By Claire van den Heever
Since its establishment in September 2013, Shanghai’sFree Trade Zone (FTZ) has been making international headlines as businesses and investors flock to take advantage of a highly appealing set of loosened restrictions that are facilitating the creation of an entirely new financial ecosystem. Among the most significant benefits of the FTZ is making company formation immeasurably easier for investors – both local and foreign. Schemes such as cross-border lending and cash pooling – which have helped facilitate yuan circulation and usage in the offshore market – are also being allowed.The Zone’s establishment is seen as actively enabling the city’s rise as an international financial center, and while it – and the handful of others within the country that are following in its footsteps – is still considered a pilot project, it is also recognized as a bold move that symbolizes the large strides China is making towards the liberalization of its currency.
Liberalization and reform of the Renminbi has long been an internationally hot topic among politicians and economists – particularly thosewho are threatened by the prospect of it becoming a reserve currency. But in recent years, Beijing’s concerted efforts to liberalize the Renminbi have been praised, and the goal of making it freely convertible in the very near future is in sight. China is now close enough to joining the International Monetary Fund’s major league of reserve currencies that there is speculation about a possible deal to include the yuan in the IMF’s unit of account later this year, illustrating just how far Beijing’s development and progress towards liberalization have come.
Among the effects of China’s ongoing Renminbi liberalization is Chinese citizens’ improved ability to move money out the country. While Chinese investors would view this development in an unequivocally positive light, it is uncertain what its effect on the offshore industry will be, and there will likely be both positive and negative features of these changes.
Currency liberalization is a relatively broad term that encompasses various different fiscal and governmental policies. In China’s case,liberalization can be broadly categorizedinto one of two main groups:policiesthat involve the internationalization of the Renminbi, and those that relate to the establishment of Free Trade Zones within the country.In essence, all efforts at liberalization aim to reduce restrictions on the movement, trade and use of a currency.
Renminbi internationalization began in earnest in July 2007, when the first dim sum bond – the Hong Kong cuisine-inspired name for a bond issued outside of China, but denominated in Chinese Renminbi – was issued by the China Development Bank.Until July 2010, only Chinese and Hong Kong banks could issue Renminbi-denominated bonds, until deregulation led to the development of an offshore market forthe currency and, in turn, the internationalization of dim sum bonds.
Since becoming the first offshore yuan clearing center, Hong Kong has had to compete with an increasing number of other jurisdictions that want to make a move towards more yuan-denominated trade settlement, reduced transaction fees, and closer ties with China. London and Singapore are foremost among them. The latter is now well on its way to becoming a gateway to Southeast Asia and, in particular, the members of the Association of Southeast Asian Nations (ASEAN), through which it will have the potential to facilitate yuan-denominated trade across the region. A mining company in Indonesia dealing with a Malaysian customer, for instance, could make use of a yuan-denominated trade settlement in order to lower transaction costs, or better manage currency risks. There has been plenty of optimism for ASEAN’s potential as a trade partner since the trading bloc surpassed Japan as China’snumber two importing region in 2012, and freer movement of Renminbi will be essential for further driving that growth.
Hong Kong reached what is believed to be its peak as an offshore yuan center in December 2011, when it held 90 percent of the yuan in the offshore market. That figure had dropped to approximately 65 percent by September 2013 – the same month Shanghai’s FTZwas established. Despite this significant reduction in yuan holdings – and the simultaneous rise of other offshore cities – Hong Kong’s head start has helped it to remain the top yuan center in terms of deposits. By the final quarter of 2014 deposits and certificates of deposit had reached approximately 1 trillion yuan, and the outstanding balance of yuan-denominated bonds issued offshore exceeded 450 billion yuan.
Today, dim sum bonds have been deregulated to the extent that their issuance is no longer restricted to mainland entities. Multilateral companies and international institutions, such as the World Bank and the Asian Development Bank, are now free to issue yuan-denominated bonds, highlighting the Renminbi’s increasingly significant role in international finance.
