WP/l3/268 IMF Working Paper Development of the renminbi market in Hong Kong SAr: Assessing Onshore-Offshore Market Integration R. Sean Craig, Changchun Hua, Philip ng, and raymond Yuen INTERNATIONAL MONETARY FUND
WP/13/268 Development of the Renminbi Market in Hong Kong SAR: Assessing Onshore-Offshore Market Integration R. Sean Craig, Changchun Hua, Philip Ng, and Raymond Yuen
o 2013 International Monetary Fund WP/3/268 IMF Working Paper Asia and Pacific Department Development of the renminbi market in Hong Kong Sar Assessing Onshore-Offshore Market Integratio Prepared by r. sean Craig, Changchun Hua, Philip ng, and Raymond Yuen Authorized for distribution by Steven Barnett December 2013 This Working Paper should not be reported as representing the views of the mme. The views expressed in this Working Paper are those of the author(s)and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s)and are published to elicit comments and to further debate Abstract Offshore use of the renminbi expanded rapidly in Hong Kong SAR as China sought to develop an international role for its currency while maintaining capital controls. This prompts two questions addressed in this paper: How far advanced is renminbi nternationalization? And, what role does Chinese capital account liberalization play? The first is addressed by testing the extent of integration of offshore and onshore markets for the renminbi using a Threshold Autoregression(TAr)model and finds that there are substantial unexploited arbitrage opportunities. A VAR model is used to indentify factors contributing to this limited market integration and finds that capital controls and shifts in global market sentiment explain much of the divergence in onshore and offshore renminbi exchange rates. To address the second question, the paper shows how capital account measures have been used to promote offshore use of the renminbi more actively in the wake of the global financial crisis, but that this was done asymmetrically with controls on inflows eased to a greater extent than on outflows. It concludes that a more balanced liberalization process will sustain progress in renminbi internationalization JEL Classification Numbers: E61 F33 F36.011019 Keywords:capital controls, offshore financial markets Authors'e-mailAddress:rcraig@imforgchangchunhua(@nomura.com phtng(@hkma. gov hk; rsyyuen @hkma. gov.hk
© 2013 International Monetary Fund WP/13/268 IMF Working Paper Asia and Pacific Department Development of the Renminbi market in Hong Kong SAR: Assessing Onshore-Offshore Market Integration Prepared by R. Sean Craig, Changchun Hua, Philip Ng, and Raymond Yuen Authorized for distribution by Steven Barnett December 2013 Abstract Offshore use of the renminbi expanded rapidly in Hong Kong SAR as China sought to develop an international role for its currency while maintaining capital controls. This prompts two questions addressed in this paper: How far advanced is renminbi internationalization? And, what role does Chinese capital account liberalization play? The first is addressed by testing the extent of integration of offshore and onshore markets for the renminbi using a Threshold Autoregression (TAR) model and finds that there are substantial unexploited arbitrage opportunities. A VAR model is used to indentify factors contributing to this limited market integration and finds that capital controls and shifts in global market sentiment explain much of the divergence in onshore and offshore renminbi exchange rates. To address the second question, the paper shows how capital account measures have been used to promote offshore use of the renminbi more actively in the wake of the global financial crisis, but that this was done asymmetrically with controls on inflows eased to a greater extent than on outflows. It concludes that a more balanced liberalization process will sustain progress in renminbi internationalization. JEL Classification Numbers: E61, F33, F36, O11, O19 Keywords: capital controls, offshore financial markets Authors’ E-Mail Address: rcraig@imf.org; changchun.hua@nomura.com; phtng@hkma.gov.hk; rsyyuen@hkma.gov.hk This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate
Page L. Introduction II. Development of the Offshore Renminbi Market II. Assessing Renminbi Internationalization by Analyzing Arbitrage A. Defining progress in Renminbi Internationalization B. Estimating Integration of Onshore and Offshore Renminbi Market C. Arbitrage Between Onshore and Offshore Markets and the Role of Capital Controls.7 D Sources of Divergence of Onshore and Offshore Renminbi Exchange Rates IV. Role of Capital Account Liberalization in Renminbi Internationalization 799 A. Evolution of China's Capital Account Liberalization Strate B. The Impact of Liberalization Measures on Mainland Capital Flows C. Hong Kong SAR's Role in Mainland Capital Account Opening D. Renminbi Internationalization and the offshore renminbi liquidity pool 1245 V Conclusions References Igures 1. Renminbi Cross-Border Trade Settlement 2."Dim-Sum"Bonds Outstanding 3. Renminbi loans in Hong Kong SAR 4. Renminbi liquidity pool in Hong SAR 5. CNY and CNd Spot Exchange Rate Differentials 6. Correlation of Basis and Renminbi Deposits and CDs in Hong Kong SAr 8 7. Correlation of Basis and Renminbi Risk Reversal 8. Mainland China's Private Capital Flows 9. Mainland China's Foreign Direct Investments by Destination 13 10. Mainland Chinas Overseas Direct Investment by Destination 11. Average Asset Allocation to Hong Kong Sar by Equity-Oriented QDII Funds 12. Mainland China's External Positions vis-a-vis Hong Kong sar bank 13. Mainland China's Renminbi FDI and oDl, monthly Flows 14. Mainland China's Renminbi fDi and oDI Percent of Total 144 15. Cross-Border Renminbi Trade Settlement 14 Tables 1. TAR Model estimation results 2. Key mainland China Capital Account Liberalization Measures 3. Measures to Support RMB Market Development in Hong Kong SAR.. 017 Technical Annex
