds and other

debt securities

Money market




















Derivatives and Foreign

other instruments investors



Direct investment Foreign


Source: IMF, HSBC




Can purchase B shares (USD/HKD) listed on the

Chinese Securities Exchange (also available for

domestic investors)

Foreign investors may make strategic investments in

domestic listed companies with some restrictions

QFIIs can purchase A shares subject to certain


Domestic companies can issue shares abroad with

CSRC approval

QFIIs are permitted to purchase exchange-listed

equities, bonds, securities investment funds and

warrants and other financial instruments

Domestic companies can issue bonds abroad with

maturities in excess of one year with prior approval by

the State Council

QFIIs may purchase money market funds, but they

are not permitted to participate directly in investment

transactions on the interbank foreign exchange


Domestic companies can issue money market

instruments (such as bonds and CP with maturities of

less than one year) with SAFE approval

QFIIs may invest in closed-end and open-end funds


Issue collective investment securities with SAFE


Not allowed

Regulated financial institutions with the approval of

the Chinese Banking Regulatory Commission

(CBRC) may sell for the purposes of hedging, gaining

profit, and providing transaction services for clients

Derivative operations are subject to prior review by

regulatory agencies and there are restrictions on

open foreign exchange positions

If approved by the Ministry of Commerce, nonresidents

are free to invest in China


Can sell A and B shares listed on the Chinese

Securities Exchange

There are no restrictions on the issuance of A or B

shares by foreign institutions under current

regulations, but no foreign institution has yet to

issue any A or B shares in China

Domestic companies may repurchase shares

issued by them abroad with SAFE approval

QDIIs purchase shares and other investment

instruments abroad subject to certain limitations

International development agencies are permitted

to issue RMB denominated bonds with the

approval of the MOF, the PBoC, and the NDRC

Foreign-funded enterprises are permitted to issue

bonds with approval

Insurance companies, securities firms, qualified

banks and groups (QDIIs) are permitted to

purchase foreign bonds that meet rating

requirements, subject to the approval of the China

Insurance Regulatory Commission (CIRC) and


Not allowed

Insurance companies, securities firms, qualified

banks and QDIIs are permitted to purchase money

market instruments that meet rating requirements,

subject to the approval of the CIRC and SAFE

Not allowed

Insurance companies, securities firms, qualified

banks and groups are permitted to purchase

collective investment securities that meet rating

requirements, subject to the approval of the CIRC

and SAFE

Not allowed

Regulated financial institutions with the approval of

the CBRC may purchase for the purposes of

hedging, gaining profit, and providing transaction

services for clients

Derivative operations are subject to prior review by

regulatory agencies and there are restrictions on

open foreign exchange positions

Regulated financial institutions that meet risk

management requirements may trade in gold

futures on domestic market

Permitted after an examination of the sources of

foreign exchange funds and approval by the

related authorities

Domestic institutions are permitted to make

outward investments using a variety of asset

sources. Individuals cannot (apart from the

Wenzhou pilot programme)




November 2012


Chart 6.2 Rising FDI into services industries








2003 2004 2005 2006 2007 2008 2009 2010 2011 2012*

FDI in serv ices industries as % of total FDI

Source: CEIC, HSBC

Overseas Direct Investment (ODI)

China is not just the world’s leading exporter of

goods but also one of the top exporters of capital.

With ODI (non-financial) topping USD68.6bn in

2011, China in now the world’s sixth largest

exporter of capital, and signs have emerged that

this figure is likely to double in the next 3-5 years

as Chinese companies expand overseas (see

chapter four of this report and China Inside Out,

China going global: key trends, 29 April 2011).

So, just as it has become easier to move money

into China, the same applies in reverse. Again,

this has been a gradual process. In 2009 Beijing

allowed Chinese companies operating overseas to

keep profits offshore. Then, last year, a trial

programme let some Chinese businesses use RMB

for ODI (see China: PBoC starts trial for RMB

direct investment overseas, 14 January 2011).

Chart 6.3 ODI is taking-off





(USD bn)

We expect this “Going out” strategy to be

promoted aggressively during the current 12 th

Five-year Plan. China is committed to improving

the country’s legal and institutional framework,

which will also enhance overseas investment. We

expect to see further relaxation of ODI foreign

exchange regulations in the coming years. We

also expect ODI to surpass FDI in the coming

three to five years.

