Asia Local Markets Guide 2012

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EMERGING MARKETS RESEARCH

December 2011

ASIA LOCAL MARKETS

2012 GUIDE


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Barclays Capital | Asia Local Markets Guide 2012

27 December 2011 1

FOREWORD

Representing more than 20% of global GDP and expected to contribute around 60% of

global growth in 2012, Emerging Asia continues to be a focal point for international

investors. However, the idiosyncratic nature of Asian policies and markets makes it

challenging for many to get a sufficiently deep understanding of the markets and the subtledifferences among various instruments. Our Asia Local Markets Guide 2012 is intended to

provide such an understanding and better position investors to take advantage of the many

opportunities that exist in the region.

In this publication, we detail the monetary, currency and fiscal policies as well as the

regulatory environment in key Emerging Asia bond and currency markets. We also provide

insights into the transmission of monetary policy into financial markets, detailing the

various instruments that are traded in each market and identifying the main drivers.

This guide is intended to help facilitate a dialogue with our analysts and with the trading

and sales professionals at Barclays Capital who are dedicated to serving your investment

needs providing you with the information and analysis that we hope will lead to more

informed investment decisions.

We welcome feedback and look forward to working with you in 2012 and beyond.

Jon Scoffin

Head of Research, Asia Pacific and Head of Credit Research


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27 December 2011 2

TABLE OF CONTENTS

CHINA 4

Monetary policy environment ................................................................................................................. 4Money markets and policy rate transmission...................................................................................... 7

Interest rate derivatives........................................................................................................................... 12Bond markets ............................................................................................................................................ 14Fiscal policy and credit ratings.............................................................................................................. 18Fixed income instruments reference guide........................................................................................ 19Currency policy and foreign exchange markets................................................................................ 20FX reference guide ................................................................................................................................... 22

HONG KONG 24

Monetary policy environment ............................................................................................................... 24Money markets and policy rate transmission.................................................................................... 27Interest rate derivatives........................................................................................................................... 29Bond markets ............................................................................................................................................ 31Fiscal policy and credit ratings.............................................................................................................. 34Fixed income instruments reference guide........................................................................................ 35Currency policy and foreign exchange markets................................................................................ 36FX reference guide ................................................................................................................................... 37

INDIA 38

Monetary policy environment ............................................................................................................... 38Money markets and policy rate transmission.................................................................................... 41Interest rate derivatives........................................................................................................................... 43Bond markets ............................................................................................................................................ 45Fiscal policy and credit ratings.............................................................................................................. 49Fixed income instruments reference guide........................................................................................ 51Currency policy and foreign exchange markets................................................................................ 52

FX reference guide ................................................................................................................................... 54

INDONESIA 55

Monetary policy environment ............................................................................................................... 55Money markets and policy rate transmission.................................................................................... 58Interest rate derivatives........................................................................................................................... 60Bond markets ............................................................................................................................................ 61Fiscal policy and the sovereign credit rating...................................................................................... 66Fixed income instruments reference guide........................................................................................ 67Currency policy and foreign exchange markets................................................................................ 68FX reference guide ................................................................................................................................... 69

MALAYSIA 70

Monetary policy environment ............................................................................................................... 70Policy rate transmission.......................................................................................................................... 73Interest rate derivatives........................................................................................................................... 75Bond markets ............................................................................................................................................ 77Fiscal policy and credit ratings.............................................................................................................. 83Fixed income instruments reference guide........................................................................................ 84Currency policy and foreign exchange markets................................................................................ 86FX reference guide ................................................................................................................................... 87


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PHILIPPINES 88

Monetary policy environment ............................................................................................................... 88Money markets and policy rate transmission.................................................................................... 90Interest rate derivatives........................................................................................................................... 91Bond markets ............................................................................................................................................ 92

Fiscal policy and credit ratings.............................................................................................................. 94Fixed income instruments reference guide........................................................................................ 95Currency policy and foreign exchange markets................................................................................ 96FX reference guide ................................................................................................................................... 97

SINGAPORE 98

Monetary policy environment ............................................................................................................... 98Policy transmission ............................................................................................................................... 102Interest rate derivatives........................................................................................................................ 105Bond markets ......................................................................................................................................... 107Fiscal policy and credit ratings........................................................................................................... 111Fixed income instruments reference guide..................................................................................... 112Currency policy and foreign exchange markets............................................................................. 113FX reference guide ................................................................................................................................ 114

KOREA 115

Monetary policy environment ............................................................................................................ 115Money markets and policy rate transmission................................................................................. 119Interest rate derivatives........................................................................................................................ 122Bond market........................................................................................................................................... 125Fiscal policy and credit ratings........................................................................................................... 130Fixed income instruments reference guide..................................................................................... 131Currency policy and foreign exchange markets............................................................................. 132FX reference guide ................................................................................................................................ 134

TAIWAN 135

Monetary policy environment ............................................................................................................ 135Money markets and policy rate transmission................................................................................. 138Interest rate derivatives........................................................................................................................ 142Bond markets ......................................................................................................................................... 144Fiscal policy and credit ratings........................................................................................................... 148Fixed income instruments reference guide..................................................................................... 149Currency policy and foreign exchange markets............................................................................. 150FX reference guide ................................................................................................................................ 152

THAILAND 153

Monetary policy environment ............................................................................................................ 153Policy rate transmission....................................................................................................................... 157Interest rate derivatives........................................................................................................................ 159Bond markets ......................................................................................................................................... 162Fiscal policy and credit ratings........................................................................................................... 167Fixed income instruments reference guide..................................................................................... 169Currency policy and foreign exchange markets............................................................................. 170FX reference guide ................................................................................................................................ 171

APPENDIX: USEFUL LINKS 172


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ChinaFI Strategist: Ju Wang +65 6308 2801; [email protected]

Monetary policy environment

Policy objectives Price and currency stability; relatively fast and stable growth;

full employment; balance in international payments.

MPC frequency and membership

The MPC meets quarterly, but policy decisions can bemade at any time. Decisions are recorded in "meeting

minutes; the PBoC can decide RRR and discount rate

changes on its own but State Council approval is required

for annual credit growth/money supply, interest rate,

exchange rate targets.

The MPC comprises the governor of the Peoples Bank ofChina and two deputy governors, a deputy secretary-

general of the State Council, a vice minister of the NDRC, a

vice finance minister, the administrator of SAFE, the

chairman of the CBRC, the chairman of the CSRC, the

chairman of CIRC, the commissioner of the NBS, the

president of the China Association of Banks and an

academic expert. (For details on the PBoC, seeAsia-Pacific

Central Banks: 2012 Guide, 4 November 2011).

Monetary policy tools

Policy rates: Both lending and deposits are regulated inChina. Policy rates are the 1y lending rate (Bloombergticker: CHLR12M) and 1y deposit rate (Bloomberg Ticker:

CNDR1Y). Since 2004, commercial lending rates have been

allowed to vary by 0.9-1.7 times the 1y lending rate for

commercial banks and by 0.9-2 times the 1y lending rate

for rural credit cooperatives. Deposit rates up to 5y are still

regulated. The spread between the lending and deposit

rates, a key source of banking system profits, remains

wide and largely unchanged 15 years after China began

the interest rate liberalisation process in 1996.

Open market operations: The PBoC began conductingopen market operations (OMOs) in October 1998. Cashbond trading initially was the most common tool, but was

replaced by bond-based repo transactions to avoid

affecting the bond market. The PBoC began auctioning

central bank bills to conduct OMOs in 2003, when it ran

out of government bonds issued by the Ministry of

Finance in the face of large FX inflows.

