By Qu Hongbin, Sun Junwei and Ma Xiaoping

As the West wobbles, Beijing eyes sweeping reforms in the next 3-5 years
Interest rates to be liberalised, the bond market to double in size...
...and the RMB to become convertible within ve years
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certications in the Disclosure appendix, and with the Disclaimer, which forms part of it
Macro
China
November 2012
Chinas Big Bang
New leaders ready to revolutionise the financial system


1
Macro
China
November 2012
abc

As the West wobbles, all eyes have now turned East to see what Chinas leaders will do to stimulate the
economy. While theres little doubt that policymakers will gear up both monetary and fiscal easing, likely
leading to a modest recovery in the coming quarters, focusing on short-term stimulus misses a far more
important trend a swathe of co-ordinated reforms which we believe will revolutionalise the countrys
financial system. In fact, there are clear signs that Chinas new leaders, who will take power in early
2013, will make speeding up reform top of their policy agenda in the coming years.
This chain reaction will change the trajectory of the institutions and policies that are all intertwined
banks, bonds, interest rates, the opening of the capital account and the convertibility of the RMB
triggering a wave of deregulation that could happen much faster than many people think. We think
interest rates will be liberalised, the bond market will double in size and the RMB will become
convertible within five years. These changes would not only make capital allocation more efficient,
boosting the private sector, but also provide the middle class with greater choice about where to put their
money so they can earn a higher return and therefore spend more. This should help rebalance growth
from investment to consumption and lift the potential growth rate in the coming years.
This report looks at how this process will unfold over the next three to five years. Reforming Chinas
financial system is unlikely to be a simple process. There will be bumps in the road and perhaps an
occasional diversion. But plenty of other countries have already gone down this route and we think
Beijings policymakers can learn from what was successful and avoid repeating some of the mistakes that
were made along the way.
Banks to bonds
The debt problems of local government financing vehicles reflect the pressing need for China to shift the
burden of distributing credit from banks to capital markets. The country has witnessed the largest and
fastest migration from the countryside to the cities in history, creating massive demand for investment in
railways, roads, bridges and other infrastructure projects related to urbanisation. Money is not an issue
given the country has a domestic savings rate above 50%, the highest in the world. Yet the absence of
long-term financing instruments means the projects have had to rely on bank loans for funding, resulting
in a big mismatch between the payback period of these projects and the maturities of bank loans.
To address this problem and meet future demand for funding urbanisation, Beijing is speeding up the
development of bond markets and other long-term financing instruments. Pilot programmes for municipal
and high-yield bonds have been introduced and the issuance of corporate bonds is also picking up. Given
the estimated RMB20-30trn of urbanisation-driven infrastructure investment in the next 10 years and the
Summary



2
Macro
China
November 2012
abc
12th Five-year Plans goal to lift the ratio of direct financing to 15%, we expect the expansion of
municipal and corporate bonds to double the size of the domestic bond markets in the coming five years.
However, some daunting challenges remain, such as the unification of the fragmented bond markets, the
establishment of a single set of regulations governing new issuances and the development of a stronger
institutional framework for the market. We believe that allowing sophisticated global institutions to
participate can help improve market efficiency. A wider, deeper bond market will likely give the banks
much more incentive to focus on financing small and medium-sized enterprises (SMEs) and consumers.
And a pilot reform programme in Wenzhou should also help explore new options for funding SMEs, the
life blood of Chinas economy; according to an industry body, SMEs account for 65% of GDP, 50% of
taxes and eight out of 10 jobs.
Liberalising interest rates
The latest move by the Peoples Bank of China (PBoC) to widen the floating band of both deposit and
lending rates while cutting interest rates is a positive surprise. We see this as an indication of Beijings
determination to push forward interest rate liberalisation in the coming years. Consensus on the need to
liberalise interest rates was reached many years ago, but reform was delayed by concerns that financial
institutions were not ready. Today, all the major state banks have been restructured and are more
commercially-driven and the non-state sector takes nearly 60% of total investment. The time is now ripe
to free interest rates, especially given the pressing need to deepen capital markets. The recent adjustment
to the ceiling for deposit and lending rates by the PBoC is the first step and more moves will likely follow
in the coming years. Meanwhile, we also expect the PBoC to gradually create a single benchmark in the
next three years, leaving all other rates freely determined by the market.
Renminbi internationalisation is taking off
Since Beijing introduced a pilot scheme to expand the role of the RMB in cross-border trade settlement
and capital flows in 2009, the momentum has been much stronger than expected. The proportion of
Chinas total trade settled in RMB has quadrupled, topping 11% in the first three quarters of 2012,
reflecting the pent-up demand for switching from issuing invoices in USD to RMB when trading with
China. In our view, this ratio is likely to reach 30% in the next three years. In volume terms, this would
make the RMB one of the top three global trade settlement currencies. This, of course, doesnt give the
RMB the status of a real global and reserve currency, as this requires full convertibility. That said, seven
foreign reserve managers are starting to invest in RMB bonds and other assets, although the amount is
relatively small.
The currency is set to become fully convertible in five years
When it comes to capital account liberalisation China is likely to adopt a gradual approach. Yet Beijing is
now more confident than ever about speeding up the process, considering that: 1) Chinas trade balance is
back on an even keel (the current account-GDP ratio has fallen below 3%) and the RMB is now close to
its market equilibrium rate; 2) domestic financial reforms have already made progress and will likely gain
momentum in the coming years; and 3) the role of the RMB in cross-border trade and investment should
continue to expand quickly. Further changes in the coming years are likely to include the further
expansion of the Qualified Foreign Institutional Investor (QFII) and the Qualified Domestic Institutional


3
Macro
China
November 2012
abc
Investor (QDII) schemes, a gradual removal of limits on foreign currency purchases by both local and
foreign individuals and increased foreign access to domestic capital markets. Combined with Chinas
policy of promoting both foreign and outward direct investment, these moves will make the RMB fully
convertible within five years, in our view. Although certain restrictions on capital inflows will likely
remain, full RMB convertibility would take Chinas financial integration with global markets to a new
level and have a profound impact on both China and the world.
The challenges
The experiences of other countries show that the road to financial reform, especially capital account
liberalisation, tends to be a bumpy one. To stay on track and to avoid major distortions, China must get
the sequence of the reforms right, that is, to strengthen its domestic banking system, liberalise interest
rates and develop a functioning bond market before making the RMB convertible. Meanwhile, the
success of the financial reforms will also depend on Beijing pushing through changes in other areas,
including fiscal and legal reforms. As people in the investment world are well aware, the term Big
Bang refers to major reforms introduced in the UK in 1986 that transformed the countrys financial
services industry from a protected species into a global powerhouse. The increase in financial activity
completely altered the structure of the market. Now its China turn.



4
Macro
China
November 2012
abc
China: Economic and financial reforms in the pipeline
Exchange rate reform Opening monopoly sectors to private investment
Why: As part of the plan to make the RMB a more international currency
China has pledged to make the exchange rate more market-oriented. In April
2012 it met this commitment by expanding the daily trading band against the
USD for the first time since 2007 to 1%, up from 0.5%.
Obstacles: Concerns that a widening of the trading band would increase
speculation about currency appreciation, triggering inflows of speculative
cash, appear to be fading. Some areas of the government notably the
Ministry of Commerce have opposed reforms that could lead to a stronger
RMB, which undermines the competitiveness of Chinas exports.
Whats happening: With a wider trading band we can expect more two-way
volatility, less consistent appreciation, and faster internationalisation of the
currency. Total trade settled in RMB increased four-fold in 2011 to reach
RMB2.1trn (USD330bn), about 9% of Chinas total trade last year.
Timeline: A managed-floating currency within five years.

Why: Allowing private firms to invest in the countrys railways, banking, energy
and healthcare sectors will boost the economy. The potentially lucrative
services sectors could help hard-pressed private firms shift from low-end
industries.
Obstacles: State industrial giants, which received the bulk of Beijings
massive spending package during the 2008-09 global crisis, have long
enjoyed favourable positions and they are reluctant to see more competition.
Whats happening: The State Council is making a fresh bid to open up
sectors dominated by state giants.
Timeline: The NDRC, the main economic policy body, has pledged to publish
details of its plan (called the New 36-Clauses) but how quickly reform will be
implemented remains uncertain.
Opening the capital account Bond market reform
Why: Liberalisation of Chinas capital account would give foreigners greater
opportunity to invest in mainland capital markets and domestic investors the
option to invest overseas. Capital allocation would become more efficient as
Chinas financial institutions are forced to compete for funds with overseas
counterparts. This would also increase pressure to introduce interest and
exchange-rate reform, as large cross-border capital flows make control of
these rates difficult to maintain.
Obstacles: The authorities believe that capital controls protected the Chinese
economy from the volatile international capital flows that hit its Asian
neighbours during the 1997-98 Asian financial crisis and again during the
2008-09 global financial crisis.
Whats happening: The PBoC, Chinas central bank, this year released a
report outlining a potential roadmap to capital account reform ending with full
convertibility of the RMB.
Timeline: Gradual reforms over the next 3-5 years.

Why: A more developed bond market would increase the efficiency of capital
allocation. It would also help to reduce the current concentration of financial
risk in the banking system. The high-yield bond market and the private-
placement SME bonds that Chinas securities regulator are promoting should
widen credit channels for small, private firms which struggle to get access to
the state-dominated financial system.
Obstacle: Bureaucratic turf battles have prevented the unification of China's
two main bond markets and the establishment of a single set of regulations
governing new issuance.
Whats happening: Chinas bond market development is hindered by the
fragmentation of the market. Different regulators oversee different types of
bonds, which also trade in different markets. However, a recent
announcement by the central bank indicated some progress towards greater
coordination among regulators.
Timeline: The private-placement SME bonds market was launched in June,
but unification of the regulatory structure will take longer.
Interest-rate liberalisation Equity listings by overseas companies
Why: Phasing out government control of interest rates would enable market
forces to play a greater role in capital allocation, allowing capital to flow to the
most dynamic sectors of the economy. This would also help shift the balance
of the economy towards consumption as higher bank deposit rates would give
households more spending power, while higher lending rates would reduce
excess investment.
Obstacles: The big state-owned banks profit from the guaranteed spread
between lending and deposit rates. State industrial firms also benefit from
access to cheap capital. These groups are likely to oppose reform.
Whats happening: Top central bank officials have said the time is ripe for
interest rate reform and that the government has a timeline for
implementation. Premier Wen Jiabao recently criticised monopoly profits by
large banks. But no concrete measures have been announced.
Timeline: Within three years but reform is likely to be gradual.

Why: Shanghai's stock exchange is considering launching an international
board that will allow foreign companies and red-chip Chinese companies
(those incorporated and listed overseas) to list and give Chinese investors
direct access to foreign firms shares.
Obstacles: This is closely linked to capital-account and exchange-rate reform.
Regulators are still working out which currency the shares would be
denominated in, and currency conversion restrictions would have to be revised
to enable foreign companies to transfer capital raised in China for use in other
countries.
Whats happening: The regulator says it will launch the international board
when conditions mature but has given no timeline.
Timeline: 1-2 years.


5
Macro
China
November 2012
abc
Fiscal reform Financial and commodity derivatives
Why: A revised tax system would enable local governments to finance their
increased social spending obligations healthcare, education, pensions, and low-
cost housing without relying on land sales and financial help from the central
government. A property valuation or transaction tax would also help to reduce over-
investment in property. Allowing local governments to issue bonds directly would
also decrease the need to use heavily-indebted local government financing vehicles
(LGFVs) to raise money.
Obstacles: The central government may be reluctant to cede revenue to local
governments. Property developers and current homeowners oppose new property
taxes, which could bring down the value of their assets.
Whats happening: Property-tax pilot schemes are under way in Shanghai and
Chongqing and may soon be expanded to Guangzhou and Nanjing. The cities of
Shanghai and Shenzhen and the provinces of Guangdong and Zhejiang became
the first local governments to issue local government bonds in late 2011, and the
Ministry of Finance expanded the quota for local-government bond issuance for
2012 to RMB250bn (USD39.6bn).
Timeline: This year for expanded property tax trial and local government bonds;
unknown for broader fiscal reform.

Why: China is considering launching new financial derivatives linked to the
RMB exchange rate, foreign currencies, international bonds and Chinese bank
interest rates. Simulated trading of government-bond futures is under way on
the Shanghai-based China Financial Futures Exchange. Regulators have also
said they will gradually open up the countrys commodity exchanges to allow
foreign investors to trade futures.
Obstacles: A government bond futures trading scandal in 1995 is still fresh in
the minds of many officials and traders. Such fears are supported by the fact
that Chinas tightly controlled interest and exchange rates offer domestic
financial institutions little experience in managing related risks.
Timeline: Individual products will be launched gradually.
Resource pricing, taxes Residence permit (Hukou) reform
Why: The NDRC has said it will accelerate reforms to its energy pricing
system, which aims to make domestic fuel and gas prices closer in line with
international rates. This would likely lead to more frequent changes in retail
fuel and power prices. Senior NDRC officials said in March that Beijing will roll
out tiered power pricing for residential customers by the first half of this year to
charge higher prices for heavy users.
Obstacles: Inflationary pressure could prompt authorities to hold off on
introducing reforms that would push up prices in the short term.
Timeline: Some changes are likely in the next few months.

Why: Since 2011 more than 50% of the population now lives in cities. The full
potential of urbanisation will not be unlocked until migrants are allowed to
settle in cities permanently. The hukou system prevents people from getting
access to healthcare and schools for their children.
Obstacles: Chinas leaders fear that a sudden influx from the countryside into
big cities could undermine social stability and create slums.
Whats happening: The government is taking small steps to overhaul the
system by launching pilot schemes in smaller cities.
Timeline: Unclear.
Source Reuters, Bloomberg, NDRC, HSBC.



6
Macro
China
November 2012
abc

From banks to bonds 7
The worlds next big bond
market 14
How to set interest rates free 22
Going global 30
The rise of the redback 37
A convertible RMB within five
years 44
Learning the lessons 52
Disclosure appendix 59
Disclaimer 60


Contents


7
Macro
China
November 2012
abc

Too big for comfort
Chinas state-owned banks are goliaths. It has
been 11 years since Chinas accession to the
World Trade Organisation, when Beijing
promised to speed up the opening of its financial
markets, but the banks still dominate the
channelling of the nations vast savings into
different areas of investment.
Their true power was seen during the global
financial crisis. They made loans of RMB9.6trn in
2009 and RMB7.6trn in 2010 (up from RMB5trn
in 2008) as Beijing rolled out a massive stimulus
package to prop up growth. The outstanding bank
lending to GDP ratio jumped to 120% in 2010
from 97% in 2008.
At the end of 2011 bank assets topped
RMB113.3trn, three times the total in 2005, the
year that major state banks went public. Despite
slowing from the peak of over 40% at the end of
2010, bank loans are still growing at around 16%
y-o-y, faster than nominal GDP growth (around
10% in the first three quarters of 2012). The
M2/GDP ratio which compares credit expansion
with economic growth surged to 1.87 at the end
3Q 2012 from around 1.5 before the financial
crisis in 2008.
This needs to change. The problem is that reform
represents a formidable challenge for the big state-
owned banks which make huge profits from their
loan books. For example, any narrowing of the gap
between savings and lending interest rates will be a
major issue. The net interest margin the
difference between the two rates is the lifeblood
of Chinas banks, on average representing around
80% of total operating income. They have a lot to
lose and may resist change.
In contrast to bank loans, financing through the
bond and equity markets has lagged behind. In
2011, total RMB bond issuance (including
treasury bonds and financial bonds issued by
policy banks) accounted for 46% of total
financing bank loans, bonds and the stock
market down from 57% in 2008. This ratio
dropped to 38% in the first three quarters of 2012
(see Chart 1.1).
This is much lower than in neighbouring countries.
For example, in South Korea over 85% of
financing was done through the bond market over
2010-11 (see Chart 1.2). In China, bond financing
as a percentage of total GDP has remained below
20% over the past two years; in Korea this ratio
was more than 33% over the same period.
From banks to bonds
Banks have dominated Chinas financial landscape for decades;
this needs to change the bond market must play a bigger role
The problem of local government debt could be resolved by a bond
for loans swap; this would give bonds a huge lift
A stronger bond market would offer a cheaper source of finance,
forcing banks to switch their focus to small companies


8
Macro
China
November 2012
abc
Chart 1.1 Fundraising in China {delete asterisk-Production}
0
2,000
4,000
6,000
8,000
10,000
12,000
2006 2007 2008 2009 2010 2011 2012*
(RMB bn)
0
20
40
60
80
Equity (Lhs)
Bonds (Lhs)
Loans (Lhs)
Bonds as % of total financing (Rhs)

Source: CEIC, HSBC



Chart 1.2 Direct financing in China needs to develop
0
20
40
60
80
100
Equity Loans Bonds
(%)
China Korea

Source: CEIC, HSBC 2010-11


Chart 1.3. Loan growth and loans to GDP ratio
90
100
110
120
130
1998 2000 2002 2004 2006 2008 2010 2012f
(%)
0
5
10
15
20
25
30
35
(%, y r)
Loan to GDP ratio (Lhs) Loan growth (Rhs)

Source: CEIC, HSBC


Bonding with bonds
Beijing wants to significantly lift the share of
direct financing and actively promote the
development of the bond market, according to
the 12
th
Five-year Plan (2011-15). More
specifically, in the financial sectors 12
th
Five-
year Plan announced in September 2012, Beijing
wants direct financing to total at least 15% by
2015, up from 14% in 2011.
Recent policy initiatives suggest things are really
starting to move. In January the influential
National Financial Work Conference, held once
every five years, stressed the importance of
building a standardised, unified bond market (see
China: National Financial Work Conference hints
further easing and reform, 8 January 2012).
Then, in April, the three bodies that oversee
different types of bonds the PBoC, the National
Development and Reform Commission (NDRC)
and the China Securities Regulatory Commission
(CSRC) put together a scheme for a co-
ordinated corporate bond market, a big step
towards ending the fragmented way bonds are
regulated. We see this as a signal that Beijing is
serious about developing the bond market.
Indeed, Guo Shuqing, the head of the CSRC, told
the official Peoples Daily newspaper in June that
international experience shows that overreliance
on bank credit in a financial system can, under
certain circumstances, lead to systemic risk,
adding that the bond market, seriously lags
behind the demands of the real economy (source:
Bloomberg, 12 June).
Since June, corporate bond issuance has started to
accelerate in tandem with efforts to stabilise growth,
such as monetary easing and the approval of a wide
range of infrastructure projects. The average
monthly issuance of corporate bonds topped
RMB173bn by September, more than 50% higher
than the monthly average of RMB113.8bn in 2011.


