The International Monetary System

The Chinese renminbi (RMB) or yuan (CNY) is evolving.2
Trading in the RMB is closely controlled by the People’s
Republic of China (PRC), the Chinese government, with
all trading inside China between the RMB and foreign currencies,primarily the U.S. dollar, being conducted only
according to Chinese regulations. Its value, as illustrated in
Exhibit 1, has been carefully controlled. Although it has
been allowed to revalue gradually against the dollar over
time, most indicators and analysts believe it to be grossly
undervalued.The degree to which trading in the yuan has beenstunted can be seen through trade transactions. Of the $1.2trillion in exports made by China in 2009, it is

estimated thatless than 1% were denominated in RMB. A Chineseexporter is typically paid in U.S. dollars, and has historicallynot been allowed to keep the dollar

proceeds in any bankaccount. Exporters are required to exchange all foreigncurrenciesfor RMB at the official exchange rate set by thePRC. All hard-currency earnings

from massive Chineseexports are therefore turned over to the Chinese government.

The result has been a gross accumulation of foreign
currency ($2,500 billion at end-of-year 2010) not seen in
global business history.3Inevitably, the currency of an economy of the size andscope of China’s will result in more and more of its currencyleaving China. Although it

has restricted the flow ofyuan out of China for many years, ultimately more andmore will find its way beyond the reach of the onshoreauthorities. Once out of the reach

of Chinese authorities,theyuan will be traded freely without government intervention.
China knows this all too well, and has therefore
adopted a gradual policy of developing the trading in the
yuan—but through its own onshore offshore market,
Hong Kong

Offshore (Hong Kong) TradingHong Kong is a product of the “one country two systems”development of the PRC. Although a possession of thePRC, Hong Kong (as well as

Macau) has been allowed tocontinue to operate and develop along its traditional freemarketways, but for currency purposes, Hong Kong wasoffshore. Hong Kong’s own

currency, the Hong Kong dollar(HKD), has long floated in value against the world’scurrencies.But Hong Kong has a preferred access to yuanunderPRC rules. Beginning in

January 2004, Hong Kong residentswere allowed to hold RMB in cash and bank deposits.

They were allowed to obtain these balances through limited
trading; daily transfers were limited to RMB 20,000
(roughly $2,400 at the exchange rate of RMB 8.27/USD at
the time). Although this did allow a legal conduit for the
movement of RMB out of the onshore market, its volume
was so small it was inconsequential.This currency, however
small in volume, is now referred to as CNH (as shown in
Exhibit 2), Hong Kong-based trading in RMB.4 It has been
the basis for some limited financial product development,
but has been significantly lacking in trading volume, liquidity,and depth. Still, over the following five years, the CNHmarket grew to about $9 billion in value.5
This has not, however, sated the thirst for RMB by a
multitude of different traders outside of mainland China.
As a result, a market has grown over the past decade for
CNY-NDFs, non-deliverable forwards (NDFs) based on the
officially cited value of the CNY by the Chinese government.

These are forward contracts whose value is determined
by the PRC-posted exchange value of the CNY, but
are non-deliverable, meaning they are settled in a currency
like the dollar or euro, not the CNY itself (because that
would take access to physical volumes or deposits of RMB).Chinese Deregulation 2010

The flow of RMB into the Hong Kong market, however,
boomed in 2010 as a result of a series of regulatory
changes by the PRC. In July 2010, the PRC began allowing
unlimited exchange and flow of RMB into Hong Kong for
trade-related transactions—payments for imports denominatedin Chinese RMB. It is now expected that the CNHmarket will rise to more than $45 billion in value by theend

of 2010, an enormous growth from the $9 billion in
value at the start of 2010.The Question of Backflow
The challenge to the growth of the Hong Kong offshore
market is what to do with the growing balances of RMB.
Although the RMB may flow from the onshore Chinese
mainland into Hong Kong for import purchases, the
receivers of the RMB will recycle these flows into the HongKong market upon receipt as the currency has no real tradinguse outside of Hong Kong or China as a

whole.Accordingto a variety of Hong Kong-based currency analysts,unless the holders of these RMB balances in Hong Kongcan gain access to the onshore market—mainland

China—the market will still be limited in its growth potential.Mr. Charles Li, Chief Executive of HKEx (Hong KongExchanges and Clearing Limited), had a unique way

ofexplaining why the accumulating RMB in Hong Kong
needs greater backflow ability to China (followed by
Morgan Stanley’s graphical depiction of the fish process in
Exhibit 3):6

To understand the different challenges in these three
stages, the following analogy might be of some help. If
we see RMB flows as water and RMB products as fish,
the logic will be clear. Fish do not exist where there is no
water and they cannot survive if the water is stagnant.
Without nutrients in the water, fish don’t grow.Thenutrients,representing returns on RMB products, can only
come from the home market. That’s why the offshore
RMB must be allowed to flow back, at least at the initial
stage.As Mr. Li (and Morgan Stanley) make so vividly clear,for the RMB market in Hong Kong to grow and sustain itneeds the ability to return to the Chinese mainland

freely tohave a “purpose”—to gain returns from RMB-based tradingand commercial purposes.The RMB can only be used inChina, and China’s State Administration of

ForeignExchange (SAFE) must approve all transfers of RMB intothe country on a case-by-case basis, even from Hong Kong.Breadth and Depth of RMB Trading
Although the quotation of CNH deposit rates are listed
on the counters of most Hong Kong banks today, side-bysidewith U.S. dollar and Hong Kong dollar rates, there
will continue to be a limited demand for these funds by
the institutions themselves in the near future unless the
PRC allows greater backflow into the onshore market.
The offshore Hong Kong market took a highly visible
step forward in August 2010 with the launch of an RMBdenominatedcorporate bond issue for McDonald’s Corporation(US):719 August 2010, Hong Kong—Standard CharteredBank

(Hong Kong) Limited proudly announces thelaunch of a RMB corporate bond for the Bank’s MultinationalCorporate Client McDonald’s Corporation. It
is the first ever RMB bond launched for a foreign MultinationalCorporate in the Hong Kong debt capital marketsignifying the commencement of a new funding
channel for international companies to raise working
capital for their China operations. It is also a significant
contribution to the development of the off-shore RMB
debt capital market in Hong Kong. The RMB 200 million
3% notes due September 2013, was targeted at institutional

The bonds—colloquially termed Panda Bonds or the Dim
Sum Bond Market—was the first issue denominated in
RMB by a nonfinancial non-Chinese firm in the global
market. Although small in size, roughly $30 million, the
issue was something of a sign of what the future might hold
for multinational enterprises operating in the world’s secondlargest economy: the ability to both operate and fund
their business growth in Chinese RMB. The McDonald’s
issuance was followed in November 2010 by a larger $150
million RMB-bond by Caterpillar Corporation (U.S.), and
in January 2011 by a CNY 500 million ($75.9 million)
issuance by the World Bank.8Many experts today believe it may take a full generationor more, 20 or 30 years, for 20% to 30% of Chinese importsto be denominated in RMB,

and the RMB to become atruly global currency.The growth of the offshore market inHong Kong represents only the first step on that journey—but an important one for the


1. How does the Chinese government limit the use of
the Chinese currency, the RMB, on the global currency
2. What are the differences between the RMB, the
CNY, the CNH, and the CNY-NDF?
3. Why was the McDonald’s bond issue so significant?

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