The frequency of OMOs has been kept at twice a week

(Tuesday and Thursday) since 2003. Currently, 52 primary

Summary table of monetary policy

ObjectiveMaintain price and currency stability, economic growth,

high employment, balance in international payments

Policy rate 1y lending and deposit rates

2011 monetary

targets

M2 growth of 16% and an implicit new loan target of

CNY7-7.5 trn

MPC

The PBoC's MPC is a consultative body for setting

monetary policy. Its responsibilities, composition and

working procedures are prescribed by the State Council

MPC frequency Meets quarterly

Policy toolsReserve requirement ratio, open market operations,

discount window, "window guidance"

The People's Bank of China (PBoC)

Source: PBoC

Policy rate, RRR, discount rate and inflation (%)

-2

0

2

4

6

8

10

2001 2003 2005 2006 2008 2010 2011

%

0

5

10

15

20

25

1y deposit rate 1y lending rate

CPI (y/y) RRR ratio (%, RHS)

Source: CEIC, Bloomberg, Barclays Capital

1y deposit rate and spread vs 1y lending rate

0

1

2

3

4

56

7

8

9

Jun-96 Jun-99 Jun-02 Jun-05 Jun-08 Jun-11

0

50

100

150

200

250

300

350

4001y lending - deposit rate spread (bp, RHS)

1y deposit rate

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dealers participate in the bill auction process (most are

domestic commercial banks, but policy banks, securities

firms, insurance companies and asset management firms

are also included; two locally-incorporated foreign banks

have also been selected as PDs). The PBoC inquires about

the primary dealers interest (level and size) one day in

advance and announces the auction size (Dutch style) at4:30pm local time on that day.

Currently, instruments used for OMOs are 3m, 1y and 3y

PBoC bills. 1y bills are auctioned every Tuesday and 3m bills

on Thursday. The 3y bill is used to lock in liquidity for longer

periods and is seen as a powerful tool. Its issuance has

varied from weekly to no auction at all. The 1y bill auction

yield is widely seen as a leading indicator of the policy rate,

particularly in hiking cycles. Primary and secondary market

bill yields can diverge, depending on market expectations of

future rates and interbank liquidity conditions.

Other key OMO instruments are repos and reverse repos.

Compared to bills, repos have shorter terms and are used for

fine-tuning liquidity purpose. In repo transactions, which

are held on Tuesdays and Thursdays without prior notice, the

PBoC sells securities to the market with an agreement to buy

them back at a specified date. Repos take liquidity out of the

system, which is returned when the contract matures.

Reserve repos have the opposite impact on market liquidity.

They are rarely used and are conducted only with select large

banks when liquidity is deemed as too tight. The interest rate

charged by the PBoC for reverse repos tends to be

significantly higher than bill and repo rates to discourageover-reliance on the central bank to provide liquidity.

Reserve requirement: The reserve requirement ratio(Bloomberg Ticker: CHRRDEP) is the percentage of

deposits banks are required to place with the central bank.

Only cash is acceptable. The PBoC currently pays 1.62%

on required reserves, 0.72% on excess reserves and 0% on

foreign currency reserves. Banks adjust their reserves with

the PBoC on the 5th, 15th, and 25th of every month

depending on their deposit base and RRR levels.

On 25 April 2004, the PBoC adopted a system of

differentiated reserve ratios. Different required reserve

ratios were applied to financial institutions according to

their capital adequacy ratio and asset quality, with weaker

institutions subject to higher RRRs. In an effort to sterilise

FX inflows and fight inflation in 2011, the PBoC hiked the

RRR to a historical high of 21.5% for big banks and 19.5%

for small banks. In September 2011, PBoC broadened the

RRR deposit base to include margin deposits for bank

acceptances, letters of credit and guarantees, absorbing

Monthly OMO drains and injections (CNY bn)

-1400-1200-1000

-800-600-400-200

0200400

600800

10001200

201420132012201120102009

Maturing bi ll s Maturing repo Issued bi ll s Issued repo


Policy deposit rate, PBoC bill auction and secondary market

yields (%)

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Jul-

09

Nov-

09

Mar-

10

Jul-

10

Nov-

10

Mar-

11

Jul-

11

Nov-

11

1y PBoC bill secondary market rate

1y deposit rate

1y PBoC bill auction yield


Monthly FX inflows, RRRs and net OMOs (CNY bn)

-1200

-800

-400

0

400

800

1200

20112010200920082007200620052004

RRR (incl. margin deposits RRR) Net OMOs FX inflows



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27 December 2011 6

an estimated CNY900bn of liquidity. On 30 November

2011, the PBoC cut the RRR for all banks by 50bp,

reversing the tightening trend.

Rediscount and relending rates: The rediscount raterefers to the rate at which the PBoC discounts bills for

financial institutions while the relending rate is the rate atwhich the PBoC relends to financial institutions on an

outright basis. Rediscount and relending rates are not

changed as frequently as policy rates. The last move was

on 30 December 2010 when the PBoC raised the

rediscount rate by 45bp, to 2.25%, and 1y relending rate

52bp, to 3.85%. Due to structurally high excess liquidity

and concerns about raising regulatory attention, banks in

China rarely resort to the PBoC for relending or

rediscounting funds.

Credit quota, M2 and total social financing: Creditinstruments are the most important policy tool in China,

including loan targets and administrative measures such

as window guidance to guide the pace and sometimes

direction (industries or regions) of bank lending. Over the

past 20 years, the implementation of credit policies has

become more indirect to avoid distortion. The PBoC

targeted M2 growth of 16% for 2011 and new loans of

CNY7.0-7.5trn.

However, the PBoC has increasingly monitored total social

financing, a broader indicator of the financial system that

includes banks off-balance-sheet lending and direct

financing, as well as bank loans.

In October 2011, the PBoC expanded the definition of M2

to include deposits at non-depository financial institutions

and social housing funds. Given the rapid development of

nonbank financing activity, the PBoC is still considering a

creating a broader money supply measure, M2+.

Administrative measures: The government also usesadministrative measures to control inflation, which is an

increasingly important policy objective in China.

Rediscount rate vs. policy deposit rate (%)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11

Rediscount rate 1y deposit rate

Source: CEIC, Barclays Capital

Credit and money growth trends

5

10

15

20

25

30

35

2001 2003 2004 2006 2007 2009 2010-200

200

600

1000

1400

1800New loans (CNY bn, RHS)

M2 y/y

Source: Bloomberg, Barclays Capital

Total social financing (CNY trn)

0

3

6

9

12

15

2011(Q1-Q3)

2010

2009

2008

2007

2006

2005

2004

2003

2002

New yuan loan Loan in foreign currencyEntrusted loan Trust loanBank acceptance Corporate bondEquity financing Others



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27 December 2011 7

Money markets and policy rate transmission

Interbank and repo market yearly turnover (CNY trn)

0

20

40

60

80

100

120

140

20112009200720052003200119991997

Bond repo Interbank


Term structure of national interbank borrowing (CNY bn)

Overnight 1w 2w 3-4w 1m 2-3m 4-12m

2002 202 852 - 100 29 11 12

2003 642 1,456 189 57 44 10 3

2004 283 1,041 64 28 19 9 3

2005 223 896 46 61 30 7 2

2006 635 1,290 147 38 19 12 1

2007 8,030 2,178 274 50 34 35 7

2008 10,651 3,500 474 111 114 45 19

2009 16,167 2,135 598 102 205 54 6

2010 24,486 2,427 506 65 161 47 20

2011 26,089 3,924 906 215 269 109 31

Note: *Figures are total trading volume over certain period.Source: CEIC, Barclays Capital

Interbank market participants by volume (November 2011)

Overview

The money markets in China underwent drasticdevelopments towards the end of the last century when

the country started to liberalise its interest rate system.

The major money markets include interbank lending and

borrowing, the repurchase market, the securities markets

and the bill market. The bond repo market is the largest

with a current daily turnover of CNY400-500bn. The PBoC

manages reserve requirement ratios and conducts OMOs

in the interbank market to influence the monetary base to

achieve its monetary targets. The correlation between

OMO interest rates and money market rates has been

strengthened. However, as interest rates offered by

commercial banks on deposits and loans are still subject to

control, the transmission between the policy and money

market rates remains weak.

Interbank lending and borrowing

A unified national interbank market was formed in Chinain 1996. It arranges non-guaranteed financing among

financial institutions, which is settled through the CFETS

trading system. Various terms are available: 1d, 7d, 14d,

21d, 1m, 2m, 3m, 4m, 6m, 9m and 1y. The majority of

borrowing is overnight and within one week.

Starting in June 1996, financial institutions were allowed tofix rates for interbank lending and borrowing. These rates

(Chibor) are published regularly. However, Chibor, which

is based on transacted rates, has failed to become

established as a useful benchmark in China.

