Strengthening RMB markets with sophisticated products

The access to onshore RMB markets has been of utmost importance to policy makers in Beijing. While the capital account remains closed, a host of initiatives such as the Shanghai-Hong Kong Stock Connect, the Shanghai Free Trade Zone as well as qualified investor programmes have all been designed to provide limited access for foreign investors. Despite these initiatives, innovative means of access alone is not sufficient to prompt foreign investors into China. Of equal relevance is the creation of credible and sophisticated RMB products and services that are supported by deep and liquid markets, and a transparent regulatory regime.

While China does have large pools of surplus capital to execute grand plans for infrastructure build, it lacks the experience and the expertise of understanding complex financial products such as derivatives, and therefore strategic partnerships over organic development is the wiser approach.

China Europe International Exchange
On October 29th 2015, Shanghai Stock Exchange (SSE), Deutsche Börse Group and China Financial Futures Exchange (CFFEX) officially announced their joint venture, China Europe International Exchange (CEINEX). The media has made comparisons of this latest initiative with the Shanghai-Hong Kong Stock Connect but the crucial differentiator with CEINEX is that the products will focus more on capital market instruments such as bonds, ETF’s and, eventually, derivatives using RMB underlings.

The first ETF has already been launched from CEINEX meaning that for the first time a complex RMB product is directly available in Europe. Han Chen, co-CEO of CEINEX, in a statement released by Bank of China stated “The launch of the ETF creates a conduit for investors to access China’s stock market and further expand RMB investment channels. As the gateway between Europe and China, CEINEX will focus on ETFs, bonds and gradually broaden its RMB financial derivatives offerings to meet the demand of overseas investors and further promote RMB internationalisation.”

Speaking at RemninbiWorld 2015, Jochen Metzger, head of payment and settlement systems at Deutsche Bundesbank shared Han’s enthusiasm and supported the view that offering more sophisticated RMB products will broaden the existing base of offshore RMB investors. He observed that “Global investors are currently under invested in Chinese assets and with the new CEINEX, it will allow for a greater proportion of Chinese assets in Europe.” Alongside the products already offered Metzger said that “Derivatives products should kick in next year which is the most important offering because it has an element of offering cross products between euro and RMB. This is where things will really start getting interesting.”

While the sophistication of products that could be offered by CEINEX will be, without a doubt, of immense interest to foreign institutional investors, the other benefits will be in the operational and technology offerings of the exchange. As Metzger pointed out, “This is not just about trading. A significant element of our offering is that all infrastructure such as post trade, clearing and settlement will be provided by Deutsche Böurse and Eurex, both of whom have existing live clients of 200 and 400 respectively”. Setting up a derivatives exchange is a monumental task as many Asian exchanges such as Singapore Exchange, Hong Kong Exchange and Shanghai Clearing are experiencing. An alliance with an existing and mature exchange such as Deutsche Böurse can provide a tried, tested and secure platform that in turn should provide assurance and comfort to offshore investors.

Liquidity pool and collateral
Chen Zhiyong, director at Shanghai Stock Exchange and Metzger, described a road map of initiatives and products that CEINEX was planning to roll out next year and commented that liquidity as well as flexibility regarding collateral issues were still major challenges. Metzger said that “the European way of dealing collateral is unique. Using Eurex as an infrastructure, you can leverage off Clearstream (a triparty platform) that has a global pool of collateral that will be made available for the clients of the EINEX. The triparty collateral service provided by Clearsteam gives borderless and seamless access to collateral around the globe.”

The access to global collateral pools for members of CEINEX gives Deutsche Böurse a major competitive edge and is unparalleled by any exchange in Asia at this stage. Thomas McMahon, CEO of UD Trading, said “the ability to tap multiple asset classes, real time that is borderless for collateral, is a unique feature offered to Asian clients.” McMahon went on to say “if you want to just trade on CME or ICE, you would be just tapping the liquidity pool offered by them which is much more generic while the collateral pools offered by CEINEX would help with risk mitigation much more effectively.”From the concluding remarks of this panel session, it is clear that the alliance formed by local exchanges in China with Deutsche Böurse is definitely a strategic move towards liberalisation, not only because it allows European investors access to sophisticated RMB products but also because of the mature and sophisticated operational and settlement infrastructure, as well as the collateral services, that can be offered by Clearstream.

The partnership with Deutsche Böurse therefore not only satisfies the initial objective of a seamless cross border trading platform but also provides strong support to participating members for post trade, operations and collateral management solutions.

From product development to capital markets
The growth of China’s capital markets has not followed the growth of the overall economy. For example, the United States capital market size relative to its GDP is around 123% compared to China’s 45%. Using this ratio as an indicator, China lags behind not only the United States but also Thailand, Korea, and Taiwan. An underdeveloped capital market has forced companies in China, to rely on banks for financing. This in turn has given rise to a shadow banking market especially in instances where the banking sector has failed to meet the demand for financing.