Foreign debt limits

China has quotas for both long-term and short-term

foreign debt. The trend is to gradually relax the

regulations for short-term debt, credit which has

helped China’s companies finance their export and

import trade. For example, to offset the impact of

the financial crisis back in 2008, SAFE allowed

companies to borrow a bigger percentage of the

value of imports and exports (25%, up from 10%).

The structural breakdown of China’s outstanding

debt suggests that over the past decade mid-tolong

term foreign debt rose modestly, while shortterm

debt surged nearly 30x, much faster than the

six-fold expansion of total trade. Trade credit,

subject to the international trade cycle, accounts

for around 50-60% of outstanding short-term

foreign debt. This makes it the largest swing

factor in China’s total foreign debt.

Chart 6.4 Relaxation of short-term foreign debt supports

trade growth






(USD bn)

1991 1994 1997 2000 2003 2006 2009 2012

Mid-long term

Short term



1991 1995 1999 2003 2007 2011

Source: CEIC, HSBC

Source: CEIC, HSBC




November 2012



While foreign direct investment is easy, portfolio

investment remains highly restricted. It is only

available in the form of QFII and QDII schemes;

both are subject to approvals and quotas.

The QFII scheme was introduced in 2003,

opening the door for foreign investors to access

China’s capital market. Investment is now

allowed in A-shares, treasury bonds (T-bonds),

convertible bonds and corporate bonds listed on

stock exchanges. By September 2012, 188 foreign

institutions had received QFII approval from the

CSRC. This has resulted in a total of USD30.8bn

being invested in the local capital market (still just

a fraction of the domestic market cap).

The QFII scheme is expanding rapidly on several

fronts. First, the number of participants is rising at a

faster pace than in previous years. Before

November 2011, on average only 2-3 new QFIIs

were approved per month but this has jumped to

eight over the last five months. Second, the total

QFII quota has been expanded to USD80bn from

USD30bn. The last time the quota was increased

was back in May 2007, when it rose from

USD10bn to USD30bn. Third, local media has

reported that hedge funds are now eligible to apply.

Chart 6.5 QFII approvals are accelerating










2004 2005 2006 2007 2008 2009 2010 2011 2012

Source: CEIC, HSBC

In the meanwhile, the RQFII scheme was

launched in December 2011. As of end 3Q, RQFII

licences have been granted to 21 companies, with

investment quota of RMB39bn (or around


In April 2006 the PBoC launched the QDII

initiative under which local RMB assets could be

pooled and converted into foreign currencies and

invested overseas. Although hit hard by the 2008-

09 financial crisis it has survived and prospered.

As of end 3Q 2012, there were 103 QDIIs that can

invest up to USD85.6bn, almost 65% more than

before the crisis.

Chart 6.6 QFII quotas are picking up pace

According to local media, the CSRC is also

considering relaxing the QFII approval rules. This

could see institutions granted more than one

licence and given greater flexibility about what

asset classes they can invest in.






(USD bn)

(RMB bn)







2003 2004 200520062007 200820092010 20112012*

QFII (Lhs) QDII (Lhs) RQFII (Rhs)


Source: CEIC, HSBC * As of end 3Q12




November 2012


Individual FX quota

The annual foreign exchange quota for individuals

is USD50,000 a year (it was increased from

USD20,000 in 2007). Chinese citizens are still not

allowed to make direct or portfolio investments in

overseas markets.

That said, things are changing. The recent pilot

scheme in Wenzhou allows residents to make ODI

(non-financial) of up to USD200m per year (no

more than USD3m per person, per project; a

maximum of USD10m for multi-person

investment in one project). Local media has

reported that other cities such as Shanghai,

Tianjin and Beijing are all preparing to launch

similar pilot programmes that will open the door

for local residents to invest abroad.

There will still be rules

An open capital account and RMB convertibility

doesn’t mean a complete absence of regulation. In

other words, it is important to distinguish between

free and full convertibility. The latter implies that

regulators will continue to monitor transactions in

order to safeguard domestic financial stability.

While these controls involve some inefficiency

and cost to the economy, they are likely to be in

place during a transitional period 3 .

Firstly, from the point of view of international

standards, the IMF doesn’t oblige member

countries to achieve convertibility under the

capital account, although according to Article VIII

there is an obligation to avoid imposing

restrictions on transactions under the current

account. In fact, Article VI (3) allows members to

“exercise such (capital) controls as are necessary

to regulate international capital movements, but

not so as to restrict payments for current

transactions or which would unduly delay

transfers of funds in settlement of commitments 4 ”.