On January 4 2007, the PBoC formally launched the Shibor(Shanghai interbank offer rate; Bloomberg Ticker: SHIF1W)

aiming to develop a benchmark market rate for the rapidly

growing bond and money markets. Shibor is a simple,

non-guaranteed, wholesale interest rate calculated by

arithmetically averaging all the interbank RMB lending

rates offered by the price quotation group of banks with a

high credit rating. Currently, Shibor consists of eight

maturities, overnight, 1w, 2w, 1m, 3m, 6m, 9m and 1y.

The National Interbank Funding Centre is responsible for

the Shibor calculation and fixing disclosure at 11:30am

each trading day. The price quotation group of Shibor

consists of 16 commercial banks. These quoting banks are

primary dealers for open market operations or market

makers in the FX market, with robust information

disclosure processes and active RMB transactions in

China's money market.

Share

holding

commercial

bank

44%

City

commerical

bank

16%

State-

owned

commerical

bank

18%

Foreign

funded or

joint funded

insititution

9%

Other

financial

institution

12%

Rural

commerical

bank and

cooperative

bank

1%



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27 December 2011 8

Relative to Chibor, Shibor is a more market-sensitivebenchmark as it is based on quoted rates, with maturity

extending to one year. However, Shibor is less liquid than

the repo market and carries a higher credit risk premium as

it is uncollateralised. As no actual transactions are needed to

set reference rates, Shibor fixing is at risk of manipulation.

Banks have the incentive to set the fixing higher as to priceShibor-linked loans at higher rates. Floaters, rediscount

rates, and short-term bills are linked to Shibor.

Repo market

Bond repo transactions first started in China in 1991 andwere carried out via the Shanghai Stock Exchange. At the

beginning of 1997, the PBoC ordered commercial banks to

transfer repo trading from the stock exchange to the

interbank bond market. Compared with interbank

borrowing, repos are more active and the interest rates

more stable, and represent the full liquidity of the financial

market. Pledged repos are the dominant format. Largestate-owned banks tend to be the main suppliers of liquidity

in the repo market, while smaller banks, insurers, securities

firms and fund managers are net recipients.

Pledged repos are a financing act in which a borrower(positive party) pledges bonds to a lender (reverse repo

party) in return for funds. The two parties also agree that

when the positive repo party returns the borrowed funds,

calculated at the specified repo rate, the reverse repo party

lifts their rights over the pledged bonds. Terms for pledged

repos range from 1 day to 365 days but overnight

transactions are dominant and actual deals longer thanthree weeks are very rare.

Based on data from the trading system, volumes and prices

for pledged repo transactions are publicly released

according to 11 term periods: 1d, 7d, 14d, 21d, 1m, 2m, 3m,

4m, 6m, 9m and 1y. Trading hours are 9:00-12:00am and

1:30-4:30pm, excluding Chinese statutory holidays.

Market participants include commercial banks, rural credit

cooperatives, urban credit cooperatives and other deposit-

taking financial institutions, insurance companies, securities

companies, fund management companies, financial

companies and other non-bank financial institutions withbond trading licences, and foreign-funded financial

institutions that conduct RMB business. The two trading

parties, at the specified deal termination date, handle the

gross settlement of funds at their own risk in accordance

with the deal sheet. Depository bond settlement is carried

out through the China Central Depository & Clearing Co.,

Ltd, while funds settlement is conducted through the China

National Automatic Payment System of PBC.

Collateralised and noncollateralised market borrowing rates (%)

-5

0

5

10

Oct-06 Oct-07 Nov-08 Nov-09 Dec-10 Dec-11

-10

10

30

50

bp7d Shibor7d repo7d Shibor - 7d repo (RHS)


Interbank bond market daily turnover (CNY bn)

0

100

200

300

400

500

600

700

800

900

1000

Dec-11Aug-11Mar-11Nov-10Jul-10Mar-10

Spot Pledged repo Outright repo


Pledged bond repo borrowing term structures (by trading

volume)

14y

4%

1m-1y

1%

21d

2%

1d

75%

7d

18%



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27 December 2011 9

Pledged repo market participants by volume (Nov 2011)

Share

holding

commercial

banks

17%

State-

owned

commercial

banks

17%

City

commercial

banks

24%

Rural

commercial

and

cooperative

banks

9%Foreign

funded or

joint funded

institutions

2%

Other

financial

institutions

31%


Bill discount rate vs. other money market rates (%)

0

2

4

6

8

10

12

May-08 Jan-09 Oct-09 Jun-10 Mar-11 Nov-11

Rediscount rate

6m bank note discount rate

7d repo

3m Shibor

0

2

4

6

8

10

12

May-08 Jan-09 Oct-09 Jun-10 Mar-11 Nov-11

Rediscount rate

6m bank note discount rate

7d repo

3m Shibor


Policy rate, PBoC bill auction yield, monetary market rate and

interest rate paid by PBoC on excess reserves (%)

-

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

Jan-07 Oct-07 Aug-08 Jun-09 Apr-10 Feb-11 Dec-11

7d repo1y PBoC bill (primary market)Interest paid on excess reserves1y deposit rate

Outright repos refer to a bondholder (positive repo party)selling bonds to a buyer (reverse repo party), which the

former will repurchase from the latter at a specified future

date and at a predefined price. Terms for outright repos

range from 1 day to 91 days. Based on data from the

trading system, volumes and prices for outright repos are

published according to seven terms: 1d, 7d, 14d, 21d, 1m,2m and 3m. Trading hours, market participants and

settlement procedures are the same as for pledged repos.

The daily repo fixings use the median of all repo pricestransacted via the China Foreign Exchange Trade System

(CFETS) between 9:00 and 11:00. Most trades occur in the

morning session, and all trades must be transacted over

CFETS. The overnight repo (R001), 7d repo (R007), and

14d repo (R014) is posted on the CFETS website at 11:00

am on each trading day. The 7d repo fixing includes all

trades with 2-7d tenors (inclusive). The 7d repo fixing is

also used as a benchmark for the IRS curve (BloombergTicker: CNRR007).

Bills market

The commercial paper market, including bankacceptances, bills of exchange, discount and rediscount

bills, has developed rapidly since the late 1990s. Typical CP

maturities are 9m to 1y. Since December 2010, short-term

commercial paper (SCP) with maturities of less than 270

days were launched by the National Association of

Financial Market Institutional Investors (NAFMII).

In China, the cost of issuing bills is determined by the

market, hence bills are seen as superior for financingcompared with controlled short-term lending rates.

FX deposits and swaps

Banks, non-bank financial institutions, non-financialenterprises or their authorised branches that have FX

interbank lending business licences, can all take FX

deposits. Lending transactions for USD, EUR, HKD, JPY,

GBP are allowed.

Policy rate transmission

As commercial banks interest rates on deposits and loansare still subject to control, there is a loose relation betweenthe policy deposit rate and the interbank rate.

Instead, the PBoCs quantitative tools (RRRs, OMOs) havemore impact on interbank rates. Compared with OMOs,

where participation is voluntary, RRR changes are a

stronger tool, as they are imposed on all banks and can

squeeze the smaller banks, which tend to be net

borrowers. Source: CEIC, Bloomberg, Barclays Capital


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27 December 2011 10

The PBoC achieves its monetary aggregate targetsthrough adjusting its degree of sterilisation of FX inflows

via changes in reserve requirements or open market

operations as well as credit quotas. This sets the basic

tone for market liquidity. However, government fiscal

spending patterns, seasonality in currency in circulation,

regulations on banks loans and deposits as well as fundflows such as IPOs/bond issuance/state company

dividend payments also influence liquidity from time to

time. Fluctuations in money market rates tend to be more

visible when excess liquidity is low (for more details see

the What drives financial system liquidity in China?

section).

Banks hold PBoC bills as part of their liquid assets, andhigher bill auction rates increase the opportunity cost of

lending funds to other banks. Therefore, PBoC bill rates

tend to guide money market rates particularly when

liquidity is tight. The 1y bill auction yield is seen as aleading indicator of the policy rate. However, when

liquidity is extremely flush, money market rates can trade

much lower than policy rates and only find a bottom at the

interest rate paid on excess reserves (72bp currently) by

the PBoC.