9
Macro
China
November 2012
abc
Chart 1.4 The surge of corporate bond issuance
0
50
100
150
200
250
300
Jan-11 May -11 Sep-11 Jan-12 May -12 Sep-12
(RMB bn)
Corporate bond issuance

Source: CEIC, HSBC

Policymakers have good reason to believe that
bank lending, supported by the huge deposit base,
is an unsustainable form of financing. They
believe it can no longer meet the infrastructure
financing needs associated with rapid urbanisation
because of the funding limits and maturity
mismatches involved in bank lending.
First, the problem of mismatches between asset
and debt maturities has become pronounced.
While more than 50% of bank deposits are
demand deposits, the bulk of lending comes in the
form of mid-to-long term loans. This mismatch
has become more pronounced as banks keep
making more mid-to-long-term loans.
Second, the excessive lending triggered by the
massive stimulus package that Beijing rolled out
to weather the global economic crisis has
increased the risks of a rebound in non-
performing loans, which have risen for three
consecutive quarters (although the NPL ratio is
almost flat). This is because the bulk of bank
lending went to LGFVs, large infrastructure
projects and state-owned conglomerates and some
of these government-led projects didnt generate
enough returns to service the loans.
This underlines the need to change the financing
structure of Chinas economy in the post-crisis
era because:
In the short term, the local government debt
problem shows that bank lending is not the
way to meet the huge and ever-growing need
for infrastructure investment. This is why it is
so important to accelerate the development of
the bond market.
In the long term, an effective financial market
would channel savings to where they are most
needed. A properly functioning bond market
would not only offer lower cost of financing
than the banks but also more effective capital
allocation as it can price risk in a more
efficient way. This would serve the financing
needs of businesses, big infrastructure
projects and different levels of government.
Bond for loans swap can fix
the local debt problem
It is high time to fix the problem of LGFVs to
minimise the loss to the banking system and avoid
another round of bail-outs. The main problem
facing local governments is liquidity. They cannot
service their bank loans because many of the
long-term infrastructure projects they borrowed
money to develop are not generating sufficient
returns. But theres no sovereign risk, as there is
in some struggling European countries. Their
balance sheets, while often lacking transparency,
remain generally strong thanks to the
accumulation of valuable assets such as
infrastructure projects and land purchases.
In our view, the most feasible solution is a bond for
loans swap which, in turn, could be the catalyst that
triggers bond market reform (see China Economic
Spotlight: Time to restructure local government
debt, 29 July 2010; China Inside Out: Local debt:
Three options, 1 August 2011).
It would work like this. Between 2009 and 2011,
Beijing issued RMB200bn of bonds annually on
behalf of provincial governments to support local
projects and this year the amount was raised to
RMB250bn. The central government would now


10
Macro
China
November 2012
abc
issue even more long-term construction bonds on
behalf of local governments, enabling them to repay
the loans they used to fund public work projects.
This would be easy to do as it does not require
any change in the fiscal arrangements between the
central and local governments. With the money
raised by the bonds, local government could either
finance the ongoing construction projects or repay
bank lending to avoid a default.
The central government would be able to issue
debt at a lower cost of funding than local
governments. Demand for these central
government bonds should not be an issue, given
1) the huge pool of funds sitting idle in individual
deposit saving accounts (RMB38trn); 2) demand
for this type of government debt from insurance
and mutual funds in China is rising.
More importantly, Beijing has allowed certain
prosperous local governments to issue their own
bonds to service existing debt and raise funds for
new projects. The obvious advantage of this
option is that each local governments debt will be
priced by the market according to its own specific
set of credit ratings, effectively imposing market
discipline on local governments.
We expect more progress on this front but
expanding the scheme to the whole nation would
require an amendment to Chinas budget law as
well as local governments adopting much higher
accounting standards, so it may take time. Clearer
delineation between local and central government
ownership rights of state assets is also needed.
The sale of state assets by local governments to
raise funds to repay loans could also help solve
the debt problem. Local governments still own
more than 20,000 state-owned enterprises (SOEs),
of which 70% are profitable. Local governments
also own toll roads, ports and other commercially
valuable assets. Selling these assets would help
them to repay their debts.
These sales are also necessary if local governments
are to shift their attention away from business
activities to public services an important objective
for government reforms in the next five years.
Public listing of local SOEs would be the best way
to do this, but the real challenge here is how to
manage the sales of these assets transparently.
A bigger bond market needed
to finance urbanisation
The increasing lure of urban life also has major
implications for the bond market as more financing
is required by Chinas cities and towns. For the first
time in the countrys history, more people now live
in urban areas than in the countryside.
At the end of last year, 51.3% of the population
were city dwellers, up from 20% 30 years ago
when China was just starting to open up its
economy. This implies that an average of 10m
people have left the countryside each year, a trend
that is likely to keep accelerating as China catches
up with developed countries. As Chart 1.6 shows, it
may take at least another two to three decades for
Chinas urbanisation rate to match that of the US.
Chart 1.5. The rise and rise of urbanisation
0
10
20
30
40
50
60
1950 1960 1970 1980 1990 2000 2010
(%)
-0.5
0.0
0.5
1.0
1.5
Urban population as % of total (Left ax is)
Percentage points change ev ery 5 y ears (Right ax is)

Source: CEIC, HSBC




11
Macro
China
November 2012
abc
Chart 1.6. Urbanisation: Following in the footsteps of the US
Rural population as % of total
0
20
40
60
80
100
1840 1860 1880 1910 1930 1950 1970 1990 2010
(%)
1950 1970 1990 2010
US China (upper scale)

Source: US Census Bureau, CEIC, HSBC

This means huge demand for infrastructure
investment. If history is a guide, for every new
urban citizen migrating from the countryside
investment of at least RMB100,000 in urban
infrastructure is needed (source: the China
Development and Research Foundation, a
government think tank). If we assume that an
average of 15-20m people a year settle in cities, a
number consistent with the last 10 years, this will
require annual investment of RMB2-3trn per year
(taking into account modest inflation) in the next
decade, or around 4.3-6.4% of GDP in 2011.
So, how will this be financed? The bond market is
the best way to meet the needs of the
infrastructure boom because:
The funds that banks have available to lend are
limited by the 75% loan to deposit ratio and
other regulatory requirements. A deep, liquid
bond market would be able to accommodate
financing on a much larger scale.
Long-term bonds are a much better way to
fund multi-year infrastructure projects than
bank loans as they remove the problem of
duration mismatches in the banking system.
They would also meet demand from
institutional investors like long-term debt
instruments.
The cost of lending is lower than bank loans.
The role of banks will change
As the bond market develops and the financial
markets become more competitive, banks should
be prepared to shift their focus away from big
projects and SOEs to retail customers and SMEs.
For some, this has already started. It can be seen
by the increase in the percentage share of the
assets of small and medium-sized banks (SMBs)
within the banking system (Chart 1.7). SMBs are
doing more and more business with SMEs, a trend
that is likely to continue in the coming years as
the reform process accelerates.
Banks have also widened their range of services,
selling different types of wealth management
products, which are short-term investments that
offer customers better returns than deposits.
Chart 1.7. Small and medium-sized banks gaining market
share
40
45
50
55
2003 2004 2005 2006 2007 2008 2009 2010 2011
(%)
Small and medium-sized banks' asset as % of total

Source: CEIC, HSBC

The Wenzhou experiment
Beijing has launched an important programme of
pilot reforms in Wenzhou, a city in Chinas eastern
Zhejiang province where many small businesses ran
into serious credit problems (see box). This city of
8m has a strong tradition of entrepreneurship, so it is
not surprising that private business represents a
remarkable 82% of the local economy. The aim of
the reforms is to standardise and regulate the
development of private financing and small-scale
financial institutions. Local residents are also
being allowed to make overseas investments.


12
Macro
China
November 2012
abc
According to local media, Wenzhous local
government has submitted a proposal to the State
Council to implement Beijings plan. It wants to
increase the number of micro-finance companies
that lend small amounts of money.
There are around 35 today and the plan is set up
another 30 next year and a further 30 in 2013,
taking the total to about 100, enough to cover
Wenzhou and neighbouring towns. At the same
time, local branches of commercial banks would
set up special departments for small companies,
the reform of rural co-operative financial
institutions should be finished by the end of this
year and village and township banks and their
subsidiaries should cover every county by 2013.
The PBoC is also playing a role in the Wenzhou
experiment by measuring lending activity. Its
Wenzhou branch has started to record the
percentage of lending made by local private lending
institutions on a monthly basis. It is using data from
30 rural co-operatives, 28 micro-lending companies,
30 guarantee companies, 50 pawn shops (which
include property among the assets they lend cash
against) and other financial services institutions.
The ratio was 20.4% in September, or 5ppts lower
than the peak in August 2011, suggesting that
demand for loans has slowed, as is the case in the
rest of the country.
This type of financial deregulation is taking place
in other regions too. Huge cities such as
Shenzhen, Shanghai and Tianjin have introduced
similar reforms and smaller places such as Li Shui
in Zhejiang province have received permission to
press ahead with change. More will follow,
setting the stage for major changes in Chinas
financial landscape.




13
Macro
China
November 2012
abc
Why Wenzhou is so different
Some say it is the mountainous terrain that has kept
the place isolated; others point to the areas distinctive
dialect. What ever the case, Wenzhou has always been
a bit different from the rest of the country.
For decades it has been known as a hotbed of
entrepreneurship and grey-market lending. The
citys thousands of small businesses make, amongst
many other things, most of the shoes, eyewear and
cigarette lighters produced in China. Its known as
one of the richest cities in the country.
But Wenzhou recently became famous for another
reason its private companies were starved of credit
by banks as the PBoC tightened monetary policy through three rate increases and six RRR hikes in 1H 2011.
This led to businesses turning increasingly to unregulated shadow banking channels. When the economy
slowed and interest payments piled up, many went broke, threatening the financial stability of the region
late last year.
That was when Beijing stepped in. Premier Wen Jiabao visited Wenzhou and said the city would be the
testing ground for breaking the monopoly of the big state banks, which will help cash-starved private
enterprises get timely access to capital. The pilot project that is just getting started may one day become a
cornerstone of nationwide financial sector reforms.
Wenzhous financial model is much closer to that of the southern province of Guangdong, the economic
powerhouse that neighbours Hong Kong, than the government-led, debt-driven Chongqing model that
attracted negative headlines earlier this year (see China Inside Out: The Guangdong way is Chinas
future, 30 April 2012).

Wenzhou and Guangdongs economic model is more
market-driven than Chongqings

Chongqing
Guangdong
Zhejiang
Wenzhou
Chongqing
Guangdong
Zhejiang
Wenzhou

Source: HSBC



14
Macro
China
November 2012
abc

Ready for take-off
From market regulation and product innovation,
to the scale of bond issuance and the growing
investor pool, it is clear that Chinas bond market
is moving into a new era. We expect its market
capitalisation to double in the next 3-5 years,
lifting it into the worlds top three bond markets.
Our confidence is based on the pace of recent
developments to deepen and broaden the market
and the growing need to fund Chinas rapid
urbanisation, as millions of people continue to
move to the city from the countryside every year.
In the past there has been limited co-operation
between competing regulators but there has been
progress in a number of different areas, including:
The expansion of local government bond
issuance (the Ministry of Finance has issued
RMB250bn on behalf of local authorities this
year, up from RMB200bn in the previous
three years) and a pilot programme allowing
local governments to issue new municipal
bonds, with the option of longer maturities.
A regulatory scheme led by the PBoC to
improve co-ordination between the different
parts of the corporate bond market.
The rapid growth of credit bonds issued by
LGFVs (although Beijing is trying to make
sure this is kept under control).
The launch of private placement SME bonds
and the expected relaunch of Treasury
bond futures.
The opening up of the bond market to
overseas investors and granting quotas to
foreign central banks.
The need to play catch-up
Chinas bond market needs to catch up fast. The
worlds second-largest economy represents over
10% of world GDP, while the countrys outstanding
bonds represent 5% of the world total (3.6% if
policy bank bonds are excluded). The gap between
Chinas bond market and GDP is huge compared
with other large economies (Chart 2.1).
The worlds next big bond
market
Chinas bond market has lagged behind the countrys spectacular
economic growth
With a wider range of products and a growing pool of investors, it
is set for rapid expansion
We expect market capitalisation to double in the next 3-5 years,
making it one of the worlds top three bond markets


15
Macro
China
November 2012
abc
Chart 2.1 Chinas bond market needs to catch up
0
5
10
15
20
25
30
35
40
US JP FR GE CH BR UK
(As % of world total)
Bonds outstanding GDP

Source: ADB, World Bank, HSBC 2011 data. China bonds excl. policy bank bonds

Over the last three decades China has maintained
spectacular growth averaging 10%. Half of this is
driven by investment roads, rail, factories and
skyscrapers which runs at around 20% y-o-y in
nominal terms despite the recent slowdown.
Despite this the financial landscape remains
dominated by banks. Bond market capitalisation
accounted for 45% of GDP in 2011 (Chart 2.2),
less than half the outstanding loans to GDP ratio
(116%), down from 125% in 2010 when it was
inflated by the effects of the stimulus package.
Chart 2.2. Bond market cap dwarfed by bank lending
0
20
40
60
80
100
120
140
2002 2004 2006 2008 2010 2012f
(%)
Bond market cap as % of GDP
Outstanding loans as % of GDP

Source: CEIC, HSBC estimates

Chinas bond market also lags its neighbours in
Asia. According to the Asian Development Bank,
the countrys bonds outstanding to GDP ratio
(44.8% in 2Q 2012) was 8.2ppts lower than the
average for emerging East Asia and more than
30ppts below Singapore, Malaysia and South Korea.

Chart 2.3. Chinas bond market lags Asian peers
0
50
100
150
200
VN ID PH CH EEA HK TH SG MA KR JP
(As % of GDP)
Gov ernment Corporate

Source: ADB, HSBC. EEA stands for emerging East Asia. Data as of 2Q 2012

The bond market is not only small but lacks
variety. It is dominated by treasury bonds and
other policy bonds and is light on local
government and corporate bonds. As of mid-
October 2012, 35% of total outstanding bonds
were financial bonds (mainly issued by policy
banks and state-owned banks), followed by
treasury bonds (30%), mid-term notes (11%) and
enterprise bonds (7%), see Chart 2.4. Put together,
government-backed bonds represent nearly 75%
of Chinas outstanding bonds.
Chart 2.4 Government-backed bonds dominate
0%
20%
40%
60%
80%
100%
VN JP PH ID TH CH EEA SG MA HK KR
Corporate Gov ernment

Source: ADB, HSBC. EEA stands for emerging East Asia. Data as of 2Q 2012




16
Macro
China
November 2012
abc
Chart 2.5. A snapshot of China's bond market (outstanding)
PBoC bills
5%
CP
4%
Corporate
2%
Others
6%
Enterprise
7%
MTN
11%
Financial
35%
Treasury
30%

Source: Wind, HSBC. MTNs refers to mid-term notes; CP refers to commercial paper

Market structure
Chinas bond market has three segments: the
national interbank market, the exchange market
and the bank counters market. It has a centralised
trust and clearance system provided by China
Government Securities Depository Trust and
Clearing Company.
1) The interbank market handles over 90% of total
daily business. Established in 1997, this is also the
countrys largest over-the-counter (OTC) market.
Bond transactions are made through inquiry and
independent negotiations. As it is the most liquid
market, this allows the central bank to conduct
open market operations through central bank bills
and repos.
The interbank bond market has opened its door to
foreign banks on a trial basis, a key step towards
internationalising the RMB (see China: Onshore
RMB bond markets open up a crack, 17 August
2010). Some 20 foreign institutions can now
invest in Chinas interbank bond market. These
include foreign central banks for example, the
Bank of Korea has a quota of USD3.2bn and the
Bank of Japan USD10bn.
In addition, Shanghais municipal government
aims to establish itself as global centre for RMB
trading, clearing and pricing by the end of the
12th Five- year Plan (2011-15). This means that
the expansion of the interbank market is likely to
be faster than expected.
2) The exchange market is open to various
(basically non-bank) investors on an automatic
matching trade system. Trading volume is limited
due to the lack of participation by banks. This
could change as commercial banks are to be
allowed to participate on a trial basis, according to
a joint circular by regulators.
3) Banks OTC market serves individual investors.
Treasury bonds (mainly certificate bonds and book-
entry bonds) are sold to individuals and companies.
There are four types of bonds: treasury bonds,
PBoC bills, financial bonds and credit bonds (see
Asia-Pacific Rates Guide 2012, 14 December 2011).
Treasury bonds, commonly referred to as
onshore Chinese government bonds (CGBs), are
issued by the Ministry of Finance (MoF) as the
governments main debt instrument. Maturities
typically range between 1-year and 10-year but
are increasingly available in longer-term tenors
(e.g. 15-, 20-, 30- and 50-year).
PBoC bills are issued by the PBoC to manage
liquidity and sterilise FX operations. Available
maturities range from 3 months to 3 years. Active
trading in PBoC bills makes it a useful benchmark
for money market rates.
Financial bonds are issued by financial
institutions and underwritten by banks and leading
securities firms. The main type of financial bonds
are policy bank bonds that are issued by three
policy banks backed by the government (China
Development Bank, Export-Import Bank of China
and Agricultural Development Bank of China) for
financing key national projects that are not
covered by the national budget.
Credit bonds in the interbank market include
enterprise bonds, commercial paper (CP),
medium-term notes (MTNs) and super and short-


17
Macro
China
November 2012
abc
term commercial paper (SCP). CP maturities are
typically 9-months and 1-year. Maturities of
MTNs vary according to business needs and
typically range between 2 and 10 years. Enterprise
bonds maturities range from 3 to 30 years. In
addition, since the end of 2010, Shanghai Clearing
House (SCH) also launched SCP with maturities
of less than 270-days. Long-dated bonds are held
mostly by insurance companies and liquidity is
limited. Only short-tenored credit bonds have
decent liquidity.
Table 2.1 Bond products in China
Type of bond Issuing entities
Treasury bonds Ministry of Finance
Policy bank financial bonds Policy banks, i.e., China
Development Bank, Agriculture
Development Bank, EXIM Bank
PBoC bills PBoC
Local government bonds Ministry of Finance on behalf of
local governments
Enterprise bonds Unlisted enterprises
Corporate bonds Listed companies
Commercial paper and mid-term
note
Non-financial firms
Convertible bonds, bonds with
warrants
Listed companies
Source: HSBC

Local government financing
Chinas local governments are deeply in debt
RMB10.7trn (23% of 2011 GDP) by the latest
conservative estimates. How did they get into this
situation when the economy has been booming for
so long? Its a long story.
In the early 1990s, Beijing launched a major fiscal
reform programme aimed at centralising tax
revenue. This resulted in the central governments
share of total fiscal revenue rising from less than
30% in the early 1990s to more than 50%, at the
expense of local governments.
The problem is that local governments still
shoulder a large part of the burden of funding
infrastructure. With insufficient revenue, most
local governments, which are not allowed to
borrow directly from banks, chose to access credit
from the banking system through what are known
as LGFVs. It is no surprise that most LGFVs have
been accumulating debt since the early 1990s, and
the pace has accelerated since the financial crisis.
Bank loans to LGFVs are made under the name of
the company responsible for the construction
project. They generally have the explicit or
implicated guarantee of local governments i.e.
local governments are responsible for their debts.
The Shanghai Securities News reported in
February that at least 65% of these loans were
fully covered by cash flows.
As we mentioned in the previous chapter, to help
stimulate the economy in 2009 Beijing started
issuing RMB200bn of bonds annually on behalf
of provincial governments to support local
projects (raised to RMB250bn this year, with the
option of a longer maturity period).
While this will help local governments in the
short term, it wont fix the problem completely.
However, Beijing may have found another
solution. In 4Q 2011 it started a municipal bond
trial programme, which allowed the wealthy cities
of Shanghai and Shenzhen, along with prosperous
Guangdong and Zhejiang provinces, to issue a
total of RMB22.9bn municipal bonds with 3 or 5-
year maturity.
We believe this trial programme is likely to be
rolled out in other parts of the country in the
coming quarters. All this sends a strong signal that
Beijing sees these new local government
municipal bonds as the way to solve the liquidity
problem facing LGFVs, while at the same time
providing long-term financing for public housing
and infrastructure projects. This is particularly
important at a time when the economy is slowing
and there are calls for additional easing measures.