Second, capital controls still co-exist with capital

account convertibility in certain economies (for

example, South Korea and Taiwan and some

Latin American countries).

According to the IMF, over 70% of its member

countries still impose restrictions on direct

investment, real estate transactions and capital

market transactions. In fact, the level of

cautiousness about capital account management

has increased since the Asian financial crisis in

1997-98. During the 2008-09 global financial

crisis many countries strengthened capital controls

to ensure domestic financial stability.

China can achieve basic full RMB convertibility,

while at the same time retaining appropriate

capital controls in order to minimise risks.

Prudent controls are likely to be kept in place,

possibly in the form of restrictions on speculative

money inflows and short-term foreign debt.

3 Stanley Fischer (1997), Capital Account

Liberalization and the Role of the IMF, Conference on

Development of Securities Market in Emerging markets,

Inter-American Development Bank, Washington DC





November 2012


Learning the lessons

The reform process is never straightforward, but China can learn

lessons – both good and bad – from other countries

The pace and sequence of reforms are the keys to success

While the process has begun, Beijing must first put its domestic

financial house in order before making bold moves to liberalise the

capital account

What China can learn from

other countries

Change is never a simple process. Like any

journey, there are bumps in the road, unexpected

delays and even the occasional diversion. The

process of reforming China’s financial system is

unlikely to be any different. Helpfully, plenty of

other countries have already gone down this route

and we think Beijing’s policymakers can learn

from what was successful and also avoid

repeating some of the mistakes that were made

along the way.

Lesson 1

The sequence and pace of capital account

liberalisation are very important

History tells us that capital account liberalisation

– broadly defined as the removal of controls on

international flows of capital to enable currency

convertibility and the opening of the financial

system – should be taken step-by-step. It must

also be part of a comprehensive package which

co-ordinates reforms of domestic financial

markets, the exchange rate and interest rate policy.

Although the sequence of change varies from one

country to another, aggressive and rapid

liberalisation of the capital account without the

correspondent measures to contain risks can lead

to distortions and even crisis.

In the early 1990s foreign capital flooded into

Thailand, attracted by high domestic interest

rates and strong GDP growth. At the same time,

the Thai baht remained pegged to the US dollar,

which led to ballooning short-term debt, which in

turn helped fuel high levels of inflation, economic

overheating and the creation of asset bubbles. In

1997 the Asian financial crisis was born – in

Thailand. The economy went into meltdown.

Another example is Indonesia, which liberalised its

capital account before the current account. It also

lifted all restrictions on capital outflows as well as

most controls on capital inflows in a relatively short

period of time (1967-1970). Indonesia subsequently

liberalised its trade and current account, financial

markets, interest rates and relaxed the restrictions on

foreign portfolio investment.

However, with a liberalised capital account and a

fixed exchange rate, the economy then came face

to face with the Mundell Impossible Trinity, the




November 2012


theory put forward by Nobel economics laureate

Robert Mundell that no economy can have free

capital flows, a fixed exchange rate and control

over its own monetary policy (i.e. stable interest

rates or stable prices) all at the same time. When

the Asian Financial Crisis struck, Indonesia was

among the countries that suffered most.

Lesson 2

Risk management, especially controls on

short-term capital flows, is key

India’s smooth liberalisation of its capital account

can also offer good lessons, for example:

Making sure the authorities can impose

restrictions that minimise risks associated

with big swings in capital flows that can

affect financial stability. For instance, the

central bank sets an adjustable quota for

foreign institutional investors (FIIs) in

government and corporate securities. In 2010

the FII limit for bonds was raised by USD5bn

for both government and corporate bonds,

taking the cap to USD10bn for government

securities and USD20bn for corporate bonds.

Recently, on 25 June this cap was revised up

to USD20bn for government securities.

Closely monitor short-term capital flows.

Short-term capital gains on the sale of

securities are subject to tax of 30%.

Foreign direct investment in India’s property

market is not allowed.

Lesson 3

Sound domestic financial markets and stable

macroeconomic environment are essential

Before fully opening its domestic capital market

in 1996, Korea introduced a range of reforms that

started way back in 1988. The development of the

country’s domestic money, securities and foreign

exchange markets paved the way for the opening

up of the capital account for portfolio capital

flows in the 1990s.