The high volatility in the Chinese money market points to anunderdeveloped system. In particular, policy rates do not

necessarily reflect the true cost of funds. And there is a

shortage of efficient balancing mechanisms for interbank

liquidity. The PBoCs discount window is rarely tapped, as

access is limited to commercial banks and policy banks withthe right to participate in lending and bill financing activities,

whereas borrowers are concerned about negative

regulation implications. The PBoC conducts reserve repos,

but they are expensive and infrequent.

Factors affecting liquidity (CNY bn)

-2000

-1500

-1000

-500

0

500

1000

1500

2000

2500

3000

Dec-11Oct-11Aug-11Jun-11Apr-11Feb-11

OMO drain RRR tightening Fiscal impact

Change in liquidity Maturing OMO FX inflows

-2000

-1500

-1000

-500

0

500

1000

1500

2000

2500

3000

Dec-11Oct-11Aug-11Jun-11Apr-11Feb-11

OMO drain RRR tightening Fiscal impact

Change in liquidity Maturing OMO FX inflows


Factors affecting liquidity - Currency in circulation, changem/m (CNY bn)

-1500

-1000

-500

0

500

1000

1500

2000

Jan-07 Feb-08 Mar-09 Apr-10 May-11



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27 December 2011 11

What drives financial system liquidity in China?

The PBoC achieves its monetary aggregate targets through adjusting its degree of sterilisation of FX inflows via changes inreserve requirements or open market operations, as well as credit quotas. This sets the basic tone for market liquidity.

However, government fiscal spending patterns, seasonality in currency in circulation, regulations on banks loans and

deposits as well as fund flows such as IPOs/bond issuance/state company dividend payments also influence liquidity from

time to time. Fluctuations in money market rates tend to be more visible when banks excess reserve ratios fall below 2%.

FX inflows and PBoC intervention have been the main drivers of growth in Chinas base money supply over the past 10years. On average, monthly inflows have been CNY200300bn since 2002, divided between trade surplus (50%), FDI

(20%) and hot money (30%) flows by our estimations. This translates into around CNY2-3trn expansion pa of the base

money supply.

The PBoC has frequently adjusted RRR levels and conducted OMOs to offset money expansion from such inflows. A 50bpRRR hike absorbs roughly CNY380-400bn of liquidity from the system. Changes in RRR levels are a powerful tool as the

impact on interbank liquidity is continuous given that banks need to tender additional reserves as long as their deposit

bases are growing. In particular, the impact on banks with weaker liquidity tends to be stronger compared with other

liquidity measures such as OMOs, where individual bank participation is usually voluntary.

In 1995. China passed a law banning fiscal overdrafts, hence government fiscal activities do not constitute base moneysupply. However, government spending patterns do have a significant seasonal impact on banks liquidity. Fiscal revenue

tends to be collected at the beginning of the year and each quarter, while payment for spending tends to happen at

quarter- and fiscal year-ends. Government spending results in a drop in the governments deposits with the PBoC but an

increase of its deposits with commercial banks. This increase in banking system liquidity is temporarily until government

bond auctions/tax collections take it out. On a separate note, the MoF occasionally auctions treasury cash deposits to

commercial banks (this activity totalled CNY400bn in 2011).

Currency in circulation also has strong seasonality in China, as demand for cash tends to be strong during holiday seasons,which sees money flowing out of the system and a tightening in interbank liquidity.

Banks have showed a tendency to move deposits into off-balance-sheet activities in recent years, which are not subject toreserve requirements. Each quarter end, banks would move deposits back onto their balance sheets to meet loan-to-

deposit ratios set by the CBRC. This pattern has tightened liquidity at quarter ends. To close this loophole, the CBRC

switched from quarterly monitoring to monthly at the beginning of 2011 and introduced a daily LDR monitoring system on

a trial basis in June. These measures are likely to make RRR more effective and reduce fluctuations in interbank liquidity.

Similar to other markets, large sized IPOs/bond issuance/dividend payments also cause temporary squeezes in liquidity asthese events tend to freeze large amounts of funds for short periods.

Liquidity in the financial system (CNY bn) Banks excess reserves with PBoC

01-Oct-11 01-Sep-11 01-Aug-11 01-Jul-11 01-Jun-11

Net OMOs 89 236 167 9 399

Regular RRR (incl.

snow ball effect)48 -157 -152 144 -794

Margin accountdeposit RRR

-225 -144 0 0 0

Fiscal impact -308 309 -84 -342 -27

FX inflows -25 247 377 220 277

Currency in

circulation114 -224 -62 -52 -17

Change in liquidity -307 267 246 -71 -112

PBOC announced

excess reserve ratio1.40% 0.80%

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Oct-11Oct-09Oct-07Oct-05Oct-03

CNY trn

0

1

2

3

4

5

6

7

%Excess reserves in banking system

Excess reserve ratio (RHS)

Source: CEIC, Barclays Capital Source: CEIC, Barclays Capital


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27 December 2011 12

Interest rate derivatives

Monthly turnover of IRS of different fixings (CNY bn)

0

50

100

150

200

250

300

350

400

Nov

11

May-

11

Nov-

10

May-

10

Nov-

09

May-

09

Nov-

08

May-

08

Nov-

07

7d repo Overnight Shibor

3m Shibor 1y depoLending rate


7d repo fixing, 1y repo IRS and 1s5s curve slope (%)

-2.00

-1.00

-

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

2006 2007 2008 2009 2010 2011

-100

-

100

200

300

400

500

600

700

800

900

NDIRS 1s5s (RHS, bp) 7d repo 1y NDIRS


Shibor IRS, repo IRS, and spread (%)

-

1.00

2.00

3.00

4.00

5.00

6.00

Jan-07 Dec-07 Dec-08 Nov-09 Nov-10 Oct-11

-100

-

100

200

300

400

500Shibor-repo ND IRS spread (RHS, bp)2y Shibor IRS2y repo IRS

Overview

The CNY IRS market started in 2006 and has since grownsignificantly. The first three quarters of 2011 saw 16,925

swap transactions with a total notional value of

CNY2.15trn, up 170% compared with the previous year.

Tenors of 1y and below remain the most active part of the

market, accounting for 70% of all transactions. Repo IRS

remains the most liquid and popular format, accounting

for 56% of the market, but Shibor IRS is catching up,

taking 40% of the market (up from 13% in 2007, its first

year). Deposit and lending rates based IRS trade only

occasionally, and represent just 4% of the market.

Repo IRS

Fixing: CNRR007 Index; Bloomberg ticker: CCSWNI1(offshore) and CCSWO1 (onshore).

The main onshore participants are banks and securitiesfirms. Hedge funds and interbank dealers are significant

participants in the offshore market. Trade size tends to be

larger in the offshore market but onshore volume is larger.

Front-end repo IRS yields depend more on systemicliquidity, but back-end IRS yields are more influenced by

global risk appetite and the performance of A-shares

versus bonds.

Shibor swaps

Fixing: SHIF3M; Bloomberg ticker: CCSH1 (offshore) andCCSHO1 (onshore).

Shibor is uncollateralised, and market participants includesmall banks that tend to have weaker liquidity positions and

are the main borrowers in the interbank market. As such,

the Shibor curve is more influenced by banking system

liquidity compared with repos. Also, as Shibor is meant to be

a benchmark for Chinas money markets, most financial

instruments and rates, including floaters, rediscount rates,

and short-term bills are linked to Shibor. This has created

more hedging demand using the Shibor curve.

Depo IRS

Fixing: CNDR1Y Index; Bloomberg ticker: CCSDF2(offshore) and CCSDO2 (onshore); Very illiquid, but is

widely used to assess rate hike expectations. It is also used

by insurance companies to hedge their floating rate assets

linked to the deposit policy rate.



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27 December 2011 13

Nondeliverable cross-currency swaps (NDS)

Fixing: USD Libor 6m; Bloomberg ticker: CCSWN1; largelytrades on CNY appreciation expectations.

Onshore CCS

Cross-currency swaps are also available onshore but arevery rarely traded. In early 2011, SAFE issued a Circular to

expand the use of cross-currency swaps beyond the

interbank market to allow CCS trading between banks and

their clients. The convention is quarterly fixed rate (Act/

365) versus 3m US Libor (Act/360) (Bloomberg Ticker:

CCUSWO1). Cross-currency basis swaps are also available.

