All Eyes on Renminbi

In Hong Kong and mainland China, the biggest trends in finance are the innovations in Rmb funding and the internationalization of China’s capital market

By Louisa Wah Hansen

Innovations in the capital market and regulatory environment are paramount in the development and growth of companies as they help attract and support the necessary funding. In Hong Kong and Mainland China, the biggest trends to watch are the innovations in RMB funding and the internationalization of China’s capital market.

Over the past few years, innovations in the area of RMB capital fund-raising have been led by Hong Kong—identified as the major offshore RMB market. According to Prof. Paul McGuinness, Department of Finance professor at CUHK Business School, Hong Kong is still playing a pioneering role in many aspects and he expects this to continue in the foreseeable future.

There are a number of important areas of innovation that will keep propelling the development of the financial industry in Greater China. These include:

“Dim sum bonds,” which generate RMB funding in “offshore” (i.e., non-mainland) markets like Hong Kong. This market now includes floating coupons with rates linked to a Hong Kong Interbank Offer Rate for the offshore RMB market (or “CNH” market as it is known in Hong Kong). The “dim sum bond” market has spread to other places like Singapore, Taiwan and London. Despite this proliferation, the name “dim sum” has stuck, to reflect the fact that Hong Kong is the pioneer in the field.

“Through these bonds, a number of issuers, not just mainland Chinese organizations but some international ones as well, have raised huge amounts of RMB funding in the Hong Kong market,” observes Prof. McGuinness. “Inevitably, the amount of offshore RMB in Hong Kong will mushroom in the next several years. Currently, Hong Kong Monetary Authority data suggest that approximately 10 percent of total bank deposits in Hong Kong are in RMB form. One would naturally expect this proportion to rise over the medium- to longer-term.”

Hong Kong Stock Exchange (HKEx)’s “dual-counter” trading arrangement, which allows investors to trade certain securities in either RMB or Hong Kong dollars, complements and supports offshore RMB-equity funding and the “CNH” market in general. “As both a frontline regulator and major international exchange, HKEx has been very innovative in responding to market needs. Based on its past track-record and the challenges ahead, I expect it to continue along this path,” comments Prof. McGuinness.

A number of exchange-traded funds (ETFs) are now available for “physical” investment in mainland-listed A-shares. “China has strict capital controls, making it difficult for foreign parties to invest directly in the A-share market,” he explains. The QFII scheme (first set up in 2002) allows foreign parties some access. This program requires the conversion of foreign currencies into RMB (subject to quota and supervision) for the purpose of investing in mainland-listed bonds and A-shares. The introduction of the RQFII (Rmb-qualified foreign institutional investor) scheme in 2011, and the utilization of some of this quota by ETF managers, constitutes an important development in providing further access to listed A-share portfolios. Among other things, it allows for investment of offshore RMB (CNH) balances held in Hong Kong in A-shares listed on the Chinese mainland. The RQFII quota has grown markedly since 2011.

“The program is evolving in terms of the size of the quota and the number of institutions that have been granted approval for investment,” he says. “Hong Kong now provides significant access for investors seeking mainland Chinese market exposure. In addition, other markets like London have recently procured RQFII quotas, stretching the bounds of RQFII well beyond Hong Kong.”

All of these new measures are giving mainland China a number of advantages. Through the offshore markets for RMB, greater funding access has opened up. Well-positioned mainland PRC-incorporated issuers are thus able to tap into both domestic mainland and offshore markets for capital funding.

Internationalization of China’s Market

Media reports have been suggesting for some time that the Shanghai Stock Exchange, together with the China Securities Regulatory Commission (CSRC), will at some future point allow foreign companies (i.e., those not legally incorporated in mainland China) to list and raise equity capital in Shanghai. Prof. McGuinness notes that despite ongoing media speculation on the subject, such an international platform has still not yet opened. Media sources largely attribute this to the poor sentiment engulfing A-share markets in recent years.

One major challenge when it comes to financial innovation is the uncertainty surrounding the implementation of anticipated regulatory and institutional change. “For major organizations involved in market innovation, the key is not so much what the changes will be but when they will happen and over what time-scale,” he says.

Nevertheless, he stresses: “Major markets where Chinese stocks and bonds are issued — Hong Kong, Singapore, London and New York — need to be proactive and think about the kinds of services they can offer. Once Shanghai’s international board comes on stream, there will inevitably be greater competition for issuers.” He also notes: “According to various media reports, relevant authorities have done much of the preparatory work for the new market’s regulatory structure. Internationalization of the mainland equity market is clearly inevitable, and Shanghai will be at the forefront. Regional and other exchanges are very much aware of this and are emboldened to develop structures that will preserve and enhance their attractiveness to Chinese issuers. So there is an even greater need to innovate.”

Another noteworthy innovation, largely pioneered in Hong Kong, is the “cornerstone” investor agreement—an arrangement in which large blocks of shares are preferentially assigned to high net-worth investing-entities at IPO. Cornerstone parties render the same purchase price per share as other IPO subscribers, but face lock-ups on assigned holdings. Prof. McGuinness says that cornerstone agreements are increasingly common for issues launched on HKEx but not that common in other jurisdictions.

“By disclosing such earmarked IPO allotments up-front in relevant prospectus documents, cornerstone parties offer potentially important value signals to subscribers. The local regulatory environment allows for such a mechanism, but we are also witnessing the migration of cornerstone-investor agreements to IPOs in other places.”

Going forward, Prof. McGuinness believes a lot of creative financial products will emerge—many of which will exploit existing and new RMB funding avenues. “Greater capital account liberalization and increased RMB convertibility over the next several years will surely provide impetus for more and more RMB funding demand,” he says. “As many of the innovations are driven by regulatory and political change, the evolution of the RMB and related CNH developments hinges on the specific timetable for regulatory change.”

Fueling Innovation

To provide fuel for innovation, CUHK Business School has been training well-qualified students to enter the financial industry. It has been running two unique professional programs aimed at filling specific gaps in the industry, namely, the BBA program in Insurance, Financial and Actuarial Analysis (IFAA); and the BSc in Quantitative Finance program.

The IFAA program, introduced in 2002, is one of the first professional insurance education programs in Hong Kong. Prof. McGuinness, as an earlier Chairman of the Department of Finance for two separate four-year terms (2000-2004 and 2005-2009), witnessed the evolution of the program from close range. He notes that despite Hong Kong being one of the biggest markets for insurance, insurance is a relatively under-researched area in academic terms. Specifically, he remarks: “There aren’t that many universities in the world that have an insurance department. But over the years CUHK has been trying to build a sizeable group of students and faculty in the insurance field. By targeting a niche area, it is possible to become a market leader and have real impact.”

The Quantitative Finance program, introduced in 1998, is another important initiative pioneered by the Department of Finance. This program has for some years enjoyed notable success in attracting top-level students and placing them in positions in the local and regional financial services arena. One of the program’s goals is to inculcate students with the important quantitative and technical skills necessary for an evolving and sophisticated finance industry.

An additional program, the MSc in Finance, has undergone a revamp and since 1-2 years ago,has attracted many students from top universities in mainland China. Those students who have chosen to return to China upon graduation are making a direct impact on the development of the financial industry there as they have been exposed to both the Chinese and Western financial systems.