18
Macro
China
November 2012
abc
The surge of LGFV bonds
Apart from bank loans, the local governments
have found another way to get themselves into
financial difficulties LGFV bonds. Strictly
speaking, local governments are not allowed to
issue bonds but they found a way round the
regulations. LGFVs started to issue mainly credit
bonds in the late 1990s (for example, the
RMB500bn Pudong construction bond to build
the subway in Shanghai in 1999).
The volume of bonds issued by LGFVs has grown
rapidly. In 2009, urban infrastructure construction
investment companies issued bonds totalling
RMB233bn, up from RMB60bn in 2008.
Despite Beijings efforts to start cleaning up local
government debt in 2H 2010, bond issuance
bounced again in 2011 and is up 160% y-o-y in the
first half of 2012 as market confidence was restored
after the last-minute bailout of Shandong Helon.
This debt-laden fibre company almost became the
first company in China to default on a corporate
bond, pushing up high-yield spreads to record
levels (see Default dynamics, 7 March 2012).
LGFV bonds are usually only thinly traded in
comparison with mainstream products such as
government bonds, central bank bills and debt
issued by large corporations. They also tend to
trade at high yields, given the concerns over the
risk of default.
Chart 2.6. LGFV bond issuance since 2009
0
100
200
300
400
500
2002 2004 2006 2008 2010 2012*
(RMB bn)

Source: Wind, HSBC * As of end Oct 2012
Corporate bonds need a boost
The corporate bond market is very
underdeveloped in both the primary and
secondary markets.
Broadly speaking, there are three types of
corporate bonds. They are regulated by different
authorities and trade in different markets.
Enterprise bonds: Mainly issued by unlisted
companies regulated by the NDRC, the main
economic policy body. First issued back in
the early 1980s, these bonds are mainly issued
by SOEs but private enterprises are
increasingly using them to raise funds. Most
enterprise bonds are traded on the interbank
market, with the exchange market handling
the balance. Insurance companies,
commercial banks and mutual funds are the
main investors.
Corporate bonds: Issued by listed
companies regulated by the CSRC and traded
on the exchange market. Their market cap is
much smaller than enterprise bonds (about
25% of enterprise bonds). Investors are
mutual funds, insurance companies, enterprise
annuity funds and commercial banks.
Corporate mid-term notes and commercial
paper: Regulated by the National Association
of Financial Market Institutional Investors
(NAFMII), a PBoC agency, and mainly
traded in the interbank market. The approval
process is easier than for enterprise and listed
companies bonds (a credit rating is needed
but there is no requirement for a bank
guarantee). These bonds were first issued in
2008 and have proved to be very popular.
Outstanding mid-term notes stood at
RMB2.7trn as of October 2012, more than the
combined amount of enterprises and
corporate bonds. Commercial banks and
mutual funds are the main investors.


19
Macro
China
November 2012
abc
We believe corporate bonds should play a larger
role in direct financing. They provide long-term
capital at a lower cost than bank loans and unlike
equities bonds dont dilute the shareholders
interests. And, more importantly, they will help
broaden the financing channels for SMEs. Today,
corporate (and enterprise) bonds account for only
9% of outstanding bonds, excluding mid-term
notes and commercial paper. The market is still
dominated by SOEs and large companies.
However, two recent policy initiatives suggest the
pace of development is speeding up.
For the first time Beijing set up a
consolidation scheme (led by the PBoC
working with the CSRC and NDRC) in April.
Few details are available but this move is
expected to eventually lead to the
consolidation of Chinas bond market, which
should boost liquidity and issuance.
The Shenzhen Stock Exchange launched
private placement SME bonds from June
2012. This should help to ease financing
difficulties for SMEs.
Asset securitisation still
minimal
China launched the first asset backed security (ABS)
in 2005. Development has been very slow due to: 1)
a lack of co-ordination among policymakers; 2) the
fragmented nature of the interbank and exchange
markets; and 3) the ABS market was suspended
during the global financial crisis.
ABS issuance resumed in 2012 when three
financial regulators the PBoC, the China
Banking Regulatory Committee and the Ministry
of Finance issued a joint notice to promote ABS.
Banks are allowed to issue up to a combined
RMB50bn in these types of securities. China
Development Bank (CDB) made the first ABS
issuance of RMB10.2bn, marking the resumption
of this process. However, outstanding ABS
represented just 0.1% of total outstanding bonds
as of end October 2012.
Chart 2.7 Outstanding asset-backed securities still minimal
0
10
20
30
40
50
60
2005 2006 2007 2008 2009 2010 2011 2012*
(RMB bn)

Source: Wind, HSBC * As of end Oct 2012

Plenty of demand
Demand for bonds is not a problem. Insurance,
pension and mutual funds as well as the large pool
of household savings are all looking for long-term
investment instruments. Chinas households and
companies have generally high savings rates,
which require effective investment channels. The
bond market provides long-term investment
instruments with fixed returns, a sharp contrast to
the more volatile and riskier equity market.
Further development of the bond market will
provide the middle class with greater choices
about where to put their money so they can earn a
higher return and therefore spend more.
Moreover, the number of institutional investors is
on the rise. By the end of September 2012, there
were 411,711 institutional investor accounts on
the Shanghai A-share market compared with
around 200,000 in early 2005. Fund management
companies, securities companies, insurance
companies and social security funds are all
important investors.


20
Macro
China
November 2012
abc
Second, the market is increasingly open to foreign
investors. By the end of September 2012, 188
institutions had received QFII licences with an
investment quota of USD30.8bn. China is now
planning to lower the entry barrier for foreign
institutional investors as part of reforms to add depth
to the countrys capital markets. The government
will cut the minimum requirement on assets under
management to USD500m from USD5bn for
companies seeking a QFII licence, the CSRC
announced on 19 June 2012 (source: Bloomberg).
The regulator also said it will allow the QFII
funds to invest in the countrys interbank bond
market. Under the new rules foreign investors will
be required to have at least two years of
operational experience, compared with the current
minimum of five years. The CSRC hopes that
introducing more long-term funds from abroad
will help improve market confidence and promote
stable growth in Chinas capital markets.
Chart 2.8. QFII investors expanding
0
20
40
60
80
100
120
140
160
04 05 06 07 08 09 10 11 12
0
10
20
30
40
(USDbn)
No. of institutions approv ed (Lhs)
Approv ed inv estment accumulated (Rhs)

Source: CEIC, HSBC

But a stronger institutional
framework is needed
An efficient, well-supervised bond market would
reduce transition costs and lower risks in the
financial system. We believe corporate
governance, the legal framework and regulatory
supervision all need to be improved. We think the
following are needed to build the right
institutional framework:
Information disclosure: Better transparency
is needed to accelerate the development of the
local government bond market. The balance
sheets of many local governments lack clarity
and need higher accounting standards. The
current accounting law only applies to
companies it should also be applied to local
governments. This will help price the risk of
local government bonds.
A credit evaluation system: A proper credit
ratings system is vital, especially in a market
which has a short history (the four major
domestic rating agencies are inexperienced)
and lacks statistics on default ratios.
Consolidation of the fragmented bond
markets, but this will take time. The current
segmentation splits liquidity and prevents the
formation of a complete yield curve.
Improving yield curves: A properly-
functioning yield curve provides the benchmark
for pricing risk. Chinas yield curves need
further improvement through: 1) the
strengthening of market makers; 2) more
diversified products and maturity; 3) deeper
liquidity; and 4) interest rate liberalisation.

Bringing in global players
would help
There are many ways Beijing can strengthen the
institutional framework of Chinas bond market
enhance regulation, increase co-operation with
overseas exchanges and regulatory authorities and
nurture domestic investors and rating agencies.
But for us the best option would be to attract top
global institutional investors who are more
capable of identifying, pricing and managing risks.
Their active participation would encourage
companies to improve the quality of disclosure
and help domestic rating agencies raise their
standards to international levels.


21
Macro
China
November 2012
abc
This can be achieved by expanding the current
QFII and RQFII schemes and further opening
bond markets to foreign central banks and
international organisations. There are signs that
this is already starting to happen.
On top of the increase in the QFII quota from
USD30bn to USD80bn, as mentioned earlier the
CSRC is considering further relaxing QFIIs
investment rules. This includes allowing QFIIs to
invest in the interbank bond market and changing
the rule that no less than 50% of QFII
investment must be in equities. Meanwhile, the
fact that Bank of Japan and Bank of Korea have
recently received approval to invest in the
interbank market is another positive sign (see the
chapter: A convertible RMB within five years).
Increased participation by sophisticated global
investors will accelerate the pace of building a
more transparent and liquid bond market one
that matches Chinas rapid economic growth.


22
Macro
China
November 2012
abc
Ready for action
Zhou Xiaochuan, governor of the central bank, the
PBoC, made his point very clearly. Writing in the
March issue of China Finance magazine, he
stated that conditions were basically ripe for
liberalising domestic interest-rate policies. His is a
powerful voice he has held that important job
since 2002.
Interest rate liberalisation lies at the heart of
Chinas financial reforms and much needs
changing. Under the current system the PBoC sets
a ceiling for bank deposit rates and a floor for
lending rates, creating a high spread that generates
fat bank profits. It also means that the returns
savers earn on their deposits are below the level of
inflation, so they are effectively losing money. As
The Economist magazine put it recently: A
banks depositors, in effect, pay the bank to
borrow their money from them.
This, in turn, works against the governments
policy to make consumption a bigger driver of
economic growth. Consumption in China was
51.6% of gross domestic product in 2011,
compared with about 70% in the US.
Chart 3.1 Real interest rates in China
-5
-4
-3
-2
-1
0
1
2
3
4
5
00 01 02 03 04 05 06 07 08 09 10 11 12
%
Real interest rate Long-term av erage

Source: CEIC, HSBC

Reformers like Mr Zhou believe that liberalising
interest rates is vital for other reasons too it
would help to develop the bond market and make
it easier to lift capital controls and internationalise
the RMB. Importantly, interest-rate liberalisation
is now official government policy as it is part of
Chinas 12th Five-year Plan, which runs from
2011 to 2015. Mr Zhou believes it should be
possible to make considerable progress during this
period for a number of reasons, including:
How to set interest rates
free
The governor of Chinas central bank says the time is ripe for
liberalising interest rate policies
The powerful state-owned banks stand to lose the most from
reform, but there is little they can do to buck the trend
In our view, liberalising interest rates will be a step-by-step
process that could be completed within three years


23
Macro
China
November 2012
abc
The process of financial restructuring and
listing the major domestic commercial banks
is largely complete. The banks should be able
to stand on their own feet.
The ability of financial institutions to price
interest rates and manage risk has improved
significantly.
The central bank has become more proficient
at adjusting market interest rates through open
market operations (buying and selling
government securities to expand or contract
the amount of money in the banking system).
The Shanghai Interbank Offered Rate
(SHIBOR) is now an established benchmark
for pricing financial products.
A deposit insurance system and a survival of
the fittest mechanism to weed out weak
financial institutions are being established.
However, the problem is that reform in China is all
about timing and the order in which changes should
be made. Beijing likes to test the water by rolling
out pilot schemes in certain cities or provinces. But
this is not practical for interest rates and thats why
they were not part of the Wenzhou reforms. With
the global economy still weak and China facing the
risk of an economic slowdown at home, liberalising
interest rates cannot be rushed. We think it will be a
step-by-step process that can be completed within
three years.
Our confidence is based on a number of factors.
Firstly, Mr Zhou is not a lone voice. In October, it
was announced that three bodies that regulate
banks, equities and insurance would all be led by
former PBoC vice-governors; Shang Fulin at the
China Banking Regulatory Commission (CBRC),
Guo Shuqing at the CSRC and Xiang Junbo at the
China Insurance Regulatory Commission (CIRC).
They are proven reform-minded problem solvers and
protgs of former premier and economic reformer
Zhu Rongji, who did much to change China in the
late 1980s and early 1990s. For more details see
China Investment Atlas, Issue 37, The markets
driving forces in 2012, 18 November 2011.
Then, in January, the powerful National Financial
Working Conference (NFWC), that meets every
five years, came out strongly in favour of a string
of broad based financial reforms.
More evidence of change came in February with
the release of the China 2030 report by the World
Bank and the Development Research Center, a
think tank with links to the State Council, the
countrys top executive body. This presented a
sweeping reform agenda, including interest-rate
liberalisation and limits on the power of SOEs.
Then came Mr Zhous comments in March. In
addition, Premier Wen Jiabao has also stated
Chinas road to reform cannot be changed and
separately called for the power of the state banks
to be reined in.
So what happens next? In the next three years or
so we think the pace of deregulation will be
guided by a series of small changes that make
both lenders and borrowers more responsive to the
cost of funding.
An assessment by the PBoC suggests that all
commercial banks and rural credit units already
have interest rates pricing systems based on cost
of funding and risks in place, ready to be rolled
out. Chinas financial institutions appear to be
ready for the complete liberalisation of
benchmark lending and deposit rates.
Indeed, Chinas Banking Association is working
on setting up a mechanism to decide benchmark
deposit and lending rates. We think the sector is
preparing for the final push towards interest rate
liberalisation. It is likely to start with rates for
long maturity, large deposits before moving to
short- term small deposits.


24
Macro
China
November 2012
abc
As the Asian Wall Street Journal reported on
20 March 2012, the PBoCs Mr Zhou and others
are also calling for the creation of a government
deposit insurance system, similar to the US and
other developed countries. This would put Chinas
banking system on a more solid footing and
ensure that depositors money would be safe even
if some banks shut down because of the
increased competition.
The next steps
Mr Zhou has laid out a widely reported two-stage
roadmap for liberalising interest rates by 2015.
First, four preconditions must be met, followed by
a six-step reform process. The preconditions are:
1) China has a competitive financial market with
diversified financial institutions that can price
market risks at different levels depending on their
funding costs and financial strength. Current
status: Some of the stronger commercial banks
already have pricing power.
2) Commercial banks, which operate in a tougher
environment than policy banks, are to be given
more price setting power. Current status:
Competition has strengthened since the banks
were restructured and floated.
3) Chinas banks still see market share as the most
important factor when it comes to competition.
This mindset needs to change. Current status:
Commercial banks are becoming increasingly
focused on promoting financial services.
4) Commercial banks need to reduce their reliance
on interest rate income. Prices of other financial
services also need to be deregulated. Current
status: The contribution of interest rate income at
the big four banks has declined significantly in the
past few years.
Where are we now
China, like many developing countries, has kept
interest rates artificially low to increase industrial
output growth and reduce financing costs for large
state-run companies. The net interest rate margins
for Chinas banks were negative during the
majority of the first two decades of economic
development (1978-1996).
The downside is that this financial repression,
as it is known, has slowed the development of
financial services and reduced the efficiency of
allocating funds to businesses. In simple terms,
credit does not always get to where it is needed
most. For example, it is easy for big SOEs to get
credit while many SMEs are starved of funds.
The aim is to establish a market-oriented structure,
with money market rates acting as the benchmark
based on supply and demand. This would mean that
the central bank becoming less dependent on
administrative policy measures such as loan quotas
and the reserve requirement ratio to influence the
system. Experiences from other countries suggest
that the pace and sequence of reform will determine
the impact liberalising interest rates will have on the
financial system and whether the real economy
would suffer a negative shock.
Interest rate liberalisation is not a new concept in
China the phrase first appeared in official
documents way back in 1993. Today, after years
of step-by-step deregulation and reforms (see
Table 3.6) much progress has been made. This
gradual approach has safeguarded the banks
profit margin, while giving businesses and
households time to adjust.
Here is whats happened so far:
Capital market rates
Money market and bond market interest rates
In a market-oriented system, inter-bank interest rates
are liberalised first, followed by bond market rates.