Bond-IRS swaps

IRS is used in both bond hedging and speculation. TheIRS-bond spread is very directional, narrowing when rates

fall and widening when rates rise.

CNH CCS

Tenors up to 2y are frequently traded. Quarterly fixed(Act/360) versus 3m US Libor (Act/360) (Bloomberg

Ticker: CGUSSW1). Increasing access between onshore

CNY and offshore CNH market is likely to lead to gradual

convergence of onshore and off rates.

Depo IRS, repo IRS, and spread (%)

-

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

5.00

Jan-08 Sep-08 Jun-09 Feb-10 Nov-10 Jul-11

-150

-100

-50

0

50

100

1502y repo IRS - 2y depo IRS (bp, RHS)

2y repo IRS2y depo IRS


Bond yield, IRS yield and spreads (%)

-

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

5.00

Jan-07 Dec-07 Dec-08 Nov-09 Nov-10 Oct-11-100

-50

-

50

100

150

200

250

300

350

4005y IRS - bond spread (RHS, bp)5y repo IRS5y government bond



15/177


27 December 2011 14

Bond markets

Outstanding onshore RMB bonds (USD trn)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Jun-98 Sep-00 Dec-02 Mar-05 Jun-07 Sep-09

Government Corporate

Source: Asian Development Bank

Outstanding onshore RMB bonds by type

Central

Bank bill s

51%

Treasurybonds

18%

Corporate

bonds

4%

MTN

5%

Commercial

paper

2%

Commercial

Bank bonds

2%

Policy Bank

bonds

18%

Source: CEIC

Book-entry treasury bonds issued since 2006, by tenor (CNY bn)

0

200

400

600

800

1000

1200

91d

182d

273d

1y

2y

3y

5y

7y

10y

15y

20y

30y

50y

2011 2010 2009 2008 2007 2006 2005

Overview

Chinas onshore RMB bond market started when thegovernment resumed bond issuance in 1981 and has

experienced significant growth over the past 10 years. By

outstanding amount, Chinas USD3.2trn bond market is

the largest in Asia ex-Japan. The main types of bonds are

government bonds, PBoC bills, local government bonds,

financial bonds, corporate bonds (divided into enterprise

bonds and listed-company bonds), medium-term notes

(MTNs), commercial paper, asset-backed securities,

convertible bonds and bonds with warrants. Compared

with government securities (eg, CGBs, PBoC bills and

quasi-government issues), the private sector bond market

is still underdeveloped, accounting for 23% of the total

outstanding at September 2011.

Currently, Chinas bond market consists of three mainmarkets: the interbank bond market, the exchange

market and the commercial bank OTC market. The

interbank market accounts for 90% of the total

outstanding and transactions, and is dominated by banks

and nonbank financial institutions (including some foreign

institutions). The exchange market consists of both

institutions and individuals, and the OTC market can be

viewed as an extension of the interbank bond market.

Bond categories

Treasury bonds (CGBs, issued by the Ministry of

Finance)

There are two types of treasury bonds: book-entry bondsand certificate savings bonds. Book-entry bonds are sold

through financial institutions via auctions. The Ministry of

Finance announces issuance plans at the beginning of the

year (details are released quarterly) and chooses a group

of underwriters to form a syndicate to auctions the bonds.

The syndicate usually includes commercial banks,

securities firms and insurance companies. Most of the

book-entry treasuries are issued in 3-10y tenors, but the

longest tenor available is 50y (the MoF has issued 50y

bonds since November 2009). On the other hand,certificate savings bonds are sold to retail customers and

are not tradable after the sale. Most treasury bonds are

fixed rate.

PBoC bills (issued by the central bank for OMOs)

For more details see the Monetary policy section.

Source: CEIC


16/177


27 December 2011 15

Breakdown of policy financial bonds issued by policy banks

ADBC

18%

EXIM

12%

CDB

70%


Monthly local government bond issuance (CNY bn)

0

10

20

30

40

50

60

70

80

90

100

Nov-11May-11Nov-10May-10Nov-09May-09


Financial bonds (issued by policy banks and financial

institutions)

More than half of all financial bonds are issued by policybanks. Among the three policy banks, China Development

Bank (CDB) is the largest issuer, but Agricultural

Development Bank of China (ADBC) and Export-Import

Bank of China (EXIM Bank) have been gaining share.

Commercial banks are allowed to issue tiered bonds,

which include senior, subordinated and hybrid tranches.

Local government bonds

According to the budget law adopted in 1994, Chinaslocal governments are forbidden from borrowing in capital

markets. As a result, local governments have relied on

government-owned entities to borrow.

Since 2009, the Ministry of Finance has issued bonds onbehalf of local governments. Issuance sizes were kept at

CNY200bn for 2009 and 2010.

In October 2011 the government allowed the localgovernments of Shanghai, Shenzhen, Guangdong, and

Zhejiang to sell bonds directly. These four governments

issued a total of CNY22.9bn of bonds in November at

yields lower than comparable central government bonds.

Corporate bonds

Enterprise bonds include corporate bonds issued byunlisted companies and bonds issued by enterprises that

are not incorporated in accordance with Chinas Company

Law. Most enterprise bonds are issued by large state-owned companies, such as the state railway and State Grid

Corp. All enterprise bond issuance is subject to NDRC

approval.

Publicly listed companies are allowed to issue bonds onthe exchange market.

Medium-term notes (MTNs)

In 2008, corporates were allowed to issue regularly viamedium-term note programmes without obtaining

regulatory approval in each case.

Commercial paper Securities firms and nonfinancial institutions are also

allowed to issue commercial paper for short-term

financing. Commercial paper is a key instrument in the bill

market with tenors mostly shorter than 1year.

Corporate bond vs. government bond yield (%)

0

1

2

3

4

5

6

7

Mar-06 Apr-07 Jun-08 Aug-09 Oct-10 Dec-11

0

100

200

300

400

500

Corporate - government spread (bp, RHS)10y fixed rate government bond10y fixed rate (AAA) corporate bond

Source: CDYC, Bloomberg, Barclays Capital


17/177


27 December 2011 16

Monthly CNH bonds issuance (CNY bn)

41

5

9

3

15

22

27

10

34

18

11 11

2

0

5

10

15

2025

30

35

40

45

2010

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

2011

Source: CMU, Barclays Capital

CNH bonds by issuer

Sovereign/

Quasi

16%

Corporates

35%

Financials

48%

Supranationals

1%

Sovereign/

Quasi

16%

Corporates

35%

Financials

48%

Supranationals

1%

Source: CMU, Barclays Capital

The offshore RMB market

The offshore RMB bond market (CNH, or dim sum) waslaunched in 2007, when mainland financial institutions

were allowed to issue RMB-denominated bonds in Hong

Kong. However, the market took off in July 2010 when

most restrictions on offshore RMB transactions were lifted.

Since then, multinational corporations and international

financial organisations have tapped the market. For

issuers, the dim sum bond market offers a low-cost source

of funding. Most bonds issued are less than 5y, given that

investor interest lies more in potential FX gains.

Restrictions on access to the mainland bond market foroffshore investors with QFII licences have increased

demand for CNH-denominated assets, where there are no

such restrictions. Despite fast growth, the supply of CNH

bonds has fallen short of the growth in the deposit pool.

The lengthy and strict regulatory process for remitting the

proceeds onshore is a key bottleneck, but the approval

process is likely to be speeded up, given Premier Lis

comments made during a visit to Hong Kong. (For details

of the offshore RMB market please see CNH Market

Primer: Food for thought, 8 November 2011).

Market participants for onshore bonds

Special members: Include the PBoC, Ministry of Finance,policy banks, and China Government Securities Depository

Trust & Clearing Co.

Banks: Banks hold about 70% of Chinese governmentbonds. The fact that banks are the dominant investors,subjects the bond market to the credit cycle. Banks have a

preference for bonds with tenors below five years.

Insurance companies: These companies hold 5% ofgovernment bonds and have a strong preference for

bonds with tenors longer than five years.