2 Contents Page I. Introduction ............................................................................................................................3 II. Development of the Offshore Renminbi Market .......................................................................3 III. Assessing Renminbi Internationalization by Analyzing Arbitrage .....................................5 A. Defining Progress in Renminbi Internationalization ......................................................5 B. Estimating Integration of Onshore and Offshore Renminbi Markets .............................6 C. Arbitrage Between Onshore and Offshore Markets and the Role of Capital Controls ...7 D. Sources of Divergence of Onshore and Offshore Renminbi Exchange Rates ................7 IV. Role of Capital Account Liberalization in Renminbi Internationalization ..........................9 A. Evolution of China’s Capital Account Liberalization Strategy ......................................9 B. The Impact of Liberalization Measures on Mainland Capital Flows ............................11 C. Hong Kong SAR's Role in Mainland Capital Account Opening ..................................12 D. Renminbi Internationalization and the Offshore Renminbi Liquidity Pool ..................14 V. Conclusions .........................................................................................................................15 References ............................................................................................................................... 23 Figures 1. Renminbi Cross-Border Trade Settlement .......................................................................... 3 2. "Dim-Sum" Bonds Outstanding .......................................................................................... 4 3. Renminbi Loans in Hong Kong SAR ................................................................................. 4 4. Renminbi Liquidity Pool in Hong SAR .............................................................................. 5 5. CNY and CNH Spot Exchange Rate Differentials ............................................................. 6 6. Correlation of Basis and Renminbi Deposits and CDs in Hong Kong SAR ...................... 8 7. Correlation of Basis and Renminbi Risk Reversal ............................................................. 8 8. Mainland China's Private Capital Flows ........................................................................... 12 9. Mainland China's Foreign Direct Investments by Destination ......................................... 13 10. Mainland China's Overseas Direct Investment by Destination ........................................ 13 11. Average Asset Allocation to Hong Kong SAR by Equity-Oriented QDII Funds ............ 13 12. Mainland China's External Positions vis-à-vis Hong Kong SAR Banks .......................... 13 13. Mainland China's Renminbi FDI and ODI, Monthly Flows ............................................. 14 14. Mainland China's Renminbi FDI and ODI Percent of Total ............................................ 14 15. Cross-Border Renminbi Trade Settlement ........................................................................ 14 Tables 1. TAR Model Estimation Results .......................................................................................... 6 2. Key Mainland China Capital Account Liberalization Measures ...................................... 10 3. Measures to Support RMB Market Development in Hong Kong SAR ............................ 11 Technical Annex ..................................................................................................................... 17
. NTRODUCTION The development of an international role for the renminbi is tied to Chinese capital account liberalization. The selective easing of mainland capital controls expanded the range of cross b transactions denominated in renminbi and led to rapid growth in offshore renminbi deposits, issuance and lending in Hong Kong SAR. This growth leveled off in 201 1 and has recently resumed at a more modest pace. These developments raise several questions. First, how far advanced is renminbi internationalization? This question can be addressed by assessing how effectively the offshore currency is functioning as a substitute for the onshore currency. Second, how has capital account liberalization supported the offshore use of the renminbi? And, third, how can this progress be sustained? The next section examines the expansion in the offshore role of the renminbi, highlighting the uneven process across different uses of the offshore currency. Section Ill assesses progress in enminbi internationalization by estimating the integration of offshore and onshore renminbi markets. Specifically, a Threshold Autoregression(TAR) model is applied to daily data to test