25
Macro
China
November 2012
abc
In 1996 the central bank abolished the upper
limit on inter-bank lending rates. It only took
from 1996-99 to fully liberalise interest rates
on the inter-bank market and bond markets.
FX and local currency lending and
deposit rates
Lending rates
The foreign currency market uses
international rates as a benchmark; lending
rates of all foreign currencies were
deregulated from September 2000.
For RMB loans the upside floating limit for
SMEs was expanded from 110% of the policy
rate to 120% in 1998 in an effort to support
small business.
Over 1998-2003 the floating limit of lending
rates for RMB loans expanded to 30%, rising
to 170% from January 2004.
The upper limit of lending rates for RMB
loans was abolished in October 2004. Only
the lending rate floor 90% of the policy rate
was kept in place.
Deposit interest rates
FX rates for large deposits of over USD3m
were liberalised in September 2000.
The number of foreign currencies subject to
deposit rate regulation was reduced from seven
to four (USD, EUR, JPY, HKD) in July 2003.
Interest rates for all small FX deposits with a
maturity of more than one year were
liberalised in November 2004.
The ceiling of RMB-denominated deposit
rates has been controlled since October 2004.
The PBoC still regulates 29 types of interest rate,
including preferential interest rates for export
credits, deposit rates for small FX deposits and
loans for anti-poverty purposes (see Table 3.3).
Problems areas
These include:
The 1-year deposit rate, the central banks
benchmark interest rate, acts as an important
reference for the rating of bonds. Chinas
single tender, fixed bid system has distorted
the bond market and does not give a true
reflection of supply and demand. Thats why
interest rates for bonds are usually higher than
the benchmark deposit interest rate.
Having regulated interest rates limits the
issuing of bonds to the central government,
central bank, state-owned banks, big SOEs
and policy banks. This has hindered the
expansion of the bond market. Financial and
corporate bonds issued by policy banks and
large SOEs account for 50% of the total bond
market (this includes 40% of short-term
financing bills and medium-term notes). Most
local governments, which have great
difficulty in raising funds for local
infrastructure development, are not qualified
to issue bonds. The exceptions are Shanghai,
Shenzhen, Guangdong and Zhejiang which
were allowed to issue bonds late last year as
part of a pilot scheme.
A lack of development of related products
such as interest rate futures. Regulated
interest rates deprive market players of risk
management tools. Put another way, in
Chinas bond market theres no interest rate
risk other than policy risk.
Theres no benchmark yield curve, weakening
the markets gauge of short-term rate trends
and inflation.



26
Macro
China
November 2012
abc
Chart 3.2 Regulated interest rates are still the market
benchmark
0
1
2
3
4
04 05 06 07 08 09 10 11 12
%
0
2
4
6
8
10
3-month time deposit rates (LHS)
Shibor: 3 month
Inter-bank 3 month money rates

Source: HSBC, CEIC

The main obstacles
The benefits from marginal changes in interest rates
in terms of improvements in banking efficiency and
allocating financial resources have come to an end.
In other words, the easy part is over.
Powerful vested interests have a lot to lose from
change especially the big banks. Experiences
from many other countries show that the net
interest margin (NIM) tends to narrow after
lending and deposit interest rates are liberalised.
This is because banks have to compete with each
other they attract deposits by raising deposit
rates and cutting lending rates to win business
from valued (normally big) clients.
This squeezes interest rate income and thats why
Chinas commercial banks are the main group
objecting to reform. NIM income represents 70-
80% of the banking sectors profits, so it is
understandable that the banks will try to postpone
reform for as long as possible. Market driven
interest rates would force them to grow their
businesses in other areas, particularly fee income.
Chart 3.3 Banks interest rate margin has stayed between 3-
4ppts
-5
0
5
10
15
90 92 94 96 98 00 02 04 06 08 10 12
%
Interest rate margin 1-y r lending rates
1-y r time deposit rates

Source: HSBC, CEIC

But interest rate liberalisation is not just about
deregulation. It is also about power. Chinas
government-controlled banking system has long
provided the financial resources that have made the
country the economic powerhouse that it is today.
Fully-liberalised interest rates would certainly
diminish the level of government control.
During the 2008-09 global financial crisis the
states control of the banking sector helped
Chinas strong economic recovery. In 2009 the
banks pumped RMB9.6trn of new loans into the
economy as Europe and the US floundered. We
believe it is this deep-seated fear of the
diminution of power that is the biggest obstacle to
be overcome.

Table 3.3 Interest rates currently under PBoC regulation
Interest rates

Numbers of rates under regulation
Deposit rates Deposit rates (demand deposit, 3-month, 6-month, 1 year, 2 years, 3
years, 5 years), negotiated deposits (upper limit restriction), savings for
personal housing funds and other small deposit accounts
10
Lending rates Lending rates (6-month, 1 year, 3 years, 5 years, more than 5 years),
personal housing loans
7
Preferential lending
rates
Export credits (China Import and Export Bank), anti-poverty 8
Small foreign currency
deposits
Deposits with maturity of less than 1-year deposits of USD, EUR, JPY,
HKD
4
Total 29
Source: PBoC, HSBC


27
Macro
China
November 2012
abc
We suggest policymakers think about this in a
different way financial repression and the
misallocation of financial resources could
ultimately threaten the sustainability of Chinas
economic growth.
It would be far better if commercial banks can
work together at an industry level to build a co-
ordinated mechanism to set a benchmark interest
rate. This, under the supervision of the central
bank during a transition period, could help
cushion the potential nasty shock of free interest
rates on the sector and, in turn, the real economy.
Chinas Banking Association, which works under
the CBRC, is already researching the best way to
set up this mechanism.
As Yi Gang, the PBoC vice governor, wrote in his
2009 book On the Financial Reform of China,
only when a market-oriented benchmark interest
rate is properly pricing lending and deposits will
the PBoC be able to exit its role of setting
benchmark interest rates.
Chart 3.4 Around 70% of total bank loans were lent at
interest rates higher than the central bank benchmark
0
20
40
60
80
08 09 10 11 12
%
Below benchmark, 10%
Abov e benchmark, 10% up to 170%

Source: HSBC, Wind

SHIBOR, an emerging benchmark
Before the PBoC can give up its role of setting
interest rates a market-oriented benchmark
interest rate needs to be in place.
The Shanghai Interbank Offered Rate (SHIBOR),
introduced in January 2007, already acts as a good
reference for short-term (less than 3-month)
money supply and demand. SHIBOR is now
widely accepted as the benchmark rate for
discount bills, wealth management products and
asset management.
However, there is still too big a difference between
offer and transaction prices for more than three-
month funding, which suggests that factors other
than supply and demand are at work between
market counterparties. Theres more work to do to
enhance SHIBORs role as a pricing benchmark.
Chart 3.5 SHIBOR, an emerging RMB rate benchmark
-1
1
3
5
7
9
00 01 02 03 04 05 06 07 08 09 10 11 12
%
SHIBOR1M USD LIBOR1M HIBOR1M

Source: HSBC, CEIC

Latest developments
China took another step towards liberalising
interest rates on 8 June when it cut borrowing
costs for the first time since 2008 and loosened
controls on banks lending and deposit rates. The
one-year lending rate was lowered 0.25ppts to
6.31% and the one-year deposit rate fell the same
amount, to 3.25%. Banks could offer a 20%
discount to the key lending rate after the move, up
from 10% previously. They will also for the first
time be able to offer savers deposit rates that are
up to 10% higher than the benchmark.
Currently around 70% of total bank loans are lent
at interest rates higher than the central bank
benchmark (see Chart 3.4), implying that Beijing
thought it was a good time to expand the floating
range as it eliminates the risk of irrational
competition between financial institutions.


28
Macro
China
November 2012
abc
Less than a month later the PBoC acted again,
asymmetrically cutting the benchmark 1-year
lending rate by 31bps to 6% and the 1-year
deposit rate by 25bps to 3%, effective 6 July. The
central bank has also announced it was further
reducing the lower limit from 80% to 70% of the
benchmark lending rate. This change is not
applicable to mortgage rates as the central bank
reiterated that property tightening measures would
stay in place.
By cutting the lending rate more aggressively than
the deposit rate, and allowing a higher discount
against benchmark lending rates, the authority is
trying to lift private sector investment demand
amid the current economic downturn.
The next steps
In September the State Council approved the 12th
Five-year Plan for Financial Sector Development
and Reform, jointly formulated by the PBoC, and
other key regulators. According to the plan,
market-based interest rate reform will progress
during the 12
th
Five-year Plan (2011-15). We
expect to see the following measures:
Further expansion of the floating band for
lending and deposit rates.
The number of lending rates categories under
regulation to fall from five to three and finally
to only one the benchmark lending rate.
The reduction of regulated deposit interest
rate categories from seven to five or fewer.
The long-term deposit rate is likely to be
liberalised first and the demand deposit rate,
which accounts for about 50% of total
liabilities in the banking system, last.
Eventually, the ceiling on the interest rate for
deposits will be removed, letting bank rates
float freely.
Conclusion
Interest rate liberalisation lies at the heart of
Chinas financial reforms. Given the latest move
on 6 July, we expect the process to accelerate
along with reforms in other areas such as the
RMB exchange rate and capital account
liberalisation. We expect the full liberalisation of
interest rates to be completed within three years.


29
Macro
China
November 2012
abc

Table 3.6. Interest rate liberalisation milestones in China
Category Year Event
Money market interest rate and bond market
interest rates
1996 PBoC abolishes upper limit on inter-bank lending rates.
1996 MoF adopts interest rate and yield bidding in treasury bond
issuance (exchange platform).
1997 Liberalised repo rates in interbank markets.
1999 MoF issues treasury bonds in the interbank market for the first
time.
Lending rates 1998 Upside floating limit for SMEs expanded from 10% to 20%;
lending rate upper limit for rural credit units increased from
40% to 50%, while limit for bid enterprises unchanged at 10%.
2003 Pilot scheme for reforming credit unit launched. Upper limit of
lending rates for rural credit units included in the scheme
expanded to 200%.
2004 Removed ceiling for all lending rates, except interest rates for
housing mortgage loans, and credit units for urban and rural
areas (upper limits were increased to 230%).
2012 Lending rate floor lowered from 90% to 70% of benchmark.
Deposit rates 1999 PBoC allowed negotiated wholesale deposits for insurance
company clients.
2000 FX lending rates fully liberalised; deposit rates freed for
USD3m deposits
2003 PBoC expands number of institutions that can apply to
negotiate wholesale deposits.
2004 Floor for all deposit rates removed.
2004 All FX deposit rates with maturity above 1-year liberalised
2012 Deposit rate ceiling was expanded to 110% of benchmark.
Source: PBoC, HSBC



30
Macro
China
November 2012
abc

Banks face big challenges
Chinas companies are going global. Faced with
tougher competition in domestic markets and slow
growth in the developed world, they are exploring
new markets, acquiring advanced technology to
sharpen their competitiveness and securing much-
needed raw materials.
The result has been a spectacular rise in Chinas
overseas direct investment (ODI) since 2002, when
the government encouraged businesses to go out.
China is now the worlds sixth biggest source of
ODI; its non-financial ODI
1
totalled USD68bn in
2011 and this figure is likely to double in the
coming 3-5 years. By 2011, there were over 13,500
Chinese companies and institutions making ODI in
more than 18,000 foreign companies across 177
countries and regions.

1
There are two categories of China ODI: financial and
non-financial. The former refers to domestic financial
institutions investment in overseas financial
institutions; the latter refers to domestic non-financial
institutions investment in overseas non-financial
institutions.
This has important implications for Chinas
banks. As more Chinese enterprises extend their
global reach they will need an increasingly wide
range of sophisticated financial services. The
banks need to follow in the footsteps of their
clients. Chinese enterprises now have investments
in more than 170 countries but the focus of the
countrys banks remains overwhelmingly
domestic in terms of networks, assets, business
models and human capital. The large state banks
will have to raise their game if they want to keep
pace with this surge of overseas investment.
Going global
Chinas ODI is set to double in the next 3-5 years
as Chinese companies venture overseas to acquire natural
resources, markets and technology
The firms will require sophisticated financial services; domestic
banks need to raise their game if they want to keep their business


31
Macro
China
November 2012
abc
Domestic financing alone will no longer be able
to meet the increasing funding needs of these
adventurous Chinese companies. More cross-
border funding will be needed and credit could be
much cheaper on international markets and in
currencies such as the USD. The domestic banks,
long used to funding the big state-owned
companies, lack experience on the global banking
stage and will find it difficult to provide all the
services these companies need.
For example, demand for the following cross-
border banking products will increase:
M&A advice: According to Dealogic, China
leads M&A activity in Asia, representing
nearly 7% of global M&A over the past three
years. In 2011, 37% of Chinas ODI flows
went to M&A.
Bank loans and debt issuance in
offshore markets.
Transaction banking for payments and cash
management, trade finance, supply chain and
securities services.
FX risk management: The increasing global
presence of Chinese companies implies rising
demand for currency settlement and risk
management. This demand will be
strengthened as RMB internationalisation
gathers pace; eventually it will be cross-
traded against most other global currencies.
Playing catch-up
Chinas banks are still very much domestic
businesses. While this was helpful during the
Chart 4.1 Chinas outward direct investment
0
10
20
30
40
50
60
70
80
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
(USD bn)
0
1
2
3
4
5
6
China's annual ODI flows (Lhs) China's annual ODI flows as % of world total(Rhs)
Source: UNCTAD, HSBC
Table 4.2 Chinese banks overseas presence (end 2011)
Bank name Number of overseas
branches
Total assets
(USDbn)
Overseas assets
(USDbn)
Overseas assets/total
assets
Bank of China (BOC) 96 2,165 429 19.8%
Industrial and Commercial Bank of China
(ICBC)
31 2,396 125 5.2%
China Construction Bank (CCB) 13 1,902 69 3.6%
Agricultural Bank of China (ABC) 10 1,808 19 1.1%
Bank of Communications (BoCoM) 12 714 51 7.2%
China Merchants Bank (CMB) 6 433 8 1.9%
China Development Bank (CDB) 3 968 145 14.9%
Total 158 10,386 846 8.1%
Source: Annual reports



32
Macro
China
November 2012
abc
2008-09 global crisis, the countrys financial
sector lags far behind manufacturing when it
comes to operating comfortably in todays
globalised world.
A few big state-owned banks have started to respond
to the go out strategy, led by China Development
Bank (CDB) and Industrial and Commercial Bank of
China (ICBC). At the end of 2011, CDB was
providing USD187.3bn in loans to Chinese
companies in over 100 countries and regions.
ICBC has also realised how important it is to build a
global network and upgrade its services. It recently
acquired Bank of East Asias US arm, making it the
first China bank to complete an M&A deal in the
US. Back in 2007, ICBC acquired a 20% stake in
Standard Bank, the largest bank in South Africa, for
USD5.5bn. ICBC now has 244 sub-branches and
outlets in more than 34 countries/regions, up from
100 in 2004.
That said, Chinese banks still have a long way to go.
Today only a few banks have an overseas presence.
As shown in Table 4.1 the number of overseas
branches was less than 160 at the end of 2011 and
overseas assets totalled just USD846bn, only 8% of
these banks total assets. They lack staff with
overseas experience and hiring talent from countries
with sophisticated international banking cultures
will not be easy, given the huge differences in
culture, pay and corporate governance.
Meanwhile, Chinas practice of separating
commercial and investment banking means most
big banks concentrate on commercial banking
rather than taking a universal approach to the
industry. The bottom line is that they may find it
difficult to match the needs and wants of
customers doing business overseas.
The future is competitive
So, what should Chinese companies do if
domestic financial institutions lack the networks
and expertise to serve them overseas?
They could choose to be patient and wait for
domestic banks to grow their international
services. This is unlikely as it could take years
and corporations will be reluctant to miss out on
good business opportunities.
Another option is to use foreign banks with global
operations. After all, time is money and Chinese
companies have to seize the moment when it
comes to expanding overseas, especially now that
there are bargains aplenty. Getting the best service
available will be the priority, no matter whether it
is from a domestic or foreign bank. There are
fears that this will slow the development of
domestic banks. They are not justified, in our
view. Increasing competition is the quickest way
to get the domestic banks to raise their game.
Just look at what happened in the manufacturing
sector. Instead of being squeezed out, the
domestic companies became more competitive by
using the technology and management skills
brought in by foreigners. In less than two decades,
the Chinese manufacturing sector has become the
most competitive in the world. As banking relies
on a very specific set of skills, strong competition
should help move the industry up the learning
curve at an even faster pace.
Deep pockets, broad horizons
There are plenty of reasons why Chinese
companies are expanding overseas. They include:
Resources: China is the worlds second
largest oil consumer (10% of global
consumption) and has to import over 50% of
its oil needs. To meet the rising gap between
domestic production and demand, state-
owned oil companies have been acquiring
stakes in oil fields around the world.
Technology and brand names: Chinese
manufacturers are buying well-known foreign
businesses to strengthen their competitiveness.
Examples include Lenovo acquiring IBMs
PC business and Geely buying Volvo.