Pension funds: The National Insurance Law mandatesthat at least 50% of social security funds be invested in

bank deposits and government bonds, 40% in equities,

and 10% in corporate bonds.

Investment funds: The Securities Investment Fund Lawrequires that 80% of fund assets be invested in the equity

and bond markets, and at least 20% invested in treasuries.

As investment funds are profit-seeking investors, their

participation in the bond market has stronger correlation

with actual bond prices (see first chart in next page). They

are more flexible on tenor length.

Others: Credit unions, securities firms, individuals.

Onshore government bond holdings among major investors

0%

20%

40%

60%

80%

100%

120%

1999 2001 2003 2005 2007 2009 2011

Special member Commercial bankTrust Cooperatives Nonbank financial institutionSecurities company Insurance companyFund house

Note: * Special members: PBoC, Ministry of Finance, policy banks, the Exchange,

China Government Securities Depository Trust & Clearing Co.



18/177


27 December 2011 17

Foreign participation

QFIIs: Starting in late 2002, FIIs were allowed to invest ingovernment bonds, convertible bonds and corporate

bonds listed on the exchange market. A local custodian

and broker are required for QFIIs. So far, very few bond

QFIIs have been approved. IFC and ADB were allowed to

issue CNY-denominated bonds in China in 2005.

As part of the effort to internationalise the RMB, foreigncentral banks and selected commercial banks that are

involved in RMB trade clearance and settlement are

allowed to access onshore interbank bond market. A

quota is assigned by PBoC, but details are not disclosed.

The RMB QFII (mini-QFII) is likely to be finalised soon,with an initial size of CNY20bn.

CNH bonds: Not accessed onshore; foreign investors only.

Auction procedure The primary market for treasury bond issuance is largely

conducted through syndication. Government bonds are

typically underwritten by the four stated-owned banks,

and other commercial banks and securities companies

play active roles in forming a syndicate.

Bond settlement

Onshore settlement: China Government SecuritiesDepository Trust & Clearing Co. Ltd has responsibility as

the general custodian. Bonds typically settle at T+1.

CNH bonds: Via CMU or Euroclear or Clearstream; T+3.

Taxation

Onshore bonds: Government bonds are exempt from the25% income tax. A 5% sales tax is applied. The

government recently exempted local government bonds

from income tax and cut the income tax by half for bonds

issued by the Ministry of Railway.

CNH bonds: No tax is applied.Regulation

There are numerous regulators in Chinas onshore bondmarket, depending on the category of the bonds and

whether it is primary market or secondary. This has to

some extent created a heavy regulatory burden and

segregation of markets.

Bonds held by investment funds vs bond price index

-100%

-50%

0%

50%

100%

150%

200%

250%

Jan-04 Jan-06 Jan-08 Jan-10

-15%

-10%

-5%

0%

5%

10%

15%

20%Growth in bonds held by funds (y/y)

Treasury bond index (y/y return, RHS)


Chinese onshore bond markets and respective regulators

Primary market Secondary market

Treasury bonds MOF CSRC, NAFMII

PBoC bills PBoC NAFMII

Financial bonds PBoC, CBRC, CSRC NAFMII, CSRC

Enterprise bonds NDRC CSRC, NAFMII

Listed-company bonds CSRC CSRC, NAFMII

CP & MTNs NAFMII NAFMII

Interbank market PBoC

Exchange market CSRC

China Government Securities

Depository Trust & Clearing

PBoC, MOF, CBRC

*MOF: Ministry of FinanceCSRC: China Securities Regulatory Commission

NAFMII: National Association of Financial Market Institutional InvestorsNDRC: National Development and Reform Commission

CBRC: China Banking Regulatory CommissionSource: Barclays Capital


19/177


27 December 2011 18

Fiscal policy and credit ratings

Book-entry treasuries issuance and fiscal trends

0.0

0.5

1.0

1.5

2.0

2.5

2003 2004 2005 2006 2007 2008 2009 20102011E

-2.5%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

Yearly gross issuance F isca l % of GDP (bp, RHS)


Chinese governments estimated contingent liabilities

0%10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

% of GDP

Local government debt

China Development Bank

SOE debt (loan default est.)

Bank NPLs

Ministry of rail debt

Official public debt

0%10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

% of GDP




Bank NPLs



0%10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

% of GDP




Bank NPLs



Source: Barclays Capital

Fiscal policy

The Ministry of Finance sets fiscal policy in China. Thefiscal deficit as a percentage of GDP fell until 2007 as a

result of fast economic growth and an improving

government tax system. However, it picked up on the back

of the proactive fiscal policy initiated after the 2008 credit

crisis. Issuance of book-entry treasuries has been around

CNY 1.5-1.8trn per year since then.

The central governments balance sheet remains solid,with outstanding debt at just 19% of GDP, although the

number would rise to 80-90% if contingent liabilities

including local government debt were taken into account.

But the risk from government contingent liabilities would

appear to be lessened by the rapid growth in government

revenues (31.2% y/y in H1 11) and value of assets owned

by the government.

The government recently announced a series of measuresto ease concerns about rising local government debt,

including categorising Ministry of Railway bonds as

government bonds (instead of corporate bonds), cutting

the income tax for local government bonds and allowing

four provinces to issue bonds on a trial basis (the MoF has

issued CNY200bn bonds a year on behalf of local

governments since 2009). These measures were taken

positively by rating agencies.

Credit ratings Chinas long-term foreign-currency sovereign debt is rated

AA- (Stable) by S&P, A+ (Stable) by Fitch and Aa3 (Pos) by

Moodys.

Chinas long-term local-currency sovereign debt is ratedAA- by S&P, Aa3 by Moodys and AA- by Fitch. Moody's S&P Fitch

Aa3 (Nov 2010) AA- (Dec 2010) A+ (Nov 2007)

A1 (Jul 2007) A+ (Jul 2008) A (Oct 2005)

A2 (Oct 2003) A (Jul 2006) A- (Dec 1997)

A3 (Sep 1993) A- (Jul 2005)

WR (Oct 1992) BBB+ (Feb 2004)

Baa1 (Nov 1989) BBB (Jul 1999)

A3 (May 1988) BBB+ (May 1997)

BBB (Dec 1992)

Foreign currency debt - rating history

Source: Ratings agencies


20/177


21/177


27 December 2011 20

CNY nominal and real effective exchange rates

90

100

110

120

130

2008 2009 2010 2011

CNY NEER

CNY REER

Source: Barclays Capital Live

CNY spot and NDFs

6.0

6.2

6.4

6.6

6.8

7.0

7.2

7.4

2008 2009 2010 2011 2012

USD/CNY USD/CNY NDFs


PBoC FX reserves (USD trn)

1.5

2.0

2.5

3.0

3.5

2008 2009 2010 2011


Currency policy and foreign exchange markets

FX Strategists: Olivier Desbarres +65 6308 2073 [email protected]; Nick Verdi +65 6308 3093 [email protected]

Exchange rate policy

On 21 July 2005, the PBoC revalued the CNY by 2.1% andmoved from a USD peg to a managed float based on

market supply/demand and with reference to a basket of

currencies. On 19 June 2010, the PBoC resumed reform of

the CNY regime to enhance exchange rate flexibility, after

about two years of a soft peg to the USD. The USD/CNY

daily trading band was widened to 0.5% around the

USD/CNY daily fix from 0.3% on 21 May 2007.

The government is promoting RMB internationalisation,through greater use of RMB in trade and investment. The

CNH market continues to thrive, helped by strong RMB

appreciation expectations. Regulation changes since mid-

2010 have largely reflected regulators preference for a

firm but measured pace of RMB internationalisation.

Further liberalisation of Chinas capital account is likely to

accelerate development of the offshore market (see CNH

Market Primer: Food for Thought, 8 November 2011).

Foreign exchange rate markets

Before the recent development of a deliverable offshoreRMB market, the offshore NDF market was the traditional

market for investors to hedge RMB exposures. The daily

spot fixing rate for NDFs is the same as the onshore PBoC

fixing. The USD/CNY forwards are nondeliverable and

dollar-settled against this fixing rate. The NDFs are driven

by supply and demand, which in turn are driven by RMB

appreciation expectations and are decoupled from the

interest rate differential between RMB and USD.