Chile also took a gradual approach. It started to

open up its capital account in 1974 but the

economic and banking crisis of early the 1980s

slowed the pace of change until 1985. Since then

the process of restructuring the banks has been

completed, along with the liberalisation of the

exchange rate system. Other reforms include the

selective liberalisation of capital inflows,

followed by the development of the domestic

capital market and controlled liberalisation of

capital outflows. This measured and well

sequenced approach to liberalising its capital

account helped the country to withstand a wave of

financial crises – Mexico (1994), Asia (1997),

Brazil (1999) and Argentina (2001).

Lesson 4

Favourable external environment helps to

minimise risk of external shocks

When Japan started to open its capital account in

1984, the world economy was just starting to

recover from the global financial crisis of 1980-

1982. Similarly, when Russia announced the full

convertibility of the rouble in 2006, external

conditions were favourable for the oil-rich nation;

the global economy was booming and commodity

prices were rising. However, the flip side is that

the 2008 financial crisis and subsequent capital

outflows put pressure on the currency and the

process of capital account liberalisation.

Don’t put the cart before the


China must put its domestic financial house in

order before making bold moves to liberalise its

capital account. Without a sound and stable

domestic financial system, China will be exposed

to an elevated level of risk and shocks from

external markets. Here are some of the problems

that need to be addressed:




November 2012


1 Local government debt

Local governments, prohibited from borrowing

money directly from bank, have set up thousands

of LGFVs to raise funds for infrastructure projects

in recent years. In 2010 the National Audit Office

put the combined debt of LGFVs at RMB10.7trn.

To put this in context, the huge economic stimulus

package announced by Beijing in late 2008

totalled RMB4trn.

Since then the central government has kept tight

control over the LGFVs and their debt increased

by only RMB300m over the course of 2011.

Banks have remained cautious about lending to

LGFVs this year, although the payback period for

some of the loans has been extended. As we

argued earlier in this report, the real problem for

local governments is liquidity rather than

sovereign debt as most LGFVs have plenty of

valuable assets.

We think the tight central government controls, plus

an increase in the issuance of local government and

corporate bonds, imply that the LGFVs can solve

this problem of liquidity, which is largely a duration

mismatch. Some 53% of their debt is due by 2013,

while the majority of the proceeds from the bonds

went on infrastructure projects, which take several

years to generate returns.

Chart 7.1. Local government debt’s maturing table

after 2015


by 2013




Source: National Audit Office, HSBC

2 Banks: Interest rate liberalisation and

credit risk controls

The reform process represents a huge challenge for

the big state-owned banks. First, the likely

narrowing of the gap between savings and lending

rates will be a major issue. The net interest margin

– the difference between the two rates – is the

lifeblood of China’s banks, on average representing

around 80% of total operating income.

In a more market-driven environment, the banks

will also be vulnerable to the interest rate

sensitivity gap, a measure of how much the price

of a fixed-income asset will fluctuate as a result of

changes in interest rates. Generally, the longer the

maturity of the asset, the more sensitive the asset

will be to changes in interest rates.

Banks also need to be well prepared for the

liberalisation of the capital account. As the

dominant financial intermediaries, they are

exposed to the risks of big swings in capital

inflows and the likely increase of foreign currency

debt due to the large inflows of foreign capital.

To minimise the risks, the authorities need to

strengthen the monitoring of cross-border capital

flows and the banks’ foreign currency positions.

For their part the banks need to improve their risk

management by establishing a rational pricing

mechanism and strengthening internal audits and

control systems and accelerating the innovation of

financial derivative products.

3 Stock market irregularities

China’s A-share market is far less mature than

those in developed economies. Its poor

performance reflects the fact that listed companies

have raised too much equity capital from the

market and paid out too little in dividends.

Meanwhile, irregularities such as insider trading,

stock manipulation, false financial data, the

spread of misleading market information and




November 2012


opaque reporting practices hinder the market’s

development and erode investor confidence.

Investors need to be properly protected; otherwise

they could opt to take their money elsewhere,

especially as more investment opportunities

become available.

Guo Shuqing, the reformist chairman of the

CSRC, has put market supervision and investor

protection at the top of his agenda. HSBC’s equity

strategists believe he will make a real difference

and expect the pace of reform to accelerate (see

China Strategy: Reforms to drive slow-paced A-

share market rerating, 13 March 2012).


The pace and sequence of the financial reforms

are the keys to success. The authorities are

following the principle of liberalising “capital

inflows before capital outflows, long-term capital

instruments before short-term capital instruments,

direct investment before indirect investment and

institutional capital flows before retail capital

flows.” They have been making steady progress.