William Lawton, founder and chairman of Seagate Global Group, presenting at RenminbiWorld 2015, was more upbeat in his assessment of China’s bond market development. He noted that the size of the onshore RMB Bond market was RMB32 trillion, approximately $4.92 trillion, and the third largest in the world. This fact was unknown to many in the audience. However, Lawton cautioned that most of the bond market was government issues and not corporate bonds which in China’s case, is much smaller.

Lawton also mentioned that one of the key indicators that he uses to assess capital markets growth in China is the Standard Chartered Renminbi Globalization Index, which measures RMB usage in capital markets. He pointed out that since 2002 activity levels have gone up 20 times in foreign exchange, fixed income and equity trading. However Lawton noted that “while the capital financing has increased, the RMB capital markets are still underdeveloped both onshore and offshore and there is a lot of space to develop these markets.”

Lawton also pointed out that the RMB offshore dim sum market is only 1% of the onshore bond market and is not growing. His view was similar to a fellow panelist, Peking University’s Balding, both of whom remarked that China’s recent move towards a gradual opening of its onshore economy is resulting in investors repaying their offshore loans in preference to tapping into onshore markets for financing.

Challenges ahead
Lionel Choong, board vice chairman of Emerson Radio Corp, and also present on the panel at RemninbiWorld 2015, acknowledged that while the onshore bond market in China has attracted strong investment, the corresponding swap market has not attracted equal interest. “The yield curve is just not deep enough in China. It is difficult to find liquidity beyond 5 years,” he said. One of the reasons for this is the lack of corporate benchmarks due to the shortage of corporate bonds in the market.

The other important challenge to the growth of capital markets in China that Lawton discussed was the lack of transparency and supervisory standards along with excessive administrative involvement in assessing the financial health of domestic companies. For example, during an IPO, the government has a right to endorse the future earnings of a company as well as the initial offer price of the equity. Even though the government wants to encourage new companies to use capital markets for financing, endorsing companies can cause investors to forgo risk assessments and their own due diligence.

On a related note, Choong also mentioned the need to reform the ratings agencies in order to have a credible capital markets offering. “Ratings agencies have conflicting interests and we need to look at who pays them. There is no transparency at the moment in China,” he said.

Choong also noted that an interesting characteristic of the Chinese market is the over-reliance on banks. He commented that “China has a high household savings rate at around 40% and most of this is locked up in banks. This should instead be fuelling capital markets.” Banks create sticky relationships with their corporate clients and attempt to provide the financing and investment services that are the normal domain of capital markets. They dominate the financing landscape and account for 60% of total household debt which is detrimental to the development of capital markets and exchanges.

The panel also discussed why capital markets in China could not develop without strong oversight and a transparent regulatory regime. “CSRC (China Securities Regulatory Commission) should do more to ensure the markets are fair and the rule of law is implemented to protect investors,” Lawton said. Choong also noted that corporate governance and supervision is very much needed especially in light of the August 2015 stock market crash.

Government response
The key issue for the current regulatory framework is that it was built for overseeing the traditional banking business. However, in recent times capital markets in China have evolved with great speed, creating more complex and innovative products while adopting high frequency trading and complex margin based foreign exchange platforms, while the regulations have remained static.

The good news is that the government is fully aware of the current gaps in regulatory oversight. Even President Xi’s awareness of this issue has been made clear. According to a local newspaper, during his November 3rd 2015 speech to Communist Party officials, he said that “Frequent exposure to risks and recent capital markets turmoil indicate that the current regulatory framework and financial industry development have institutional contradictions.”

The acknowledgement by the government that regulatory standards need to be improved is encouraging and there is speculation about an overhaul of the existing system. Another local paper reported that the authorities are considering merging the three regulators - China Securities Regulatory Commission (CSRC), the China Banking Regulatory Commission (CBRC) and the China Insurance Regulatory Commission (CIRC). “The People’s Bank of China is considering to oversee the three regulators under one roof, as a way of strengthening its regulatory clout,” the paper reported.

The way forward
China’s strategic partnership with Deutsche Böurse in creating CEINEX will undoubtedly help boost capital market offerings by creating more sophisticated RMB products ranging from ETF’s to derivatives. It will also allow the Chinese exchanges to leverage off Deutsche Böurse’s partners such as Eurex for OTC trading and Clearstream for collateral management. The end result should see an increase in demand for RMB products as well as a larger investor base.

However, the successful rollout of CEINEX alone will not solve all of China’s slow capital markets growth problems. Following the stock market crash of August 2015, the Chinese authorities realised that an overhaul of the regulatory framework is needed. A strong and transparent capital market base is essential to support the growth and innovation of RMB products. Without the necessary reforms, opening up the onshore markets to overseas investors will be a futile exercise.