33
Macro
China
November 2012
abc
New markets: As domestic competition
intensifies Chinese companies are creating
direct distribution networks to boost exports
and setting up factories to avoid trade barriers.
Money is not a problem. Chinese companies,
especially large SOEs are flush with cash total
corporate profits topped RMB5.45trn in 2011, up
nearly 12 times from 2001. This implies an annual
growth rate of around 28%, outperforming GDP
growth of 10.4% during the same period. SOEs
represent nearly 30% of total corporate profits. At
government level, net dollar inflows remain
robust and Beijing is also sitting on huge foreign
exchange reserves.
Chart 4.3. Chinese companies total profits
0
1,000
2,000
3,000
4,000
5,000
6,000
2001 2003 2005 2007 2009 2011
(RMB bn)
0
5
10
15
SOE (Lhs)
Non-SOE (Lhs)
Total profit as % of GDP (Rhs)
Source: CEIC, HSBC

ODI taking off
China is not just the worlds biggest exporter of
goods but also one of the top exporters of capital.
Annual ODI for non-financial companies has
surged more than 20 time between 2002 and 2011
and five times in the past five years. It even rose
11% y-o-y in 2009 during the global financial
crisis, a time when global ODI contracted 37%. In
2011 non-financial ODI surged 14% y-o-y to
USD68bn, up from just USD2.7bn in 2002,
implying an annual growth rate of 43%.
Despite the rapid increase, as of 2011 Chinas
ODI still only accounted for 4.4% of global FDI
flows and Chinas cumulative ODI represented
just 2% of global total cumulative direct
investment. This doesnt match Chinas economic
status as the worlds second largest economy
(10% of world GDP). Put another way, Chinas
ODI needs to double to match its economic power.
It seems the only way for ODI is up.
SOEs dominate
SOEs account for most of ODI. In 2011, around
90% of ODI flows came from big SOEs, while
private enterprises accounted for a marginal share.
In cumulative terms, SOEs have accounted for
around two thirds of total ODI.
Non-financial ODI constitutes more than 80% the
of Chinas total. In 2011 it was concentrated in
five sectors (in cumulative terms): leasing and
commercial services, mining, wholesale and retail,
manufacturing and transportation (Chart 4.5).
Manufacturing ODI rose to 10.3% in 2011 from
4.2-4.7% in 2008-09. Here the focus is on
transport equipment, machinery, textiles, special
purpose equipment, information and technology
and electronics.
Chart 4.4. Sector distribution of non-financial ODI
0
10
20
30
40
50
60
2003 2004 2005 2006 2007 2008 2009 2010 2011
(% of total)
Leasing & Commercial Serv ice
Mining
Manufacturing
Wholesale & Retail Trade

Source: CEIC, HSBC




34
Macro
China
November 2012
abc
Chart 4.5. Top five sectors for Chinas accumulative ODI
0
10
20
30
40
50
60
Leasing &
Commercial
Serv ices
Mining Wholesale,
retail
Manuf Transport
(% of total)
2005 2011

Source: CEIC, HSBC

Banking dominates financial ODI, with a share of
nearly 80%, followed by securities and insurance.
The overseas expansion of state-owned banks
started from 2006 when they were listed and
demand for overseas financial support from SOEs
surged. By 2011, state-owned banks hired 32,000
foreign employees in 32 countries/regions.
Asia the main target
By region, emerging markets remain the top
destination for Chinese funds (developed markets
account for only 11% of cumulative ODI by 2011).
More specifically, as of 2011 Asia represented
71.4% of cumulative ODI, followed by Latin
America (13%), Europe (5.8%), Africa (3.8%),
North America (3.3%) and Oceania (2.8%) .
Chart 4.6. Regional allocation of China ODI (2011 stock)
0
20
40
60
80
100
2003 2004 2005 2006 2007 2008 2009 2010 2011
(%)
0
2
4
6
8
(%)
Asia (Lhs) LatinAm (Rhs)
Africa (Lhs) Europe (Rhs)
North Am (Rhs) Oceania(Rhs)

Source: CEIC, HSBC

Hong Kong, with an overwhelming share in
Chinese ODI (47.8% of 2011 flow and 61% of
2011 stock), should be treated as an exception.
The top three industries are leasing and
commercial services, financial services and
wholesale and retail sales.
Chinas direct investment into Hong Kong is
mainly due to its unique position as a gateway to
the Asia-Pacific region and the world. Aside from
being a logistics hub, Hong Kongs developed
financial markets and advanced services industries
help Chinese enterprises establish an international
presence, build better regional distribution and
marketing channels, and enjoy easier access to the
regions financial resources.
Within Latin America, the Virgin Islands and
Cayman Islands, both offshore tax havens, are the
top two destinations, accounting for a combined
12 % in cumulative total ODI by 2011, or over
92% in accumulative ODI to Latin America.
While Brazil is an attractive destination for
Chinese investors, its share of ODI was only 0.2%
in 2011 and 0.3% in cumulative terms. But it is
growing fast. In 2010 China became Brazils top
FDI investor (USD17bn, up from USD360m
accumulative FDI over previous years).
Within Africa, ODI is evenly distributed among a
handful of countries. In cumulative terms, by
2011 South Africa was the top destination,
accounting for 1% of total ODI, followed by
Sudan (0.4%), Nigeria and Zambia (0.3%).
Why emerging markets are so
important
Emerging markets are likely to remain the focus
of Chinese investors global expansion. They are
made for each other China is the worlds largest
producer of manufactured goods, while emerging
countries have rich resources and commodities
that China needs to meet domestic demand.


35
Macro
China
November 2012
abc
We believe Chinese companies will keep
expanding overseas for many years to come for
two reasons they need new markets abroad and
raw materials at home.
1 New markets
Chinas manufacturers need to explore new markets
because the economies in so many developed
countries, their traditional export destinations, are in
such poor shape. HSBCs economics team forecasts
1.2% y-o-y and 1.2% y-o-y growth for developed
markets in 2012 and 2013, respectively, much lower
than the 4.9% y-o-y and 5.6% y-o-y for emerging
markets (see Global Economics Quarterly: Why
pump-priming isnt working, 27 September 2012).
The robust recovery in emerging markets points to
new sources of export growth for Chinas
manufacturers. Their exports to emerging markets
have outperformed those to developed countries
since 2005, resulting in a 6ppt increase in the
emerging market share of Chinas total exports
(58.5% in the first three quarters of 2012).
Chart 4.7 Exports to emerging markets have outperformed
-20
-10
0
10
20
30
40
1996 1998 2000 2002 2004 2006 2008 2010 2012*
(%y r)
Dev eloped markets Emerging markets

Source: CEIC, HSBC * As of end September 2012

The nature of Chinas ODI is also changing.
Besides setting up manufacturing plants in foreign
countries, more and more mergers and
acquisitions are taking place.
Tapping local markets and lifting market share are
the top considerations for Chinese manufacturers as
they expand overseas. Having local manufacturing
bases should give these companies better local
knowledge of and access to local markets. In many
cases they can also avoid any trade barriers and
make use of cheap labour and resources.
Examples of major Chinese enterprises expanding
internationally include white goods producer
Haier, which has built manufacturing bases in
South East Asia and North America, and domestic
car marker Chery, which plans to build a plant in
Brazil, the largest car market in Latin America.
2 Raw materials
China accounted for two thirds of the increase in
global demand for hard commodities over 2003-
07, and this share surged to over 100% during
2008-10. While tighter credit and the cooling of
the property market have led to a cyclical
slowdown in fixed-asset investment, Chinas
structural growth story remains intact. So securing
the necessary supply of resources will continue to
drive Chinese ODI for the foreseeable future.
While there will be some roadblocks, Beijings
increasing investment in infrastructure in
emerging economies should help to clinch deals to
secure resources.
Led by SOEs such as Sinopec, PetroChina and
Chinalco, Chinese companies have speeded up the
pace of acquiring overseas mines. According to
the Chinese Academy of Social Sciences (CASS),
a Beijing-based think tank, over the past seven
years they have made over 91 overseas mining
acquisitions worth USD32bn.
As well as making acquisitions in Australia and
other resource-rich countries, China has been very
aggressive in building infrastructure in Africa as
well as co-operating with or sponsoring local
companies to jointly develop mining projects.
Chinese companies have also helped with
construction projects, including a gas turbine
power plant in Nigeria and the Souapiti Dam in
Guinea (source: World Bank).


36
Macro
China
November 2012
abc
ODI is sometimes difficult. The upheavals in the
Middle East and North Africa have slowed
progress in that part of the world. For example,
there are over 50 projects still under construction
by Chinese companies in Libya, raising concerns
about the outlook for ODI in the region.
Despite this setback, the big picture remains
unchanged. Chinas surging ODI in emerging
markets is part of a new recycling of trade
between China and the countries in which it is
investing. On top of the injection of revenue,
Chinese investment boosts the local economies.
The spill-over from industrial projects helps
increase local productivity growth and improve
infrastructure networks.
This, in turn, consolidates complimentary
comparative advantages. Chinese direct
investment strengthens emerging market
purchasing power and also increases the domestic
acceptance of Chinese manufacturing goods.
Meanwhile, Chinas rapid domestic demand
growth allows huge imports of raw materials from
these countries, fortifying a benign trade cycle.
ODI and the RMB
Chinas ambition to internationalise the RMB (see
The rise of the redback, 8 November 2010) has
resulted in faster-than-expected progress in RMB
international trade settlement (Chart 4.8) and an
acceleration in the pace of using RMB for cross-
border trade investment. This has several
implications for Chinese ODI.
First, the PBoC has started to allow domestic
companies to use RMB for ODI (see China:
PBoC starts trial for RMB direct investment
overseas, 14 January 2011). Chinese companies
can now make ODI and remit revenues in RMB.
This will not only make ODI more convenient but
also reduce the exchange rate risk. The expected
gradual appreciation of the RMB in coming years
should also benefit Chinese companies that
expand overseas.
Chart. 4.8: RMB trade settlement taking off
0
2,000
4,000
6,000
8,000
10,000
12,000
2009 2010 2011 2012e 2013f 2014f
(RMB bn)
0
10
20
30
40
(%)
Trade settled in renminbi (Lhs)
RMB trade settlement as % of China's total trade (Rhs)

Source: CEIC, PBoC, HSBC

Second, most of the increase in RMB trade
settlement is taking place in emerging countries,
paving the way for wider acceptance of the RMB
as an investment currency. This should encourage
the recycling of trade-related RMB funds for
offshore investment.
Third, Beijing policymakers are actively relaxing
restrictions on ODI. In February 2011, the NDRC
raised the threshold for ODI projects seeking
central governments approval to USD300m from
USD30m for the resources category and USD100m
from USD10m for non-resources projects.
Approval procedures were also simplified.
Meanwhile, the pilot reforms in Wenzhou allow
local residents to invest in overseas non-financial
projects that have clear, clean sources of capital.
The quotas for ODI have been reported as: 1)
USD3m for an individuals investment in one
project; 2) USD10m for a collective investment in
one project; 3) USD200m for an individuals total
annual investment.
Even more reason for the banks to improve.






37
Macro
China
November 2012
abc

Matching Chinas rising
economic power
What are the key factors that turn a currency into
an international one? A number of empirical
studies
2
conclude that the international acceptance
of a currency goes hand in hand with the rise and
fall of a countrys economic power.
In the 19
th
century, 60-90% of international trade
was priced in British pounds. After eclipsing
Britains economy in the late 19
th
century, the US
rose in economic power and turned into a net
creditor from a net debtor. Meanwhile, the dynamics
of economic power were reflected in the strength of
the US dollar, which overtook sterling as the
international reserve currency after World War II.

2
Bergsten, C. Fred., 1975, The Dilemmas of the
Dollar: the Economics and Politics of United States
International Monetary Policy, published for the
Council on Foreign Relations by New York University
Press, and Eichengreen, Barry, 1994, History and
Reform of the International Monetary System, Center
for International and Development Economics Research
(CIDER) Working Papers C94 -041 , University of
California at Berkeley.
The dominant role of the US dollar has seemed
unshakeable despite the challenge from the euro.
Although the recent financial crisis has
undermined investors faith in the US dollar to
some extent, the primacy of this currency in
international use should keep it as the top
international currency for the foreseeable future.
The internationalisation of the deutschemark,
which was the second-largest international
currency after the US dollar before the circulation
of the euro, can be attributed to Germanys
economic power and the currencys stability.
Germany became the third-largest economy after
the US and Japan in 1968, thanks to its remarkable
economic growth after World War II, which also
lifted its competitiveness in machinery exports.
Germanys excellent trade record helped the
deutschemark appreciate against the US dollar
and British pound, while the liberalisation of trade
and capital paved the way for internationalising
the deutschemark. More importantly, the
Bundesbank, known as the most independent
central bank in the world, pursued a stable
currency as one of its most important objectives,
due to the fear of inflation.
The rise of the redback
We expect RMB trade settlement to account for over 30% of
Chinas total trade in less than three years
Inbound and outbound RMB direct investment is also rising
The easing of capital controls is likely to further increase the
global importance of the currency in the coming years


38
Macro
China
November 2012
abc
By limiting the growth of money supply, the
Bundesbank backed a strong and stable currency that
foreign investors and central banks chose to hold to
avoid exchange rate losses. Thus, the deutschemark
accounted for as much as 18% of the worlds foreign
exchange reserves by the early 1990s.
The internationalisation of the yen began in the
1970s, when Japan became the worlds second-
largest economy after two decades of nearly 10%
growth. However, fearing some negative impact
from the yens internationalisation on domestic
financial markets, Japanese policymakers had not
actively pushed for yen internationalisation until the
Asian financial crisis and the launch of the euro.
Thus, the international use of the yen is not as
wide as it perhaps could be. This reflects: 1) the
initial passive attitude of the Japanese authorities
towards internationalising the yen; 2) the less
open domestic financial markets hindered
efficient yen internationalisation; 3) big swings in
the JPY/USD exchange rate have effectively
undermined the international use of the yen in
global trade and investment flows.
Long overdue
If history is any guide, the internationalisation of
the RMB is long overdue considering Chinas
rising economic power relative to the limited use
of the RMB overseas. Chinas nominal GDP
topped USD7.3trn at market exchange rates last
year, finally overtaking Japan as the worlds
second-largest economy.
Moreover, China is also probably the most
globalised of all the major economies, with the
value of its foreign trade growing at a pace of
21% per year over the last decade, more than
double the average growth rate of global trade in
the same period. China overtook Germany as the
worlds second-largest trading country in 2009.

From strength to strength
The RMB still has a long way to go before it can
match the influence of the countrys economy,
now the second largest in the world. But, as with
everything in China, things are moving very
quickly and the RMB is making giant strides
towards becoming a global currency.
For example, the pace of RMB trade settlement
has accelerated much faster than expected since it
was introduced in 2009. As Chart 5.1 shows, trade
volumes surged from a monthly average of
RMB18bn in 1Q10 to RMB173bn in 2011 and
RMB227bn in the first three quarters of 2012.
Cross-border trade settled in RMB accounted for
11% of total trade (exports and imports) in the
first three quarters 2012, a full percentage point
higher than in the same period last year. We
expect this to rise to above 12% by the end of this
year and well over 30% in less than three years.
This is much earlier than our initial expectation of
3-5 years.
HSBCs survey of over 6,000 companies in 21
countries and markets showed that the RMB is
expected to overtake sterling to become the No 3
trade settlement currency in the coming months.
In mainland China, over a third of surveyed
companies expect to use RMB as a settlement
currency in the next six months, well ahead of the
EUR (24%). When the same survey was
conducted six months ago more businesses
expected to use EUR than the RMB.
We expect a further leap in RMB trade settlement
as trade with emerging economies continues to
increase (Chart 5.2).
Firstly, these markets represented about 70% of
Chinas total imports in 2011, up from 52% in the
1990s. Chinas exports to these countries account
for 53% of total exports, from less than 50% in
the 1990s. With growth likely to continue, we
expect at least half of Chinas trade flows with


39
Macro
China
November 2012
abc
emerging market countries to be settled in RMB
in the next 3-5 years.
Secondly, as emerging markets supply China with
commodities and intermediate goods for assembly
before final shipment to the developed world, this
should further increase RMB trade settlement.
RMB trade settlement is triggering a chain
reaction in Chinas capital markets. Rising
overseas demand for RMB is smoothing the path
for Chinese corporations to invest abroad using
RMB. As RMB trade revenue accumulates
outside China, it is smoothing the path for foreign
companies wishing to invest in China with RMB.
Chart 5. 2. Strong potential for RMB trade settlement with
emerging markets
40
45
50
55
60
65
70
1995 1997 1999 2001 2003 2005 2007 2009 2011
%
EM ex ports as % of China total ex ports
EM imports as % of total imports

Source: CEIC, HSBC


A three-stage process
Beijing sees internationalising the RMB as a
three-stage process:
1) Global trade settlement currency: The first
stage started in June 2009 with the RMB trade
settlement pilot scheme.

Table 5.1 Policy initiatives to internationalise the RMB
Date Policy initiative
April 14 2012 PBoC expands the RMB daily trading band from 0.5% to 1%.
June 21, 2011 A PBoC circular on cross-border RMB transactions states that FDI in RMB settlement business is at a pilot stage.
June 22, 2010 Pilot scheme for RMB trade settlement expanded to 20 provinces and municipalities. Overseas trade settlement rolled out
to rest of the world.
July, 2009 Six government departments jointly launch pilot programme for cross-border trade transactions.
April 2, 2009 PBoC signs bilateral currency swap agreement with Argentina.
March 23, 2009 PBoC signs bilateral currency swap agreement with Indonesia.
March 11, 2009 PBoC signs bilateral currency swap agreement with Belarus.
March 9, 2009 PBoC confirms that the State Council has approved a pilot scheme making Hong Kong the offshore centre for RMB trade
settlement.
February 8, 2009 PBoC signs bilateral currency swap agreement with Malaysia.
December 25, 2008 The State Council allows cross-border trade between Guangdong, Yangtze Delta, Guangxi and Yunnan with Asian
countries to be settled in RMB. China signs bilateral currency settlement agreement with neighbouring countries, including
Mongolia, Vietnam, and Myanmar. This is considered a big step towards speeding up the regionalisation of the RMB.
December 4, 2008 Trade settlement between China and Russia to switch to their domestic currencies. The PBoC signs bilateral currency
swap agreement with the Bank of Korea, providing each other with RMB180bn in short-term liquidity.
July 10, 2008 PBoC sets up a new department responsible for exchange rate policy. One of its key functions is to "develop the offshore
RMB market in accordance with the evolution of internationalisation of RMB".
June, 2007 First RMB-denominated bond issued by the China Development Bank, worth RMB5bn, debuts on the Hong Kong stock
exchange, making it the first publicly-listed bond to be traded and settled in RMB. RMB bond issuance by mainland banks
totalled RMB 20bn by the end of 2007.
July 21, 2005 China moves to a managed floating exchange rate regime based on market demand and supply with reference to a
basket of currencies. The revaluation puts the RMB at 8.11 to the USD, an appreciation of 2.1%.
Source: PBoC, HSBC
Chart 5.1 RMB trade settlement is growing quickly
0
50
100
150
200
250
300
Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12
RMB bn
Value of renminbi trade settlement