whether differential between the offshore exchange rate(the CNh)and the onshore exchange rate (the CNy) involves unexploited arbitrage opportunities and finds that this is the case. This likely reflects the limits on arbitrage from capital controls together with other factors. a VAR model is applied to monthly data to identify these factors and finds that shifts in global market sentiment plays a key role along with capital controls. Section IV examines how Chinese liberalization measures have promoted offshore use of the renminbi in Hong Kong SAR Controls on capita inflows have been eased more than on outflows, suggesting that, going forward, more balanced liberalization measures would help sustain progress in renminbi internationalization I. DEVELOPMENT OF THE OFFSHORE RENMINBI MARKET China is seeking to promote the international use of its currency while maintaining capital controls through the development of offshore markets for the renminbi. The offshore renminbi was established in 2003, with the creation of an offshore settlement infrastructure and personal renminbi banking services in Hong Kong SAR. Efforts to develop offshore renminbi financial products and services accelerated in 2009 as the global financial crisis exposed the fragil ities of the dollar-based international financial system Figure 1. Renminbi Cross-Border Trade Settlement Promotion of an international role of the renminbi (RMB bn) initially focused on trade settlement. This started 1000 with a pilot scheme for cross-border trade settlement 900 Service trade(left axis) Goods trade(left axis) in renminbi in 2009 that had expanded to all Share of goods mainland exporters and importers by 2012. This 600F trade settled in reflected the practical objective of allowing more goods trad Chinese corporates to conduct cross-border trade their own currency to eliminate the currency risk The effort met with considerable success as the share of mainland goods trade denominated in renminbi 2012 2013 3
3 I. INTRODUCTION The development of an international role for the renminbi is tied to Chinese capital account liberalization. The selective easing of mainland capital controls expanded the range of cross border transactions denominated in renminbi and led to rapid growth in offshore renminbi deposits, bond issuance and lending in Hong Kong SAR. This growth leveled off in 2011 and has recently resumed at a more modest pace. These developments raise several questions. First, how far advanced is renminbi internationalization? This question can be addressed by assessing how effectively the offshore currency is functioning as a substitute for the onshore currency. Second, how has capital account liberalization supported the offshore use of the renminbi? And, third, how can this progress be sustained? The next section examines the expansion in the offshore role of the renminbi, highlighting the uneven process across different uses of the offshore currency. Section III assesses progress in renminbi internationalization by estimating the integration of offshore and onshore renminbi markets. Specifically, a Threshold Autoregression (TAR) model is applied to daily data to test whether differential between the offshore exchange rate (the CNH) and the onshore exchange rate (the CNY) involves unexploited arbitrage opportunities and finds that this is the case. This likely reflects the limits on arbitrage from capital controls together with other factors. A VAR model is applied to monthly data to identify these factors and finds that shifts in global market sentiment plays a key role along with capital controls. Section IV examines how Chinese liberalization measures have promoted offshore use of the renminbi in Hong Kong SAR. Controls on capital inflows have been eased more than on outflows, suggesting that, going forward, more balanced liberalization measures would help sustain progress in renminbi internationalization. II. DEVELOPMENT OF THE OFFSHORE RENMINBI MARKET China is seeking to promote the international use of its currency while maintaining capital controls through the development of offshore markets for the renminbi. The offshore renminbi was established in 2003, with the creation of an offshore settlement infrastructure and personal renminbi banking services in Hong Kong SAR. Efforts to develop offshore renminbi financial products and services accelerated in 2009 as the global financial crisis exposed the fragilities of the dollar-based international financial system. Promotion of an international role of the renminbi initially focused on trade settlement. This started with a pilot scheme for cross-border trade settlement in renminbi in 2009 that had expanded to all mainland exporters and importers by 2012. This reflected the practical objective of allowing more Chinese corporates to conduct cross-border trade in their own currency to eliminate the currency risk. The effort met with considerable success as the share of mainland goods trade denominated in renminbi Figure 1. Renminbi Cross-Border Trade Settlement 0 2 4 6 8 10 12 14 16 18 0 100 200 300 400 500 600 700 800 900 1,000 2010 2011 2012 2013 Service trade (left axis) Goods trade (left axis) (RMB bn) (%) Share of goods trade settled in RMB in total goods trade Source: People’s Bank of China