The deliverable RMB spot rate against the USD quoted inthe offshore market (for all practical purposes, Hong

Kong) is referred to as the USD/CNH spot rate.

The CNH and onshore CNY markets are similar as the RMBis deliverable in Hong Kong. There are no requirements for

underlying trade activity to access RMB via this market.

But, if the RMB is to be repatriated to mainland China,

documentation supporting trade or an approved capitalaccount item is needed. The gap between CNH and CNY

spot rates reflects different fixing dynamics in these two

markets and expectations for CNY appreciation. Improving

access between the onshore and offshore RMB markets

and creation of a complete regulatory framework should

help keep the basis steady longer term.

The CNH FX market has seen significantly improvedliquidity and a broadening in key instruments, with


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27 December 2011 21

tradable tenors now extending to three years, with the

average interbank deal size about USD10mn and daily

interbank liquidity estimated at USD1.2bn. Investors can

also access deliverable FX forwards and FX swaps.

CNH forward points closely track CNY NDF points and areinfluenced by NDF curves. RMB appreciation pressures andoffshore arbitrage activities tend to translate into a more

downward-sloping CNH curve. The CNH forward curve is

ultimately a function of: a) interest rate differentials

between offshore RMB and USD interbank deposits; and

b) RMB appreciation expectations. The divergence

between CNY and CNH forwards is likely to continue until

China fully lifts its capital account controls.

The CNH FX option market is still nascent but developingrapidly, with the increase in RMB liquidity in Hong Kong.

USD/CNH option-implied vols were lower than onshore

USD/CNY vols until September 2011. The Hong Kong

Treasury Market Association has published a daily

USD/CNH fix since 26 July 2011. However, the current

market convention for settling USD/CNH options is to use

the Tokyo 3pm USD/CNH rate (as per Reuters Screen) as

the option settlement fixing.

Restrictions: Only entities registered in China can tradeCNY onshore. Nonresident investors are limited to

offshore nondeliverable forwards (NDFs), CNH and swap

instruments. Repatriation of principal and proceeds

derived from CNY-denominated equity and bond

investments is subject to strict controls. Sales and

proceeds from B-shares denominated in USD and HKD

can be repatriated freely. In the onshore FX market, CNY

forwards and FX swaps are available to onshore

institutions to hedge FX exposure.

Banks are permitted to engage in FX swaps (CNY againstforeign currency) after registering for the record only if

they have had the qualification for RMB forward business

transactions for more than six months. The State

Administration of Foreign Exchange (SAFE), under PBoCs

supervision, enforces exchange controls.

CorporatesExposure for multinationals in China

Equity inflows: An overseas parent entity can hedge itsforeign direct investment (FDI).

Intercompany loans: Hedged by Chinese subsidiaries. Trade- and operations-related flows: Can be hedged by

Chinese subsidiaries; subject to State Administration of

Foreign Exchange (SAFE) classification.

Equity and dividend repatriation: Can be hedged by Chinesesubsidiaries; subject to tax bureau and regulator clearance.

Regulations governing transactions

Foreign direct investment: A parent entity can hedge itsinvestment in its Chinese entities. Investments fall under

the regulatory domain of SAFE and the Ministry ofCommerce under FDI regulations.

External commercial borrowing (ECB): A Chinese entitycan hedge loans from the parent company. Subject to

SAFE approval.

Trade receivables and payables: A Chinese entity can puton a hedge but needs to undertake Know Your Client

verification and provide proof of actual underlying exposure.

Repatriation regulations

Dividends: Companies may remit dividends overseas toforeign investors after they have been declared by the

board of directors. Companies may also hedge the FX

exposure on this dividend on behalf of foreign investors.

Companies can remit dividends to nonresident

shareholders after all applicable taxes are paid and tax

bureau clearance and SAFE approval is received.

Interest: A local entity is permitted to remit interest (onparent entity loan/bond) to its overseas parent, subject to

SAFE clearance.

Principal: Remittance of principal is allowed as per theoriginal loan agreement. Tax-clearance documentationmust be submitted for non-trade-related payments.

Recent change in regulations CNY hedging foroverseas corporates

The creation of the CNH market has significantly increasedthe use of CNY in trade transactions.

Advantages to multinational corporates: By virtue of CNHbilling, current legislation allows the transfer of currency

risk from Chinese subsidiaries to parent companies.

Potential cost savings for importers of Chinesegoods/services: Due to the significant interest ratedifferential between most G7 currencies and the CNY,

importers of Chinese goods/services can use the high

forward premium to achieve potential cost benefits by

billing in CNY and hedging the payables with a sell

USD/buy CNH forward contract.

Taxation

There is a 5% business tax on gains from FX transactions.


23/177


27 December 2011 22

FX reference guide

MARKET CHARACTERISTICS

Overview

CNY is a managed, nondeliverable currency with a +/-0.5% intra-day trading band on the USD/CNY cross. Banks bid/offer spread of USD/CNYon quotes to non-bank clients is also limited to 1% of the USD/CNY fixing rate, which is announced by the PBoC at 09:15 Beijing time every day.

Security

Liquidity

(daily volume)

Bid/Offer

spread

Tenor/

Maturity

Local open/

closing times Settlement

Reuters

page Additional information

OnshoreFX spot

USD20bn 5-10 pips Spot 09:30 16:30 T+2 CNY=CFXS

CN/CONT4

Available only to domestic corporates

and institutions. Must be executedwith a designated FX bank (DFXB).

DFXBs can square the net CNY positionin the China Foreign Exchange TradeSystem (CFETS).

Onshore

FXforwards

USD6bn 10-30 pips

(1-3m)

30-50 pips

(3m-1y)

Somequotations

beyond 1y

but poorliquidity

09:30 16:30 T+2 CNYFWD=

CN/CONT6

Previously, this market was restrictedto the four major state-affiliatedbanks and corporates hedging for

underlying external trades in goodsand services. On 2 August 2005, PBoC

expanded the participation to allpolicy banks, city and ruralcommercial banks, rural cooperative

banks and select foreign banks.

Onshore

FX swaps

USD3-5bn 10-30 pips

(1-3m)

30-50 pips

(3m-1y)

Up to 1y 09:30 16:30 T+2 CNYFWD=

CN/CONT6

In the onshore market, CNY forwards

and FX swaps are available to onshoreinstitutions to hedge FX exposure.

Onshore

FX Options

The onshore options market is in its infancy. Onshore corporates are only allowed to buy options from local banks, who are in turn

allowed to cover their risk with offshore banks.

Non-deliverable

forwards

USD2bn Depends ontenor and size

(20-130 pips)

Liquid to 2y;traded up to

10y

24 hours a day T+2 PNDF

PBOCA

SAEC

CHIBOR

The CNY nondeliverable forward isrestricted to foreign investors and the

offshore market only. Cross-border NDFneeds to be approved by the SAFE.

Non-deliverable

swaps

USD100mn 15-20bp (upto USD10mn),

50-70bp

(USD50mn)

Illiquidbeyond 5y

09:30 16:30 T+2 PNDS

PBOCA

SAEC

CHIBOR

The CNY nondeliverable swap marketis restricted to foreign investors and

the offshore market only. SAFE needsto approve cross-border NDS.

Security

Liquidity

(daily volume)

Bid/Offer

spread

Tenor/

Maturity

Local open/

closing times Settlement

Reuters

page Additional information

Non-deliverable

FX options

USD600mn 0.2-0.4 vol up

to 2y

No liquidity

beyond 5y09:30 16:30 T+2 PBOCA

SAEC

CHIBOR

CNHDeliverable

spot

USD1-1.5bn 10 pips forUSD20mn

Liquid to 2y;traded up to

5yr

09:30 16:30 T+2 CNHFIX= Most interbank deals are aroundUSD10mn.

CNHdeliverable

forwards

USD2bn forwhole curve

1y bid/offer30 pips forUSD20mn

Liquidityextends to3y

24 hours a day T+2 CNHFWD= Interbank liquidity has improvedsignificantly. Typical size is USD20mn.

CNH Cross-

currencySwap

(CCS)

Not liquid 1y CCSbid/offerabout 10bp

Most activetraded tenoris 1y; traded

to 3y

24 hours a day T+2 CNHUSCS=ICHK

No active interbank market.