Source: CEIC, HSBC



40
Macro
China
November 2012
abc
2) International investment/debt currency: The
launch of a new RMB products platform in Hong
Kong in July 2011 laid the groundwork for a wide
range of future offshore RMB investment vehicles
for foreign holders of Chinas currency. An
announcement by the PBoC that it was rolling out a
pilot scheme for RMB direct investment will open
up an array of future onshore RMB investments.
3) An international reserve currency. This is still a
long way off. The RMB still lacks many of the
required characteristics of a reserve currency.
This step-by-step process is being closely
supervised by the PBoC. The imposition of
trade-only limitations, quotas

and the
opaqueness of Chinas onshore

interbank bond
market serve as reminders that Beijing wants to
make sure that the internationalisation of the
RMB is both gradual and controlled.
How things got started
Making the RMB a global currency became a
major priority during the global financial crisis
when the value of the USD tumbled, putting at
risk Chinese assets worth USD1.8trn (this figure
had risen to USD3.3trn by the end of September
2012). The US Federal Reserves response, the
introduction of quantitative easing, caused
concerns in Beijing about inflationary risk
weighing on the value of the greenback, creating a
dollar trap.
This had major implications for Chinese exporters
and importers who used USD invoices. For more
details see From Peoples banks to peoples hands,
8 March 2006, and Recycling Chinas trade
dollars, 7 May 2007).
The first step was to increase the level of
acceptance of the RMB among neighbouring
countries. This was done through currency swaps
between the PBoC and other emerging economies.
For example, South Korea proposed a currency-
swap agreement with China in 2008 to bolster
market liquidity and confidence amid massive
capital outflows. At that time, a currency swap
deal using USD was not feasible given the
uncertainties created by the US sub-prime crisis.
Instead, China suggested a swap deal based on the
RMB, a proposal South Korea accepted.
Subsequently more countries entered RMB-based
currency-swap agreements with China (Table 5.2),
and many wanted to go a step further by using
RMB for trade and investment settlement.
Since then the internationalisation of the RMB has
surprised even the sceptics (see The rise of the
redback, 9 November 2010).
Table 5.2 Foreign currency swaps outstanding (as of September
2012)
Total RMB1,266.2bn
Bilateral swaps Amount
RMBbn
Swap Expiry date
Iceland 3.5 ISK-RMB 9-Jun-13
Singapore 150 SGD-RMB 23-Jul-13
New Zealand 25 NZD-RMB 18-Apr-14
Uzbekistan 0.7 UZS-RMB 19-Apr-14
Mongolia 10 MNT-RMB 6-May-14
Kazakhstan 7 KZT-RMB 13-Jun-14
South Korea 360 KRW-RMB 26-Oct-14
Hong Kong 400 HKD-RMB 22-Nov-14
Thailand 70 THB-RMB 22-Dec-14
Pakistan 10 PRK-RMB 24-Dec-14
UAE 35 AED-RMB 27-Jan-15
Malaysia 180 MYR-RMB 9-Feb-15
Ukraine 15 UAH-RMB 26-Jun-15
Source: PBoC, HSBC
From trade to investment
Apart from trade, it is also necessary to develop
offshore RMB products and expand investment
channels so foreign investors and businesses have
an incentive to hold, trade and invest RMB. To
become an international currency, the RMB must
be widely used for investment as well as for trade
settlement.
This is happening in a number of different ways:


41
Macro
China
November 2012
abc
RMB bonds in the Hong Kong offshore RMB
market (known as dim sum bonds) are
expanding rapidly.
Beijing started an R-QFII (RMB qualified
foreign institutional investor) scheme at the
end of last year, allowing offshore RMB to be
recycled back into domestic capital markets.
The R-QFII quota was increased from
RMB20bn to RMB70bn in April.
The domestic RMB market was further
liberalised this year, giving wider access to
foreign investors to the inter-bank bond
market and equity market.
Qualified China fund management companies
and Hong Kong branches of Chinese
securities firms can sell R-QFII products to
individual and institutional investors in Hong
Kong and use the RMB to invest in Chinas
bond and equity markets. A total of 21
financial institutions were granted R-QFII
licences in December (nine fund management
companies and 12 securities firms).
HK as an offshore RMB centre
Hong Kong continues to play a leading role in the
RMB story. The city was responsible for 79% of
all cross border RMB trades, according to the
latest SWIFT report (Chart 5.3).
5.3. Hong Kong responsible for 79% of all cross-border RMB
trade settlement
79%
Jan-11 Apr-11 Jul-11 Oct-11 Jan-12
Hong Kong China Other Countries

Source: SWIFT. Customer initiated and institutional payments, sent and received, base on value.

As of August 2012, total RMB deposits in Hong
Kong stood at RMB552bn, accounting for 8.6%
of total deposits in the banking system. Hong
Kongs RMB bond market is valued at RMB74bn,
still a fraction of the RMB834bn that foreign
central banks can theoretically tap into through
outstanding FX swap contracts.
In an effort to broaden the offshore Hong Kong
RMB bond market, the NDRC in May released a set
of rules standardising the process for offshore RMB
bond issuance by onshore non-financial entities.
By setting minimum requirements even lower
than those for onshore bond issuance, the new rule
greatly expands the number of eligible offshore
issuers and paves the way for a material increase
in Chinese corporate bond supply over the
medium term. The main beneficiaries are Chinese
companies that do not already have substantial
offshore exposure.
Gross issuance of bonds and certificates of deposit
(CDs) totalled RMB103bn by 10 May 2012. Of
this RMB36.75bn (36%) was bonds, with
RMB8.5bn (8%) issued by Chinese companies.
(see Offshore RMB bonds: Standardised issuance
framework launched, 10 May 2012).
But Hong Kong is only part of the bigger picture.
To complete the on/offshore RMB circle, foreign
holders of RMB need to be able to retain and
invest RMB both inside and outside the mainland.
Hong Kongs comparative strength as an offshore
RMB centre lies in its ability to develop a wide
range of RMB-related products and services,
rather than simply creating depth in one product
(e.g. RMB bonds).
Hong Kong Exchanges and Clearing (HKEx), the
citys securities and futures exchange, launched a
USD-RMB contract on 17 September to meet
investors hedging needs. This is the first futures
contract denominated in RMB. To broaden the
range of products, it also plans to launch RMB


42
Macro
China
November 2012
abc
commodities derivatives to meet demand risk
management in mainland China.
All in all, a lot of progress has been made in the
past few months. We have seen wider remittance
channels (e.g. RMB foreign direct investment, R-
QFII), RMB cross-border trade settlement
expanded to the whole nation and banks given
greater flexibility to conduct offshore RMB
business (through two HKMA refinements
released in January and February).
Shanghai: An international financial
centre of the future
Shanghais municipal government has ambitious
plans for RMB business as part of its plan to
become an international financial centre by 2020.
As well as more cross-border trade settlement,
Shanghai is encouraging trial RMB settlement in
capital accounts, including using the currency for
overseas project financing and direct overseas
investment. RMB cross-border trade settlement in
Shanghai already accounts for nearly 16% of the
national total in 2011.
The PBoC is allowing Chinese enterprises to use
RMB in ODI on a trial basis. This opens another
offshore channel and will encourage more
investment of RMB offshore trade funds
outside China.
Shanghai is the first mainland city open for RMB
denominated FDI settlement. Inward RMB
investment in the domestic bond market by
foreign central banks and trade clearance banks is
already allowed (see China: PBoC starts trial for
RMB direct investment overseas, 14 January
2011). Seven foreign reserve managers are
starting to invest in RMB bonds and other assets,
although the amount is still small (the amount
disclosed is less than USD20bn).
For the first nine months of this year, RMB ODI by
Chinese companies totalled RMB22.1bn and RMB
FDI into the mainland reached RMB154.5bn;
combined, this represents nearly 20% of total cross-
border investment for the same period.
Chart 5.4 RMB FDI inflows picking up
0
5
10
15
20
25
30
2011
av g.
Feb-
12
Apr-
12
Jun-
12
Aug-
12
RMB bn
FDI outflows FDI inflows

Source: PBoC, HSBC

Onshore is important too
The faster than expected development of RMB
internationalisation also has important
implications for the onshore financial markets.
They include:
Domestic financial markets to be opened
further to offshore RMB investors: The
markets are increasingly open to foreign
investors. Institutional investors have been
allowed to invest in the interbank bond
market since December 2010; they are now to
be given further access to the domestic bond
and equity markets. By September 2012, 152
institutions had QFII licences with a quota of
USD29.9bn.
Further RMB exchange rate reform: This
will become more pressing as the amount of
inward and outward RMB investment gets
larger and larger. Shanghais plans to be an
international financial centre also require the
RMB to be more flexible to reflect market
supply and demand.


43
Macro
China
November 2012
abc
Acceleration of interest rate liberalisation:
A competitive financial market with
diversified financial institutions is a
prerequisite for liberalising interest rates.
Armed with a stronger pricing capability,
domestic financial institutions could offer
deregulated interest rates depending on their
own funding costs and financial strength.
New RMB daily trading band offers
greater flexibility
The PBoC announced the widening of the USD-
RMB daily trading band to 1% from 0.5%,
effective 16 April 2012. This is another step
towards a more flexible and market-driven regime
based on supply and demand (see Asian FX: RMB
band widening: even more flexibility, 14 April).
Chart 5.5 Trade is basically balanced
-50
0
50
100
150
200
250
300
350
1990 1993 1996 1999 2002 2005 2008 2011
USD bn
-4
-2
0
2
4
6
8
10 %
Trade balance, USD bn as % of GDP

Source: CEIC, HSBC

The widening of the trading band was done to
internationalise the currency and not because it is
significantly undervalued (it has strengthened
30% since 2005). We believe the currency is close
to its equilibrium level, as indicated by Chinas
more balanced current account. A market
oriented-exchange rate mechanism, once
established, will help to pave the way for RMB
convertibility and capital account liberalisation.
Greater RMB volatility will create more currency
risk, which will encourage the banks to develop
more risk management products, such as currency
forwards, swaps, options and other financial
derivatives to meet hedging demand. At the same
time, this will increase trading volumes, which
will in turn help to deepen and expand Chinas FX
market, improving price discovery in the process.
We see the widening of the band as a strong signal
Beijing recognises that now is the right time to
push forward with financial reforms, including
capital account and interest rate liberalisation.



44
Macro
China
November 2012
abc

The time is ripe
Signs are emerging that Beijing policymakers are
going to speed up the opening of the countrys
capital account. We think the pace of progress in
the next few years will be much faster than many
expect and now believe that the RMB will
become a convertible currency within five years.
Making the RMB a fully convertible currency is
the ultimate goal of Chinas exchange rate reform.
While the currency has been convertible under the
current account for 15 years, recent steps have been
taken to make the RMB more convertible through
the gradual liberalisation of the capital account.
Policymakers now see a window of opportunity to
further speed up the process, although debate over
the pace of reform continues. In our view,
conditions are ripe for further action. Consider the
following factors:
1 More developed domestic financial markets
The rapid development of the domestic financial
market has paved the way for further capital
account liberalisation. First, the debt-laden big
state-owned banks have been transformed into
listed companies with stronger corporate
governance and risk controls.
Second, after 20 years of development Chinas
capital market has become much more
sophisticated in terms of financial instruments and
investor base, and the market cap of both the
equity and bond markets has reached nearly 100%
of GDP. This means the market can accommodate
increased participation by foreign investors who,
in turn, will strengthen and deepen the domestic
financial markets. Meanwhile, the growing pool
of domestic funds also points to the need for
domestic investors to be able to invest more
outside China.
2 More balanced capital flows
Capital flows have become more balanced for
several reasons. First, Chinas trade surplus has
dropped to around 2% of GDP in 2011 from the
peak of 7.5% in 2007. Consequently, the current
account surplus to GDP ratio fell to around 3%,
well within the target band set during the G20
summit in 2010.
A convertible RMB
within five years
China is increasing the pace at which it is opening its capital
account
We think this paves the way for the RMB to be fully convertible
within five years
Expect greater foreign access to Chinas capital markets and
more individual Chinese to be allowed to invest overseas


45
Macro
China
November 2012
abc
The RMB exchange rate is also much closer to its
equilibrium level after appreciating 30% against a
basket of currencies since it was de-pegged from
the USD in 2005. Markets now have two-way
expectations for the RMB exchange rate;
previously investors were only betting on it
appreciating against the USD. In April, China
doubled the RMBs trading band to 1% from
0.5%, the first widening since 2007. This signals a
move towards a more flexible and market driven
currency regime (see Asian FX: RMB band
widening: even more flexibility, 14 April 2012).
3 Fast development of RMB trade settlement
RMB trade settlement has taken off, a key
stepping stone to making the RMB a global
currency. A small pilot RMB trade settlement
scheme introduced in July 2009 expanded rapidly
to the extent that total trade settled in RMB
increased four-fold in 2011 to reach RMB2.1trn
(USD330bn), about 9% of Chinas total trade last
year. And this is likely reach a new record in 2012
thanks to the nearly 20% y-o-y growth in the first
three quarters, when renminbi trade settlement
represented 13% of total trade in 3Q 2012. To
support the programme, China has signed bilateral
currency swaps with a wide range of countries
and regions worth RMB1.3trn (see Table 5.2 and
The View, April 2012).
Whats next?
China currently restricts some movements of
money flowing into the country including
investments in real estate, stocks and bonds to
prevent sudden inflows and outflows of capital
that could destabilise its financial system. These
controls protected China during the Asian
financial crisis of 1997-98 and helped the country
weather the global financial crisis in 2008-09.
Essentially, Chinas capital account is partially
open. For example, foreigners have full access to
B shares but A shares are restricted by a quota
system; a Chinese investor can buy foreign stocks
via QDII funds but cannot make direct
investments in overseas markets. Liberalising the
capital account will involve a gradual relaxation
of capital controls that will allow Chinese and
overseas investors to hold cross-border assets and
engage in cross-border asset transactions, which,
in turn, would increase RMB convertibility.
We expect Beijing to take the following steps to
further liberalise the capital account:
Further expansion of the QFII scheme which
has opened Chinas domestic equity markets
to overseas investors. The quota was recently
increased from USD30bn to USD80bn and
the RQFII, its RMB equivalent, from
RMB20bn to RMB70bn.
The lifting of restrictions on foreign investors
participating in the domestic bond market and
the futures market.
An increase in the quota for individual
foreign exchange purchases, which stands at
USD50,000 per year. There is no evidence
that there has been an increase in the risk of
money outflows despite a rapid rise in the
number of Chinese tourists. We think this
quota is likely to be lifted to USD200,000 in
the coming years.
Permission for domestic individuals to invest
in overseas markets. The pilot programme in
Wenzhou is likely to be extended to
other regions.
Permission for foreign companies to raise
RMB on onshore capital markets.
The RMB has been convertible for current
account items since 1996. China started its foreign
exchange reform in 1994 by unifying the dual
exchange rates and introducing a market-based
unified floating exchange regime. In reality, this
was a de facto USD peg for the majority of the
time after the Asian financial crisis.


46
Macro
China
November 2012
abc
Schemes introduced in 1994 and 1996 that
required companies to surrender foreign exchange
earnings that exceeded their quotas to domestic
banks were finally phased out in 2002. Today,
Chinese companies are allowed to keep their
foreign exchange earnings and also hold accounts
overseas. This has helped to support the boom in
Chinas foreign trade, which has expanded 12-
fold over the past 15 years.
Its official policy
Senior officials have made it clear that Beijing
aims to continue the gradual opening of the
capital account during the 12
th
Five-year Plan
(2011-15), a policy that goes hand in hand with
increasing the convertibility of the RMB.
Premier Wen Jiabao has spoken of promoting
RMB convertibility in a steady and orderly
manner, a sentiment echoed by PBoC governor
Zhou Xiaochuan. PBoC Vice Governor Yi Gang
put it this way in an interview with Caixing
magazine in 2010: A convertible yuan remains
the ultimate goal for the nations currency
exchange rate reform.
It is easy to see why. Foreign trade and
investment an important driver of Chinas
spectacular growth over the past two decades
would benefit not least because of the high cost of
retaining restrictions on capital flows and the
difficulty of differentiating capital account from
current account transactions (many involve both).
At the same time, capital account controls are
normally aligned with a fixed exchange rate
policy, resulting in imported inflation (or
deflation), posing risks to economic growth.
Controls are less tough than
many think
Following a series of steps towards liberalisation,
Chinas control of the capital account is not as
tight as many think. According to the PBoC,
between 2002 and 2009 China announced 42
reform measures in this area. These loosened
administrative controls and eliminated differences
in the way domestic and foreign-invested
companies, state-owned and private enterprises
and institutions and individuals are treated.
The result is that the RMB is now more
convertible under the capital account than many
may think. Only four of 40 items under the capital
account are non-convertible (institutional
investor participation in domestic money markets,
funds and trust markets and trading
derivative instruments).
Twenty-two are partially convertible, including
transactions in the bond market, stock market, real
estate market and personal capital transactions.
The other 14 are basically convertible, including
credit operations, direct investment and the
liquidation of direct investment (see Table 6.1).