reached 1l percent. Adding trade in services to goods, the quarterly volume exceeds RMB 1 trillion in Q1 2013 for the first time( Figure 1). This strong progress in renminbi trade settlement was not matched on the financing side Most firms reportedly continued to denominate offshore treasury operations in dollars. This is attributed by market participants to the fact that offshore currency markets are more developed than offshore rates markets. There is reportedly good liquidity in renminbi spot, forwards and swap markets but renminbi interest rate swap and repo markets are still lacking This leads corporate treasury managers to continue to operate in dollars where these markets are well developed, deep and liquid, which allow more effective hedging of interest rate and other risks. There has been substantial growth in offshore renminbi debt instruments, but secondary market liquidity is low partly owing to the lack of offshore money markets. The introduction of an offshore renminbi interest rate fixing in June 2013(that is, a CNH HIBOR fixing)should help by anchoring pricing in offshore interest rate swap and repo markets The stock of offshore renminbi financial assets expanded steadily with the supply of Dim Sum"bonds reaching RMB 267 billion by March 2013(Figure 2 ) Renminbi bank loans in Hong Kong Sar also expanded, reaching RMB 89 billion by March-2013(Figure 3). Both benefitted from liberalization measures that opened channels for offshore renminbi to flow back to the Mainland through renminbi denominated fdi and into mainland interbank bond equity and fixed income markets, which allowed these onshore investments to be funded offshore. Finally, a wide range of specialized offshore renminbi products have been created, including equity reit (listed in April 2011), renminbi Exchange-Traded Funds, insurance products, derivatives(offshore deliverable renminbi futures and options)and commodities (e.g, Gold ETFS, listed in February 2012) Figure 2."Dim-Sum"Bonds Outstanding Figure 3. Renminbi Loans in Hong Kong SAR (RMB bn) (RMB bn) March o/s: RMB aOutstanding RMB loans in Hong Kong SAR 200 200 100 2010 Source: Hong Kong Monetary Authority(HKMA Growth in renminbi bank deposits, including certificates of deposits, has been less steady They rose from 2 percent to 1 l percent of total deposits in Hong Kong Sar in less than two years; but, then, peaked at RMB 700 billion in November 201 1 and contracted. Only recently have they started to expand again, reaching of rMb 812 billion in March 2013( Figure 4) This temporary stagnation in renminbi deposits was associated with an increase in the I This working paper uses information up to April 2013
4 reached 11 percent. Adding trade in services to goods, the quarterly volume exceeds RMB 1 trillion in Q1 2013 for the first time (Figure 1).1 This strong progress in renminbi trade settlement was not matched on the financing side. Most firms reportedly continued to denominate offshore treasury operations in dollars. This is attributed by market participants to the fact that offshore currency markets are more developed than offshore rates markets. There is reportedly good liquidity in renminbi spot, forwards and swap markets but renminbi interest rate swap and repo markets are still lacking. This leads corporate treasury managers to continue to operate in dollars where these markets are well developed, deep and liquid, which allow more effective hedging of interest rate and other risks. There has been substantial growth in offshore renminbi debt instruments, but secondary market liquidity is low partly owing to the lack of offshore money markets. The introduction of an offshore renminbi interest rate fixing in June 2013 (that is, a CNH HIBOR fixing) should help by anchoring pricing in offshore interest rate swap and repo markets. The stock of offshore renminbi financial assets expanded steadily with the supply of “DimSum” bonds reaching RMB 267 billion by March 2013 (Figure 2). Renminbi bank loans in Hong Kong SAR also expanded, reaching RMB 89 billion by March-2013 (Figure 3). Both benefitted from liberalization measures that opened channels for offshore renminbi to flow back to the Mainland through renminbi denominated FDI and into mainland interbank bond, equity and fixed income markets, which allowed these onshore investments to be funded offshore. Finally, a wide range of specialized offshore renminbi products have been created, including equity REIT (listed in April 2011), renminbi Exchange-Traded Funds, insurance products, derivatives (offshore deliverable renminbi futures and options) and commodities (e.g., Gold ETFs, listed in February 2012). Source: Hong Kong Monetary Authority (HKMA) Figure 3. Renminbi Loans in Hong Kong SAR 0 10 20 30 40 50 60 70 80 90 2010 2011 2012 Outstanding RMB loans in Hong Kong SAR (RMB bn) Growth in renminbi bank deposits, including certificates of deposits, has been less steady. They rose from 2 percent to 11 percent of total deposits in Hong Kong SAR in less than two years; but, then, peaked at RMB 700 billion in November 2011 and contracted. Only recently have they started to expand again, reaching of RMB 812 billion in March 2013 (Figure 4). This temporary stagnation in renminbi deposits was associated with an increase in the 1 This working paper uses information up to April 2013. Figure 2. “Dim-Sum” Bonds Outstanding 0 50 100 150 200 250 300 0 50 100 150 200 250 300 2007 2008 2009 2010 2011 2012 2013 Bonds/Notes March o/s: RMB 267 bn (RMB bn) (RMB bn)