CNH

FX options

USD100-

150mn0.8 vol Liquid to 1y 24 hours a day T+2 N/A



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27 December 2011 23

FX MARKET PARTICIPANTS IN CNY MARKET

Description

Corporates Corporates are allowed to engage in spot and forward transactions.

Banks Banks use spot, forward and swap transactions to hedge FX risk.

PBoC The central bank intervenes to maintain USDCNY in daily trading band of +/-0.5%.


FX MARKET PARTICIPANTS IN CNH MARKET

Description

Clearing bank, the Bank ofChina (HK)

The clearing bank, Bank of China (HK), brings RMB from mainland China into Hong Kong. A participatingauthorised institution (AI) is allowed to hedge its trade-related flows with the clearing bank. So, if a corporatewants to hedge its exports denominated in USD or imports denominated in CNY, it will sell USD/CNY (at the

onshore USD/CNY spot rate) to a participating AI bank. The participating AI will, in turn, sell USD/CNY to theclearing bank ie, Bank of China (HK). The clearing bank hedges its risk through its branch in the mainland,thus bringing RMB liquidity into Hong Kong. Corporates are also allowed to buy USD/CNY from participating

AIs if they have relevant trade documents. The PBoC established a settlement quota for BoC (HK), initially set atCNY8bn per annum is 2010. This was later changed to CNY4bn for each of the first three quarters of 2011 and

then set at CNY8bn for Q4 2011 in response to increased market demand.

Hong Kong Monetary Authority

(HKMA)

The HKMA has a CNY400bn swap line with the PBoC valid until November 2014. If trade settlement flows

require more CNH than the quota with the clearing bank, the HKMA will use its CNH swap lines with the PBoC,allowing participating AIs to hedge their open positions with the former. Thus, the HKMA acts as anothersource of CNH liquidity in Hong Kong if the trade settlement flow exceeds the clearing banks quota.

Offshore-domiciled exporters Mainland importers that have trade settlement in USD can obtain approval to remit RMB out of China into

Hong Kong to buy USD for their import needs. Given the demand for RMB liquidity in Hong Kong, theseimporters are incentivised to not use their trade documents to buy USD in Hong Kong. These importers aresuppliers of RMB to the CNH market as they try to capture the differential between onshore CNY and CNH

markets, providing RMB liquidity in Hong Kong in addition to that provided by the clearing bank. Onshoreimporters then buy USD in the CNH market. However, the onshore importer is not permitted to buy USD in theoffshore market itself and pay the offshore exporter (although the onshore importer can set up a financing

entity offshore to meet its USD buying purposes).

Individuals Hong Kong citizens who might have accumulated RMB deposits with Hong Kong banks, provide the marketwith RMB liquidity. Other groups are investors and tourists from mainland China bringing in cash RMB, which

is a significant source of the Chinese currency in Hong Kong.

Multi-nationals FX hedging

Hong Kong domiciled importers Hong Kong domiciled importers (from mainland China) who settle trade in RMB will absorb RMB out of Hong

Kong and remit it back into mainland China.

Bond issuers Proceeds from RMB-denominated bond issues will most likely be repatriated to mainland China for investmentpurposes, thereby draining RMB from Hong Kong. RMB bond issuance has expanded rapidly since 2009. As of

July 2011 there was CNY150bn outstanding of such paper. Although this is a significant source of RMBdemand, it is still well short of the rapid growth of RMB deposits in Hong Kong.

CNH interbank participants More than 10 foreign banks (including foreign central banks) now have access to the onshore interbank bond

market. While the details have not been confirmed by the Chinese authorities, the quotas are likely to havebeen kept small to limit the near-term impact on the CNH market. Over time, the greater access to the onshore

market should promote the convergence of onshore and offshore rates, and FX levels.

CNH equity issuers Similar to bond issues, if equity issuance proceeds are transferred to mainland China, this takes RMB liquidity

out of Hong Kong. If the proceeds are not remitted to mainland China, the liquidity impact is temporary fromthe funds being locked up during the issue process. Hui Xian REIT became HKs first IPO denominated in RMB

when it raised USD1.6bn (CNY10.48bn) with a yield of 4.33%.



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27 December 2011 24

Hong KongFI Strategists: Rohit Arora +65 6308 2092; [email protected]; Ju Wang +65 6308 2801; [email protected];

Kumar Rachapudi +65 6308 3383; [email protected]

Monetary policy environment

Monetary policy

Hong Kong Monetary Authority (HKMA) and thecurrency board1: The HKMA is responsible for achieving

monetary policy objectives in Hong Kong. The HKMAs

main objectives are: 1) currency stability, which is defined

as a stable value for Hong Kongs currency in terms of its

exchange rate against the USD, within a band of 7.75

7.85, and 2) managing the Exchange Fund (Hong Kongs

official reserves). The financial secretary is the ex-officio

chairman of the HKMA, which also has a chief executive

and an additional nine members appointed by the chief

executive of the SAR.

The Linked Exchange Rate System: Hong Kong operatesa linked exchange currency exchange rate system (a

currency board) instead of implementing policy via

interest rates (monetary policy committee). The system

was established in 1983. The structure of the monetary

system is characterised by a currency board arrangement,

which requires the monetary base to be at least 100%

backed by USD reserves held by the Exchange Fund.

Changes in the monetary base are matched by

corresponding changes in USD reserves held by the

Exchange Fund2 at the fixed exchange rate of 7.80.

Convertibility: Since September 1998, the HKMA hasprovided a clear undertaking to licensed banks to convert

HKD in their clearing accounts into USD. On 18 May 2005

the HKMA introduced a strong-side convertibility

undertaking (CU) to buy USD from licensed banks at 7.75,

and announced the shifting of the existing weak-side

convertibility undertaking from 7.80 to 7.85, to achieve

symmetry around the linked rate of 7.80. Within the

convertibility zone, defined by the levels of the

convertibility undertakings, the HKMA may choose to

conduct market operations consistent with currency board

principles with the aim of promoting the smooth

functioning of the money and foreign exchange markets.

Summary of monetary policy

Objective(i) Currency stability (USDHKD within a band of 7.75-7.85)

(ii) Managing the Exchange Fund

Policy rate Base rate (Bloomberg ticker: HKBASE Index)

Decision

making

Formula based: MAX (US fed funds target rate + 50bps, 5d

average of overnight and 1m Hibor)

Other

tools

(i) Open Market Operations (overnight and intraday repos,

issuing and buying EF paper, direct buying and selling in the

FX market;

(ii) Under the convertability undertaking, HKMA undertakes

to buy USD from banks at 7.75 (on strong side), and sell USD

at 7.85 (on weak side)

Hong Kong Monetary Authority (HKMA)

Source: HKMA

USD/HKD exchange rate

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

1974 1978 1982 1986 1990 1994 1998 2002 2006 2010

Linked exchange rate 1983 onwards

HKD during the floating

years (1974-1983)

7.60

7.65

7.70

7.75

7.80

7.85

2003 2004 2005 2006 2007 2008 2009 2010 2011

Spot USD/HKD 1y forward USD/HKD

Convertibility zone

Source for both charts: Bloomberg, HKMA

1 Currency Board: A currency board is a monetary authority that is required to maintain a fixed exchange rate with a foreign currency. This policy objective requiresthe conventional objectives of a central bank to be subordinated to the exchange rate target.2 Exchange Fund: The Exchange Fund's primary objective is to affect the exchange value of the currency of Hong Kong. The HKMA, under the delegated authority ofthe Financial Secretary and within the terms of the delegation, is responsible for the use and for the investment management of the Exchange Fund.


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The monetary base comprises: Certificates of indebtedness, which provide full

backing to the banknotes issued by the three note-

issuing banks: Bank of China, HSBC and Standard

Chartered.

Government-issued notes and coins in circulation. The aggregate balance, which is the sum of the

balances of banks clearing accounts maintained with

the HKMA for the purpose of clearing and settling

transactions among themselves, and also between

banks and the HKMA. The balance, therefore, varies

with the flow of funds in and out of HKD. Since there is

no reserve requirement for ban

Documents

Asia Local Markets Guide 2012