Table 6.1 Restrictions on Chinas capital account
Not convertible Partially
convertible
Basically
convertible
Fully
convertible
Total
Transactions in capital market and money market instruments 2 10 4 16
Transactions in derivatives and other instruments 2 2 4
Credit operations 1 5 6
Direct investment 1 1 2
Liquidation of direct investment 1 1
Real estate transactions 2 1 3
Personal capital transactions 6 2 8
Total 4 22 14 40
Source: PBoC, HSBC. Here partially convertible means strict restrictions and quota controls on payment for capital account transactions, basically convertible means loose restrictions on
payments for capital transactions, fully convertible means no restrictions on payment for capital transactions a status rarely achieved even in advanced economies


47
Macro
China
November 2012
abc
Foreign Direct Investment (FDI)
China started to liberalise FDI in the 1990s and
investors have long been free to convert foreign
currency into RMB. According to a 2003 circular
issued by the State Administration of Foreign
Exchange (SAFE), overseas investors can invest
in foreign-invested companies with freely
converted currency. This covers imported
equipment, intangible assets as well other
categories approved by the foreign exchange
bureau. RMB profits are fully convertible.
FDI is mainly monitored by the Ministry of
Commerce (some strategic sectors are restricted)
but forex controls over FDI inflows focus on
investigating the genuineness of the transaction.
According to the United Nations Conference on
Trade and Development (UNCTAD), China has
been the top FDI destination in the developing
market since the middle of 1990s. The countrys
FDI has surged 2.5 times over the last 10 years to
USD116bn last year.
There has been a modest decline in FDI this year
(down by 3.8% y-o-y as of end 3Q), which mainly
reflects the cyclical slowdown of investment
growth, the correction in the property market and
impact of the EU debt crisis. According to
UNCTAD, China surpassed US as the largest
recipient of FDI in the first half this year, with the
US experiencing a 39% y-o-y decline.
In addition to the capital flows into manufacturing
sectors (which represented over 55% of total FDI
before 2007), Chinas FDI has been
increasingly driven by the opening up of the
services sector (including banking, retailing
and telecommunications).
Chart 6.2 Strong FDI growth despite modest decline this year
0
20
40
60
80
100
120
140
1998 2000 2002 2004 2006 2008 2010 2012*
(USD bn)

Source: CEIC, HSBC * As of end 3Q 2012




48
Macro
China
November 2012
abc

Table 2.2 Summary of Chinas rules about major capital account transactions -- Production please improve spacing between columns
Inflows Outflows
Stock market Foreign
investors
Can purchase B shares (USD/HKD) listed on the
Chinese Securities Exchange (also available for
domestic investors)
Can sell A and B shares listed on the Chinese
Securities Exchange
Foreign investors may make strategic investments in
domestic listed companies with some restrictions

QFIIs can purchase A shares subject to certain
limitations
There are no restrictions on the issuance of A or B
shares by foreign institutions under current
regulations, but no foreign institution has yet to
issue any A or B shares in China
Domestic
investors
Domestic companies can issue shares abroad with
CSRC approval
Domestic companies may repurchase shares
issued by them abroad with SAFE approval
QDIIs purchase shares and other investment
instruments abroad subject to certain limitations
Bonds and other
debt securities
Foreign
investors
QFIIs are permitted to purchase exchange-listed
equities, bonds, securities investment funds and
warrants and other financial instruments
International development agencies are permitted
to issue RMB denominated bonds with the
approval of the MOF, the PBoC, and the NDRC
Foreign-funded enterprises are permitted to issue
bonds with approval
Domestic
investors
Domestic companies can issue bonds abroad with
maturities in excess of one year with prior approval by
the State Council
Insurance companies, securities firms, qualified
banks and groups (QDIIs) are permitted to
purchase foreign bonds that meet rating
requirements, subject to the approval of the China
Insurance Regulatory Commission (CIRC) and
SAFE
Money market Foreign
investors
QFIIs may purchase money market funds, but they
are not permitted to participate directly in investment
transactions on the interbank foreign exchange
market
Not allowed
Domestic
investors
Domestic companies can issue money market
instruments (such as bonds and CP with maturities of
less than one year) with SAFE approval
Insurance companies, securities firms, qualified
banks and QDIIs are permitted to purchase money
market instruments that meet rating requirements,
subject to the approval of the CIRC and SAFE
Collective
investment
securities
Foreign
investors
QFIIs may invest in closed-end and open-end funds
locally
Not allowed
Domestic
investors
Issue collective investment securities with SAFE
approval
Insurance companies, securities firms, qualified
banks and groups are permitted to purchase
collective investment securities that meet rating
requirements, subject to the approval of the CIRC
and SAFE
Derivatives and
other instruments
Foreign
investors
Not allowed Not allowed
Domestic
investors
Regulated financial institutions with the approval of
the Chinese Banking Regulatory Commission
(CBRC) may sell for the purposes of hedging, gaining
profit, and providing transaction services for clients
Regulated financial institutions with the approval of
the CBRC may purchase for the purposes of
hedging, gaining profit, and providing transaction
services for clients
Derivative operations are subject to prior review by
regulatory agencies and there are restrictions on
open foreign exchange positions
Derivative operations are subject to prior review by
regulatory agencies and there are restrictions on
open foreign exchange positions
Regulated financial institutions that meet risk
management requirements may trade in gold
futures on domestic market
Direct investment Foreign
investors
If approved by the Ministry of Commerce, non-
residents are free to invest in China
Permitted after an examination of the sources of
foreign exchange funds and approval by the
related authorities
Domestic
investors
Domestic institutions are permitted to make
outward investments using a variety of asset
sources. Individuals cannot (apart from the
Wenzhou pilot programme)
Source: IMF, HSBC





49
Macro
China
November 2012
abc
Chart 6.2 Rising FDI into services industries
0
10
20
30
40
50
60
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012*
FDI in serv ices industries as % of total FDI

Source: CEIC, HSBC

Overseas Direct Investment (ODI)
China is not just the worlds leading exporter of
goods but also one of the top exporters of capital.
With ODI (non-financial) topping USD68.6bn in
2011, China in now the worlds sixth largest
exporter of capital, and signs have emerged that
this figure is likely to double in the next 3-5 years
as Chinese companies expand overseas (see
chapter four of this report and China Inside Out,
China going global: key trends, 29 April 2011).
So, just as it has become easier to move money
into China, the same applies in reverse. Again,
this has been a gradual process. In 2009 Beijing
allowed Chinese companies operating overseas to
keep profits offshore. Then, last year, a trial
programme let some Chinese businesses use RMB
for ODI (see China: PBoC starts trial for RMB
direct investment overseas, 14 January 2011).
Chart 6.3 ODI is taking-off
0
20
40
60
80
1991 1995 1999 2003 2007 2011
(USD bn)

Source: CEIC, HSBC
We expect this Going out strategy to be
promoted aggressively during the current 12
th

Five-year Plan. China is committed to improving
the countrys legal and institutional framework,
which will also enhance overseas investment. We
expect to see further relaxation of ODI foreign
exchange regulations in the coming years. We
also expect ODI to surpass FDI in the coming
three to five years.
Foreign debt limits
China has quotas for both long-term and short-term
foreign debt. The trend is to gradually relax the
regulations for short-term debt, credit which has
helped Chinas companies finance their export and
import trade. For example, to offset the impact of
the financial crisis back in 2008, SAFE allowed
companies to borrow a bigger percentage of the
value of imports and exports (25%, up from 10%).
The structural breakdown of Chinas outstanding
debt suggests that over the past decade mid-to-
long term foreign debt rose modestly, while short-
term debt surged nearly 30x, much faster than the
six-fold expansion of total trade. Trade credit,
subject to the international trade cycle, accounts
for around 50-60% of outstanding short-term
foreign debt. This makes it the largest swing
factor in Chinas total foreign debt.
Chart 6.4 Relaxation of short-term foreign debt supports
trade growth
0
200
400
600
800
1991 1994 1997 2000 2003 2006 2009 2012
1H
(USD bn)
Mid-long term Short term

Source: CEIC, HSBC



50
Macro
China
November 2012
abc
QFII, RQFII and QDII
While foreign direct investment is easy, portfolio
investment remains highly restricted. It is only
available in the form of QFII and QDII schemes;
both are subject to approvals and quotas.
The QFII scheme was introduced in 2003,
opening the door for foreign investors to access
Chinas capital market. Investment is now
allowed in A-shares, treasury bonds (T-bonds),
convertible bonds and corporate bonds listed on
stock exchanges. By September 2012, 188 foreign
institutions had received QFII approval from the
CSRC. This has resulted in a total of USD30.8bn
being invested in the local capital market (still just
a fraction of the domestic market cap).
The QFII scheme is expanding rapidly on several
fronts. First, the number of participants is rising at a
faster pace than in previous years. Before
November 2011, on average only 2-3 new QFIIs
were approved per month but this has jumped to
eight over the last five months. Second, the total
QFII quota has been expanded to USD80bn from
USD30bn. The last time the quota was increased
was back in May 2007, when it rose from
USD10bn to USD30bn. Third, local media has
reported that hedge funds are now eligible to apply.
According to local media, the CSRC is also
considering relaxing the QFII approval rules. This
could see institutions granted more than one
licence and given greater flexibility about what
asset classes they can invest in.
Chart 6.5 QFII approvals are accelerating
0
2
4
6
8
10
12
14
16
2004 2005 2006 2007 2008 2009 2010 2011 2012

Source: CEIC, HSBC

In the meanwhile, the RQFII scheme was
launched in December 2011. As of end 3Q, RQFII
licences have been granted to 21 companies, with
investment quota of RMB39bn (or around
USD6.2bn).
In April 2006 the PBoC launched the QDII
initiative under which local RMB assets could be
pooled and converted into foreign currencies and
invested overseas. Although hit hard by the 2008-
09 financial crisis it has survived and prospered.
As of end 3Q 2012, there were 103 QDIIs that can
invest up to USD85.6bn, almost 65% more than
before the crisis.
Chart 6.6 QFII quotas are picking up pace
0
20
40
60
80
100
20032004200520062007 20082009201020112012*
(USD bn)
0
10
20
30
40
50
(RMB bn)
QFII (Lhs) QDII (Lhs) RQFII (Rhs)

Source: CEIC, HSBC * As of end 3Q12



51
Macro
China
November 2012
abc
Individual FX quota
The annual foreign exchange quota for individuals
is USD50,000 a year (it was increased from
USD20,000 in 2007). Chinese citizens are still not
allowed to make direct or portfolio investments in
overseas markets.
That said, things are changing. The recent pilot
scheme in Wenzhou allows residents to make ODI
(non-financial) of up to USD200m per year (no
more than USD3m per person, per project; a
maximum of USD10m for multi-person
investment in one project). Local media has
reported that other cities such as Shanghai,
Tianjin and Beijing are all preparing to launch
similar pilot programmes that will open the door
for local residents to invest abroad.
There will still be rules
An open capital account and RMB convertibility
doesnt mean a complete absence of regulation. In
other words, it is important to distinguish between
free and full convertibility. The latter implies that
regulators will continue to monitor transactions in
order to safeguard domestic financial stability.
While these controls involve some inefficiency
and cost to the economy, they are likely to be in
place during a transitional period
3
.

3
Stanley Fischer (1997), Capital Account
Liberalization and the Role of the IMF, Conference on
Development of Securities Market in Emerging markets,
Inter-American Development Bank, Washington DC
Firstly, from the point of view of international
standards, the IMF doesnt oblige member
countries to achieve convertibility under the
capital account, although according to Article VIII
there is an obligation to avoid imposing
restrictions on transactions under the current
account. In fact, Article VI (3) allows members to
exercise such (capital) controls as are necessary
to regulate international capital movements, but
not so as to restrict payments for current
transactions or which would unduly delay
transfers of funds in settlement of commitments
4
.
Second, capital controls still co-exist with capital
account convertibility in certain economies (for
example, South Korea and Taiwan and some
Latin American countries).
According to the IMF, over 70% of its member
countries still impose restrictions on direct
investment, real estate transactions and capital
market transactions. In fact, the level of
cautiousness about capital account management
has increased since the Asian financial crisis in
1997-98. During the 2008-09 global financial
crisis many countries strengthened capital controls
to ensure domestic financial stability.
China can achieve basic full RMB convertibility,
while at the same time retaining appropriate
capital controls in order to minimise risks.
Prudent controls are likely to be kept in place,
possibly in the form of restrictions on speculative
money inflows and short-term foreign debt.

4
http://www.imf.org/external/pubs/ft/aa/index.htm


52
Macro
China
November 2012
abc

What China can learn from
other countries
Change is never a simple process. Like any
journey, there are bumps in the road, unexpected
delays and even the occasional diversion. The
process of reforming Chinas financial system is
unlikely to be any different. Helpfully, plenty of
other countries have already gone down this route
and we think Beijings policymakers can learn
from what was successful and also avoid
repeating some of the mistakes that were made
along the way.
Lesson 1
The sequence and pace of capital account
liberalisation are very important
History tells us that capital account liberalisation
broadly defined as the removal of controls on
international flows of capital to enable currency
convertibility and the opening of the financial
system should be taken step-by-step. It must
also be part of a comprehensive package which
co-ordinates reforms of domestic financial
markets, the exchange rate and interest rate policy.
Although the sequence of change varies from one
country to another, aggressive and rapid
liberalisation of the capital account without the
correspondent measures to contain risks can lead
to distortions and even crisis.
In the early 1990s foreign capital flooded into
Thailand, attracted by high domestic interest
rates and strong GDP growth. At the same time,
the Thai baht remained pegged to the US dollar,
which led to ballooning short-term debt, which in
turn helped fuel high levels of inflation, economic
overheating and the creation of asset bubbles. In
1997 the Asian financial crisis was born in
Thailand. The economy went into meltdown.
Another example is Indonesia, which liberalised its
capital account before the current account. It also
lifted all restrictions on capital outflows as well as
most controls on capital inflows in a relatively short
period of time (1967-1970). Indonesia subsequently
liberalised its trade and current account, financial
markets, interest rates and relaxed the restrictions on
foreign portfolio investment.
However, with a liberalised capital account and a
fixed exchange rate, the economy then came face
to face with the Mundell Impossible Trinity, the
Learning the lessons
The reform process is never straightforward, but China can learn
lessons both good and bad from other countries
The pace and sequence of reforms are the keys to success
While the process has begun, Beijing must first put its domestic
financial house in order before making bold moves to liberalise the
capital account


53
Macro
China
November 2012
abc
theory put forward by Nobel economics laureate
Robert Mundell that no economy can have free
capital flows, a fixed exchange rate and control
over its own monetary policy (i.e. stable interest
rates or stable prices) all at the same time. When
the Asian Financial Crisis struck, Indonesia was
among the countries that suffered most.
Lesson 2
Risk management, especially controls on
short-term capital flows, is key
Indias smooth liberalisation of its capital account
can also offer good lessons, for example:
Making sure the authorities can impose
restrictions that minimise risks associated
with big swings in capital flows that can
affect financial stability. For instance, the
central bank sets an adjustable quota for
foreign institutional investors (FIIs) in
government and corporate securities. In 2010
the FII limit for bonds was raised by USD5bn
for both government and corporate bonds,
taking the cap to USD10bn for government
securities and USD20bn for corporate bonds.
Recently, on 25 June this cap was revised up
to USD20bn for government securities.
Closely monitor short-term capital flows.
Short-term capital gains on the sale of
securities are subject to tax of 30%.
Foreign direct investment in Indias property
market is not allowed.
Lesson 3
Sound domestic financial markets and stable
macroeconomic environment are essential
Before fully opening its domestic capital market
in 1996, Korea introduced a range of reforms that
started way back in 1988. The development of the
countrys domestic money, securities and foreign
exchange markets paved the way for the opening
up of the capital account for portfolio capital
flows in the 1990s.
Chile also took a gradual approach. It started to
open up its capital account in 1974 but the
economic and banking crisis of early the 1980s
slowed the pace of change until 1985. Since then
the process of restructuring the banks has been
completed, along with the liberalisation of the
exchange rate system. Other reforms include the
selective liberalisation of capital inflows,
followed by the development of the domestic
capital market and controlled liberalisation of
capital outflows. This measured and well
sequenced approach to liberalising its capital
account helped the country to withstand a wave of
financial crises Mexico (1994), Asia (1997),
Brazil (1999) and Argentina (2001).
Lesson 4
Favourable external environment helps to
minimise risk of external shocks
When Japan started to open its capital account in
1984, the world economy was just starting to
recover from the global financial crisis of 1980-
1982. Similarly, when Russia announced the full
convertibility of the rouble in 2006, external
conditions were favourable for the oil-rich nation;
the global economy was booming and commodity
prices were rising. However, the flip side is that
the 2008 financial crisis and subsequent capital
outflows put pressure on the currency and the
process of capital account liberalisation.
Dont put the cart before the
horse
China must put its domestic financial house in
order before making bold moves to liberalise its
capital account. Without a sound and stable
domestic financial system, China will be exposed
to an elevated level of risk and shocks from
external markets. Here are some of the problems
that need to be addressed:


54
Macro
China
November 2012
abc
1 Local government debt
Local governments, prohibited from borrowing
money directly from bank, have set up thousands
of LGFVs to raise funds for infrastructure projects
in recent years. In 2010 the National Audit Office
put the combined debt of LGFVs at RMB10.7trn.
To put this in context, the huge economic stimulus
package announced by Beijing in late 2008
totalled RMB4trn.
Since then the central government has kept tight
control over the LGFVs and their debt increased
by only RMB300m over the course of 2011.
Banks have remained cautious about lending to
LGFVs this year, although the payback period for
some of the loans has been extended. As we
argued earlier in this report, the real problem for
local governments is liquidity rather than
sovereign debt as most LGFVs have plenty of
valuable assets.
We think the tight central government controls, plus
an increase in the issuance of local government and
corporate bonds, imply that the LGFVs can solve
this problem of liquidity, which is largely a duration
mismatch. Some 53% of their debt is due by 2013,
while the majority of the proceeds from the bonds
went on infrastructure projects, which take several
years to generate returns.
Chart 7.1. Local government debts maturing table
by 2013
53%
2014-15
17%
after 2015
30%

Source: National Audit Office, HSBC


2 Banks: Interest rate liberalisation and
credit risk controls
The reform process represents a huge challenge for
the big state-owned banks. First, the likely
narrowing of the gap between savings and lending
rates will be a major issue. The net interest margin
the difference between the two rates is the
lifeblood of Chinas banks, on average representing
around 80% of total operating income.
In a more market-driven environment, the banks
will also be vulnerable to the interest rate
sensitivity gap, a measure of how much the price
of a fixed-income asset will fluctuate as a result of
changes in interest rates. Generally, the longer the
maturity of the asset, the more sensitive the asset
will be to changes in interest rates.
Banks also need to be well prepared for the
liberalisation of the capital account. As the
dominant financial intermediaries, they are
exposed to the risks of big swings in capital
inflows and the likely increase of foreign currency
debt due to the large inflows of foreign capital.
To minimise the risks, the authorities need to
strengthen the monitoring of cross-border capital
flows and the banks foreign currency positions.
For their part the banks need to improve their risk
management by establishing a rational pricing
mechanism and strengthening internal audits and
control systems and accelerating the innovation of
financial derivative products.
3 Stock market irregularities
Chinas A-share market is far less mature than
those in developed economies. Its poor
performance reflects the fact that listed companies
have raised too much equity capital from the
market and paid out too little in dividends.
Meanwhile, irregularities such as insider trading,
stock manipulation, false financial data, the
spread of misleading market information and


55
Macro
China
November 2012
abc
opaque reporting practices hinder the markets
development and erode investor confidence.
Investors need to be properly protected; otherwise
they could opt to take their money elsewhere,
especially as more investment opportunities
become available.
Guo Shuqing, the reformist chairman of the
CSRC, has put market supervision and investor
protection at the top of his agenda. HSBCs equity
strategists believe he will make a real difference
and expect the pace of reform to accelerate (see
China Strategy: Reforms to drive slow-paced A-
share market rerating, 13 March 2012).
Conclusions
The pace and sequence of the financial reforms
are the keys to success. The authorities are
following the principle of liberalising capital
inflows before capital outflows, long-term capital
instruments before short-term capital instruments,
direct investment before indirect investment and
institutional capital flows before retail capital
flows. They have been making steady progress.
Meanwhile, Beijing is making efforts to co-
ordinate the liberalisation of the capital account
with domestic financial market and exchange rate
reforms. Policymakers have speeded up the pace
of interest rate liberalisation by expanding the
floating band of both lending and deposit rates
when cutting interest rates. They have also
increased exchange rate flexibility by widening
the trading band to 1%. These measures should
improve the flexibility and efficiency of monetary
policy and strengthen the resilience of the
domestic financial market.
Despite the wobbly state of global financial
markets and fragile growth rates, the world
economy is still heading for a recovery. At the
same time, China is adopting a cautious and
gradual approach to opening its capital account
and making its currency fully convertible. We
believe the combination of a better economic
outlook and Beijings risk management skills
should help China to achieve a smooth opening of
its capital account in the coming 3-5 years.