Meanwhile, Beijing is making efforts to coordinate

the liberalisation of the capital account

with domestic financial market and exchange rate

reforms. Policymakers have speeded up the pace

of interest rate liberalisation by expanding the

floating band of both lending and deposit rates

when cutting interest rates. They have also

increased exchange rate flexibility by widening

the trading band to 1%. These measures should

improve the flexibility and efficiency of monetary

policy and strengthen the resilience of the

domestic financial market.

Despite the wobbly state of global financial

markets and fragile growth rates, the world

economy is still heading for a recovery. At the

same time, China is adopting a cautious and

gradual approach to opening its capital account

and making its currency fully convertible. We

believe the combination of a better economic

outlook and Beijing’s risk management skills

should help China to achieve a smooth opening of

its capital account in the coming 3-5 years.




November 2012


China: Economic milestones since 1978

1978: Deng Xiaoping launches reforms. Household

responsibility system introduced in the countryside,

giving some farmers ownership of their produce.

1979: Diplomatic relations with the US normalised.

1990: The Shanghai

Stock Exchange opens.

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

1980: Southern city of Shenzhen bordering Hong Kong is the first

Special Economic Zone to experiment with more flexible market

policies. It is rapidly transformed from a fishing village into a

manufacturing powerhouse.

1988: Bank runs and panic buying are

triggered by rising inflation that peaks

at over 30% in cities.

1996: China fulfils IMF’s article IIIV and allows the RMB to be convertible on the

current account, enabling the free flow of money for imports and exports.

1998: China bails out its banking sector, which was

weighed down by bad loans to state-owned enterprises.

1994: Fiscal reforms split tax

sharing between central and

local governments

2001: China joins the World Trade Organization.

2003: National People’s

Congress endorses Hu Jintao

as successor to Jiang as

president. SARS breaks out.

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

2005: China sweeps past Britain, France and Italy to

become the world’s fourth-largest economy. China

frees the RMB from a dollar peg, letting it float within

a tightly managed band. Beijing launches the nontradable

share reform.

1997: Deng dies and is

succeeded by Jiang

Zemin. Hong Kong

returns to Chinese rule.

1999: Beijing proposes a

strategy to accelerate the

development of the western

regions. Macau returns to

Chinese rule.

2008: Start of global financial

crisis. Beijing hosts successful

Olympic Games.

2002: Entrepreneurs

allowed to join the Chinese

Communist Party. The first

National Financial

Economic Work Conference

is held in Beijing.

2010: Unprecedented measures to cool the property

market introduced; Shanghai hosts Expo.

2004: State-owned banks

reform; the protection of

ownership of private

property stipulated in

China’s Constitution.

2011: Reformers appointed to head financial regulatory

agencies for banks, equities and insurance.

2005 2006 2007 2008 2009 2010 2011 2012 2013

Source: Reuters, Bloomberg, HSBC

2006: Two huge infrastructure projects, the

Three Gorges Dam and a railway to Tibet, are

completed. China’s foreign currency reserves,

already the world's biggest, top USD1trn.

Beijing starts the strategy of advancing the rise

of central China.

2009: Beijing unveils

massive stimulus package

to offset impact of the

global financial crisis.

2012: January: The influential National Financial Working

Conference (NFWC) releases an eight-point, five-year

blueprint for reform. February: RRR cut by another 50bp.

March: Wenzhou pilot scheme announced. April: the RMB

daily trading band against the USD was increased for the

first time since 2007 to 1%, up from 0.5%. May: Foreign

companies permitted to raise stakes in joint ventures with

domestic securities firms to as much as 49%.




November 2012






November 2012






November 2012


Disclosure appendix

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opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their

personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific

recommendation(s) or views contained in this research report: Hongbin Qu, Jun Wei Sun and Xiaoping Ma

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Qu Hongbin

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Qu Hongbin is Managing Director, Co-Head of Asian Economics Research, and Chief Economist for Greater China. He has been an

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Sun Junwei


The Hongkong and Shanghai Banking Corporation Limited

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Sun Junwei is an economist for China on the Asian Economics team. Prior to this, she worked as an economic analyst at a leading

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from Peking University.

Ma Xiaoping


The Hongkong and Shanghai Banking Corporation Limited

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Ma Xiaoping is an economist for China on the Asian Economics team. Prior to joining the HSBC China Economics team in 2005,

she worked with a leading academic research institute in Beijing. Xiaoping holds an MA in Economics from Peking University.

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