The continued internationalization of China’s currency has largely been viewed in positive light on a global scale. It adds efficiency and resilience to China’s trade and investment flows, lowers transaction costs byeliminating foreign exchange exposure, optimizes liquidity management and allows for better management of currency risks. Similarly, China’s recent efforts to establish Free Trade Zones have obvious advantages for individuals, companies and institutions who have investment or business interests in China. But, as is always the case with unfamiliar innovations, there are skeptics, too.
One reason for skepticism, explains Nathan Chow, an economist with DBS Bank, is that some worry the establishment of Shanghai’s FTZ will undermine the development of offshore yuan markets. Although Hong Kong’s establishment as an offshore yuan market predates the Shanghai FTZ, the jurisdiction is a useful example of how heightened competition is not always detrimental. While the rise of other offshore yuan markets such as London and Singapore have led to a reduction in Hong Kong’s proportion of yuan deposits, it’s exactly that: a reduction in proportion, not capital itself. Arguably, the growth in number of offshore yuan clearing centers has only increased demand for yuan-denominated bonds, Chinese currency accounts, and the various related Renminbi services that are steadily becoming expected of forward-thinking financial institutions–becauseof pioneers like Hong Kong.
Colin Riegels, a partner and head of the banking and finance global practice group at Harneys (one of the world’s largest and oldest offshore law firms), does not see continued Renminbi liberalization as a threat to the offshore industry in any sense. “At its heart, the offshore industry is primarily based upon cross border capital movements,” he explains. “Accordingly, any kind of liberalization which increases the ability of one fifth of the population of the globe to move money internationally can only be a good thing.”
Chow shares Riegels’ optimism, and says that fear about the establishment of Shanghai’s FTZ is “unwarranted”. He explains that looking at the Eurodollar market sheds light on how the offshore market could, in fact, grow in spite of deregulation onshore.
Changes in US regulations during the 1960s, including changes to reserve requirements, interest rate restrictions and borrowing limits, had the effect of making offshore banking more appealing to local banks. As a result, US dollar liquidity was directed to London, where non-US banks did not face Federal Reserve imposed regulations. The Eurodollar market consequently saw rapid growth.
According to Chow, the sustainable growth of the Eurodollar market can be attributed to several factors – most characteristically, its function as a third party intermediary between non-US lenders and non-US borrowers of dollars. Making use of offshore jurisdictions is also motivated by adesire to separate currency risk from country risk, Chow points out. In the same way that overseas central banks with dollar securities held in European depositories were still able to carry out normal operations during the September 11th terrorist attacks in New York in 2001, concerns over China’s political stability are largely mitigated if yuan is held offshore, rather than exclusively on PRC soil.
International investors generally prefer to transact in a particular currency through offshore marketsand therefore, where the yuan is concerned, offshore markets in Hong Kong and beyond are expected to evolve along similar paths to their Eurodollar counterparts.
Head of Renminbi internationalization for HSBC, Vina Cheung, describes how she views China’s approach to Renminbi internationalization in a recent article in Global Trade Review about the introduction of a two-way Renminbi sweeping solution between China and Germany. “China has established a three-pronged approach to Renminbi internationalization: expanding the currency’s role in cross-border trade settlement, developing offshore Renminbi centers and encouraging a wider use of Renminbi in cross-border investment.”
Renminbi cross-border sweeping is one way that enables the circulation of the currency between onshore and the offshore markets, she explains. “These are generally the emerging offshore Renminbi centers in the process of deepening the Renminbi liquidity pools and developing Renminbi investment, financing, and hedging/risk management products. Coupled with a strong business relationship with China, Renminbi trade settlement becomes a visible option with commercial benefits.”
Rather than see Renminbi liberalization as a threat to the offshore industry, she points out that the “liberalization of China’s payments landscape” has addressed a challenge that international companies doing business in China faced for approximately a decade: how to redeploy surplus liquidity accumulatedin China in a cost-efficient way. “(These businesses’) ability to mobilize working capital in China to contribute to global or regional liquidity optimization has been limited, resulting in external borrowing costs while surplus liquidity remained unused.” HSBC is a known proponent of Renminbi internationalization, and Cheung told Global Trade Reviewthat she hopes the government will continue along this path.