56
Macro
China
November 2012
abc
China: Economic milestones since 1978

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992
1978: Deng Xiaoping launches reforms. Household
responsibility system introduced in the countryside,
giving some farmers ownership of their produce.
1980: Southern city of Shenzhen bordering Hong Kong is the first
Special Economic Zone to experiment with more flexible market
policies. It is rapidly transformed from a fishing village into a
manufacturing powerhouse.
1990: The Shanghai
Stock Exchange opens.
1988: Bank runs and panic buying are
triggered by rising inflation that peaks
at over 30% in cities.
1979: Diplomatic relations with the US normalised.
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
1997: Deng dies and is
succeeded by Jiang
Zemin. Hong Kong
returns to Chinese rule.
1999: Beijing proposes a
strategy to accelerate the
development of the western
regions. Macau returns to
Chinese rule.
2002: Entrepreneurs
allowed to join the Chinese
Communist Party. The first
National Financial
Economic Work Conference
is held in Beijing.
1996: China fulfils IMFs article IIIV and allows the RMB to be convertible on the
current account, enabling the free flow of money for imports and exports.
1998: China bails out its banking sector, which was
weighed down by bad loans to state-owned enterprises.
2001: China joins the World Trade Organization.
2003: National Peoples
Congress endorses Hu Jintao
as successor to Jiang as
president. SARS breaks out.
2004: State-owned banks
reform; the protection of
ownership of private
property stipulated in
Chinas Constitution.
1994: Fiscal reforms split tax
sharing between central and
local governments
2005 2006 2007 2008 2009 2010 2011 2012 2013
2008: Start of global financial
crisis. Beijing hosts successful
Olympic Games.
2011: Reformers appointed to head financial regulatory
agencies for banks, equities and insurance.
2012: January: The influential National Financial Working
Conference (NFWC) releases an eight-point, five-year
blueprint for reform. February: RRR cut by another 50bp.
March: Wenzhou pilot scheme announced. April: the RMB
daily trading band against the USD was increased for the
first time since 2007 to 1%, up from 0.5%. May: Foreign
companies permitted to raise stakes in joint ventures with
domestic securities firms to as much as 49%.
2009: Beijing unveils
massive stimulus package
to offset impact of the
global financial crisis.
2006: Two huge infrastructure projects, the
Three Gorges Dam and a railway to Tibet, are
completed. Chinas foreign currency reserves,
already the world's biggest, top USD1trn.
Beijing starts the strategy of advancing the rise
of central China.
2010: Unprecedented measures to cool the property
market introduced; Shanghai hosts Expo.
2005: China sweeps past Britain, France and Italy to
become the worlds fourth-largest economy. China
frees the RMB from a dollar peg, letting it float within
a tightly managed band. Beijing launches the non-
tradable share reform.
Source: Reuters, Bloomberg, HSBC


57
Macro
China
November 2012
abc
Notes


58
Macro
China
November 2012
abc
Notes



59
Macro
China
November 2012
abc
Disclosure appendix
Analyst Certification
The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the
opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their
personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific
recommendation(s) or views contained in this research report: Hongbin Qu, Jun Wei Sun and Xiaoping Ma
Important Disclosures
This document has been prepared and is being distributed by the Research Department of HSBC and is intended solely for the
clients of HSBC and is not for publication to other persons, whether through the press or by other means.
This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer
to buy the securities or other investment products mentioned in it and/or to participate in any trading strategy. Advice in this
document is general and should not be construed as personal advice, given it has been prepared without taking account of the
objectives, financial situation or needs of any particular investor. Accordingly, investors should, before acting on the advice,
consider the appropriateness of the advice, having regard to their objectives, financial situation and needs. If necessary, seek
professional investment and tax advice.
Certain investment products mentioned in this document may not be eligible for sale in some states or countries, and they may
not be suitable for all types of investors. Investors should consult with their HSBC representative regarding the suitability of
the investment products mentioned in this document and take into account their specific investment objectives, financial
situation or particular needs before making a commitment to purchase investment products.
The value of and the income produced by the investment products mentioned in this document may fluctuate, so that an
investor may get back less than originally invested. Certain high-volatility investments can be subject to sudden and large falls
in value that could equal or exceed the amount invested. Value and income from investment products may be adversely
affected by exchange rates, interest rates, or other factors. Past performance of a particular investment product is not indicative
of future results.
Analysts, economists, and strategists are paid in part by reference to the profitability of HSBC which includes investment
banking revenues.
For disclosures in respect of any company mentioned in this report, please see the most recently published report on that
company available at www.hsbcnet.com/research.
* HSBC Legal Entities are listed in the Disclaimer below.
Additional disclosures
1 This report is dated as at 05 November 2012.
2 All market data included in this report are dated as at close 31 October 2012, unless otherwise indicated in the report.
3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research
operate and have a management reporting line independent of HSBC's Investment Banking business. Information Barrier
procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or
price sensitive information is handled in an appropriate manner.
4 HSBC is part of a syndicate of banks providing financing facilities to Hong Kong Exchanges & Clearing in regard to the
acquisition of the London Metals Exchange.


60
Macro
China
November 2012
abc
Disclaimer
* Legal entities as at 8 August 2012
UAE HSBC Bank Middle East Limited, Dubai; HK The Hongkong and Shanghai Banking Corporation
Limited, Hong Kong; TW HSBC Securities (Taiwan) Corporation Limited; 'CA' HSBC Bank Canada,
Toronto; HSBC Bank, Paris Branch; HSBC France; DE HSBC Trinkaus & Burkhardt AG, Dsseldorf; 000
HSBC Bank (RR), Moscow; IN HSBC Securities and Capital Markets (India) Private Limited, Mumbai; JP
HSBC Securities (Japan) Limited, Tokyo; EG HSBC Securities Egypt SAE, Cairo; CN HSBC Investment
Bank Asia Limited, Beijing Representative Office; The Hongkong and Shanghai Banking Corporation Limited,
Singapore Branch; The Hongkong and Shanghai Banking Corporation Limited, Seoul Securities Branch; The
Hongkong and Shanghai Banking Corporation Limited, Seoul Branch; HSBC Securities (South Africa) (Pty)
Ltd, Johannesburg; HSBC Bank plc, London, Madrid, Milan, Stockholm, Tel Aviv; US HSBC Securities (USA)
Inc, New York; HSBC Yatirim Menkul Degerler AS, Istanbul; HSBC Mxico, SA, Institucin de Banca Mltiple,
Grupo Financiero HSBC; HSBC Bank Brasil SA Banco Mltiplo; HSBC Bank Australia Limited; HSBC Bank
Argentina SA; HSBC Saudi Arabia Limited; The Hongkong and Shanghai Banking Corporation Limited, New
Zealand Branch incorporated in Hong Kong SAR
Issuer of report
The Hongkong and Shanghai Banking
Corporation Limited
Level 19, 1 Queen's Road Central
Hong Kong SAR
Telephone: +852 2843 9111
Telex: 75100 CAPEL HX
Fax: +852 2801 4138
Website: www.research.hsbc.com
The Hongkong and Shanghai Banking Corporation Limited (HSBC) has issued this research material. The Hongkong and Shanghai Banking Corporation
Limited is regulated by the Hong Kong Monetary Authority. This material is distributed in the United Kingdom by HSBC Bank plc. In Australia, this
publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970, AFSL 301737) for the general
information of its wholesale customers (as defined in the Corporations Act 2001). Where distributed to retail customers, this research is distributed by HSBC
Bank Australia Limited (AFSL No. 232595). These respective entities make no representations that the products or services mentioned in this document are
available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law. No consideration has been
given to the particular investment objectives, financial situation or particular needs of any recipient.
This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited, New Zealand Branch incorporated in Hong
Kong SAR.
This material is distributed in Japan by HSBC Securities (Japan) Limited. HSBC Securities (USA) Inc. accepts responsibility for the content of this research
report prepared by its non-US foreign affiliate. All US persons receiving and/or accessing this report and intending to effect transactions in any security
discussed herein should do so with HSBC Securities (USA) Inc. in the United States and not with its non-US foreign affiliate, the issuer of this report. In Korea,
this publication is distributed by either The Hongkong and Shanghai Banking Corporation Limited, Seoul Securities Branch ("HBAP SLS") or The Hongkong
and Shanghai Banking Corporation Limited, Seoul Branch ("HBAP SEL") for the general information of professional investors specified in Article 9 of the
Financial Investment Services and Capital Markets Act (FSCMA). This publication is not a prospectus as defined in the FSCMA. It may not be further
distributed in whole or in part for any purpose. Both HBAP SLS and HBAP SEL are regulated by the Financial Services Commission and the Financial
Supervisory Service of Korea. In Singapore, this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited, Singapore Branch for
the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (SFA)
and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA. This publication is not a prospectus
as defined in the SFA. It may not be further distributed in whole or in part for any purpose. The Hongkong and Shanghai Banking Corporation Limited
Singapore Branch is regulated by the Monetary Authority of Singapore. Recipients in Singapore should contact a "Hongkong and Shanghai Banking
Corporation Limited, Singapore Branch" representative in respect of any matters arising from, or in connection with this report. In the UK this material may
only be distributed to institutional and professional customers and is not intended for private customers. It is not to be distributed or passed on, directly or
indirectly, to any other person. HSBC Mxico, S.A., Institucin de Banca Mltiple, Grupo Financiero HSBC is authorized and regulated by Secretara de
Hacienda y Crdito Pblico and Comisin Nacional Bancaria y de Valores (CNBV). HSBC Bank (Panama) S.A. is regulated by Superintendencia de Bancos de
Panama. Banco HSBC Honduras S.A. is regulated by Comisin Nacional de Bancos y Seguros (CNBS). Banco HSBC Salvadoreo, S.A. is regulated by
Superintendencia del Sistema Financiero (SSF). HSBC Colombia S.A. is regulated by Superintendencia Financiera de Colombia. Banco HSBC Costa Rica S.A.
is supervised by Superintendencia General de Entidades Financieras (SUGEF). Banistmo Nicaragua, S.A. is authorized and regulated by Superintendencia de
Bancos y de Otras Instituciones Financieras (SIBOIF).
Any recommendations contained in it are intended for the professional investors to whom it is distributed. This material is not and should not be construed as an
offer to sell or the solicitation of an offer to purchase or subscribe for any investment. HSBC has based this document on information obtained from sources it
believes to be reliable but which it has not independently verified; HSBC makes no guarantee, representation or warranty and accepts no responsibility or
liability as to its accuracy or completeness. Expressions of opinion are those of HSBC only and are subject to change without notice. The decision and
responsibility on whether or not to invest must be taken by the reader. HSBC and its affiliates and/or their officers, directors and employees may have positions
in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment).
HSBC and its affiliates may act as market maker or have assumed an underwriting commitment in the securities of any companies discussed in this document
(or in related investments), may sell them to or buy them from customers on a principal basis and may also perform or seek to perform banking or underwriting
services for or relating to those companies. This material may not be further distributed in whole or in part for any purpose. No consideration has been given to
the particular investment objectives, financial situation or particular needs of any recipient. (070905)
In Canada, this document has been distributed by HSBC Bank Canada and/or its affiliates. Where this document contains market updates/overviews, or similar
materials (collectively deemed Commentary in Canada although other affiliate jurisdictions may term Commentary as either macro-research or
research), the Commentary is not an offer to sell, or a solicitation of an offer to sell or subscribe for, any financial product or instrument (including, without
limitation, any currencies, securities, commodities or other financial instruments).
Copyright 2012, The Hongkong and Shanghai Banking Corporation Limited, ALL RIGHTS RESERVED. No part of this publication may be reproduced,
stored in a retrieval system, or transmitted, on any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior
written permission of The Hongkong and Shanghai Banking Corporation Limited. MICA (P) 038/04/2012, MICA (P) 063/04/2012 and MICA (P) 206/01/2012
[348494]


abc

Global
Stephen King
Global Head of Economics
+44 20 7991 6700 stephen.king@hsbcib.com
Karen Ward
Senior Global Economist
+44 20 7991 3692 karen.ward@hsbcib.com
Madhur Jha
+44 20 7991 6755 madhur.jha@hsbcib.com
Europe & United Kingdom
Janet Henry
Chief European Economist
+44 20 7991 6711 janet.henry@hsbcib.com
Simon Wells
Chief UK Economist
+44 20 7991 6718 simon.wells@hsbcib.com
John Zhu
+44 20 7991 2170 john.zhu@hsbcib.com
Germany
Stefan Schilbe
+49 211910 3137 stefan.schilbe@hsbc.de
France
Mathilde Lemoine
+33 1 4070 3266 mathilde.lemoine@hsbc.fr
North America
Kevin Logan
Chief US Economist
+1 212 525 3195 kevin.r.logan@us.hsbc.com
Ryan Wang
+1 212 525 3181 ryan.wang@us.hsbc.com
David G Watt
+1 416 868 8130 david.g.watt@hsbc.ca
Asia Pacific
Qu Hongbin
Managing Director, Co-head Asian Economics Research and
Chief Economist Greater China
+852 2822 2025 hongbinqu@hsbc.com.hk
Frederic Neumann
Managing Director, Co-head Asian Economics Research
+852 2822 4556 fredericneumann@hsbc.com.hk
Leif Eskesen
Chief Economist, India & ASEAN
+65 6658 8962 leifeskesen@hsbc.com.sg
Paul Bloxham
Chief Economist, Australia and New Zealand
+61 2925 52635 paulbloxham@hsbc.com.au
Donna Kwok
+852 2996 6621 donnahjkwok@hsbc.com.hk
Trinh Nguyen
+852 2996 6975 trinhdnguyen@hsbc.com.hk
Ronald Man
+852 2996 6743 ronaldman@hsbc.com.hk
Luke Hartigan
+612 9255 2635 lukehartigan@hsbc.com.au
Sun Junwei
+86 10 5999 8234 junweisun@hsbc.com.cn
Sophia Ma
+86 10 5999 8232 xiaopingma@hsbc.com.cn
Su Sian Lim
+65 6658 8963 susianlim@hsbc.com.sg
Izumi Devalier
+852 2822 1647 izumidevalier@hsbc.com.hk
Global Emerging Markets
Pablo Goldberg
Head of Global EM Research
+1 212 525 8729 pablo.a.goldberg@hsbc.com
Bertrand Delgado
EM Strategist
+1 212 525 0745 bertrand.j.delgado@us.hsbc.com
Emerging Europe and Sub-Saharan Africa
Murat Ulgen
Chief Economist, Central & Eastern Europe and sub-Saharan
Africa
+44 20 7991 6782 muratulgen@hsbc.com
Alexander Morozov
Chief Economist, Russia and CIS
+7 495 783 8855 alexander.morozov@hsbc.com
Artem Biryukov
Economist, Russia and CIS
+7 495 721 1515 artem.biryukov@hsbc.com
Agata Urbanska
Economist, CEE
+44 20 7992 2774 agata.urbanska@hsbcib.com
Melis Metiner
Economist, Turkey
+90 212 376 4618 melismetiner@hsbc.com.tr
Middle East and North Africa
Simon Williams
Chief Economist
+971 4 423 6925 simon.williams@hsbc.com
Liz Martins
Senior Economist
+971 4 423 6928 liz.martins@hsbc.com
Latin America
Andre Loes
Chief Economist, Latin America
+55 11 3371 8184 andre.a.loes@hsbc.com.br
Argentina
Javier Finkman
Chief Economist, South America ex-Brazil
+54 11 4344 8144 javier.finkman@hsbc.com.ar
Ramiro D Blazquez
Senior Economist
+54 11 4348 5759 ramiro.blazquez@hsbc.com.ar
Jorge Morgenstern
Senior Economist
+54 11 4130 9229 jorge.morgenstern@hsbc.com.ar
Brazil
Constantin Jancso
Senior Economist
+55 11 3371 8183 constantin.c.jancso@hsbc.com.br
Mexico
Sergio Martin
Chief Economist
+52 55 5721 2164 sergio.martinm@hsbc.com.mx
Claudia Navarrete
Economist
+52 55 5721 2422 claudia.navarrete@hsbc.com.mx
Central America
Lorena Dominguez
Economist
+52 55 5721 2172 lorena.dominguez@hsbc.com.mx


Global Economics Research Team
Qu Hongbin
Co-Head of Asian Economic Research and Chief China Economist
The Hongkong and Shanghai Banking Corporation Limited
+852 2822 2025
hongbinqu@hsbc.com.hk
Qu Hongbin is Managing Director, Co-Head of Asian Economics Research, and Chief Economist for Greater China. He has been an
economist in nancial markets for 17 years, the past eight at HSBC. Hongbin is also a deputy director of research at the China Banking
Association. He previously worked as a senior manager at a leading Chinese bank and other Chinese institutions.
Sun Junwei
Economist
The Hongkong and Shanghai Banking Corporation Limited
+86 10 5999 8234
junweisun@hsbc.com.cn
Sun Junwei is an economist for China on the Asian Economics team. Prior to this, she worked as an economic analyst at a leading
US bank and in the public sector. Junwei holds an MSc in Economics from the London School of Economics and a BA in Economics
from Peking University.
Ma Xiaoping
Economist
The Hongkong and Shanghai Banking Corporation Limited
+86 10 5999 8232
xiaopingma@hsbc.com.cn
Ma Xiaoping is an economist for China on the Asian Economics team. Prior to joining the HSBC China Economics team in 2005,
she worked with a leading academic research institute in Beijing. Xiaoping holds an MA in Economics from Peking University.