The Shanghai FTZ has become the poster child forChina’s currencyliberalization, but it soon may have to share the limelight when it is be joined by three other pilot zones in Tianjin, Guangdong, and Fujian Province. All three will replicate the Shanghai model by offering relaxed company formation requirements and streamlined approval procedures that, previously, were largely only available to Chinese investors if theylookedto offshore financial solutions. These draw cards, and the encouraging number of new companies or foreign invested enterprises that were opened in Shanghai’s FTZ between September 2013 and January 2014 – in excess of 2600 and 280, respectively – are the reason that a degree of concern has arisen about offshore jurisdictions further afield losing their appeal with Chinese investors.
January 2015 data from Shanghai Customs showed that trade generated from the FTZ reached 762.4 billion yuan ($122.8 billion) in 2014, accounting for an impressive 26.6 percent of total trade in Shanghai. But there is still room for the growth, Bai Ming, a research fellow at the Chinese Academy of International Trade and Economic Cooperation, told the Global Times in late March. More policies are expected to further open up the investment climate in the zone. The Shanghai FTZ had gained useful knowledge on financial liberalization and trade facilitation, and this could be applied to the three new zones, he said.
Designed as a testing ground for further reforms and policies, the Shanghai FTZ features lower thresholds for corporate establishment and liberalized foreign exchange. The zone also offers special benefits to certain industries – among them e-commerce, legal services, and logistics – and adopts a “negative list” approach to foreign investment. In addition to establishing new outlets, foreign banks will also be allowed to form joint venture banks with private capital in the zone. As far as private banking and wealth management are concerned, the FTZs create investment opportunities for foreign investors. The zone’s long-term goals include allowing free yuan convertibility under the capital account, interest rate liberalization, and cross-border yuan usage. In future, China is likely to speed up the liberalization of its capital account within the FTZ, both in order to achieve full convertibility of the yuan and affirm Shanghai’s status as an international financial center.
The Guangdong FTZ was the first of the three new zones to be launched, on 18 March 2015. Each will make full use of its geographic location and carry special local features. The Guangdong FTZ, for example, spans the Nansha area of Guangzhou, the Qianhai area of Shenzhen and the Hengqin area of Zhuhai, offering proximity to Hong Kong’s offshore yuan hub. Hong Kong and Guangdong have agreed to “capitalize on the opportunity arising from the Shenzhen-Hong Kong Stock Connect to further deepen the co-operation of the securities markets in the coming year,” according to Hong Kong’s chief secretary for administration, Carrie Lam.
“Financial innovation and construction of offshore financial centers are the two principal axes of the Shanghai FTZ,” says Dr. Li Zhiren, Greater China’s Chief Executive and Vice-President of Jepun International Financial Group. “Banks and other financial institutions provide offshore financial services to residents outside the jurisdiction. They include deposits and loans for non-resident clients who undertake the role of financial intermediary, as well as services such as fund management, insurance, tax planning, trust and asset protection.” He then raises a pertinent question: “But will Shanghai’s FTZ become a springboard for offshore finance?”
The offshore finance industry is constantly evolving – as are people’s reasons for forming companies offshore or availing ofoffshore vehicles to best manage their own changing financial needs. China’s first FTZ is certainly playing a major role in facilitatingcurrency liberalization and as the Renminbi continues along this path, so it will continue to reduce the difficulties of the past in freely moving capital in and out of China. But, as Colin Riegels emphasizes, “People set up offshore companies for a large number of different reasons, and those reasons tend to shift and evolve over time – sometimes rapidly.” The Shanghai Free Trade Zone is still extremely young, even in the context of China’s relatively short history of financial reform. By its nature as a pilot project, its role – and the role of the subsequent FTZs that join the ranks – will necessarily adapt and change in response to the physical, economic and political environment in which it exists. “Some people have made some fairly wild predictions as to how (Renminbi liberalization) is likely to affect the (offshore) industry, and it is always possible that some of the wilder predictions may prove to be correct,” says Riegels.“But whether it is a mild increase in workflow or a boom similar to what we saw in 1997 leading up to the handover of Hong Kong, only time will tell.”
