STRATEGY
Liquidity Management In China - Questions Answered
June 6, 2007
Staff Writers

We asked three experts on liquidity management in China to answer questions on topics such as deregulation of the renminbi, central bank regulations of the renminbi money markets, compliance with the Pudong Nine Measures and also the advantages of operating as a foreign-invested enterprise (FIE) in China.

Experts:

• Jin Kok Teoh, head of payments and cash management, HSBC, China
• Alan Chan, risk treasury head, Citi, China
• Cline Zhang, liquidity and liability management product head, Citi, China

Question 1: How important is it that foreign banks get a renminbi (RMB) licence that allows them to accept deposits of less than RMB1m?

Cline Zhang and Alan Chan, Citigroup: Firstly, one must be cautious with the terminology, which can be confusing. The appropriate post-World Trade Organisation (WTO) formulation is 'to incorporate locally', or more colloquially, 'to subsidiarize', rather than to obtain an RMB licence. The reason for potential confusion is that banks that did not or will not apply to incorporate may still want an RMB licence if they want to accept deposits of more than RMB1m.

Secondly, if the China growth strategy of a foreign bank depends on accumulating RMB deposits, then yes, it is very important to incorporate locally (or subsidiarize), otherwise there is limited chance of meaningful RMB driven growth. However, if a foreign bank strategy does not depend on individual RMB deposits for growth, then it may not be as important to incorporate. At present, nine foreign banks have been approved for local incorporation.

Question 2: Does the current RMB interbank market practice allow foreign banks to raise funds to support their loan assets growth?

Zhang and Chan, Citigroup: On 4 January 2007 the People's Bank of China (PBOC), China's central bank, launched a set of market-determined interest rates for borrowing between banks called the Shanghai Interbank Offered Rate (SHIBOR), a move aimed at creating depth in the onshore money market. This move will help to further liberalize interest rates and cultivate a benchmark interest rate system for China's money market. SHIBOR, which replaces the government-set China Interbank Offered Rate (CHIBOR), will be based on interest rates offered by 16 banks on the interbank market for periods ranging from one night to one year.

However, SHIBOR is still not a tradable benchmark on the RMB interbank market. Additionally, the borrowing/lending limit for branches of foreign banks remains capped at 1.5 times injected capital. As a consequence, borrowing/lending activity is rather limited when compared with the RMB repo market.

Foreign banks can raise funds to fund loan assets from the interbank market for up to one year, however, due to the limitations mentioned above, most loans are funded from outside the CHIBOR / SHIBOR market, i.e. through TongYeChaiJie rather than TongYeJieKuan. The CHIBOR/SHIBOR market is mainly used to satisfy liquidity needs.

SHIBOR is tradable for very short tenors from overnight to seven days, as these rates are very close to repo rates. Therefore, banks with good credit and a sufficient line can borrow at SHIBOR without bond collateral.

Question 3: What is the difference between TongYeChaiJie and TongYeJieKuan?

Jin Kok Teoh, HSBC: TongYeChaiJie and TongYeJieKuan are two different types of RMB interbank borrowing used by many foreign banks. TongYeChaiJie means interbank borrowing and lending on a clean basis (i.e. no collateral) through the National Interbank Funding Centre platform. The maximum tenor of a TongYeChaiJie is 12 months. Foreign banks with an RMB licence can borrow and lend in the form of a TongYeChaiJie, subject to a ceiling of 1.5 times the bank's RMB operating funds (capital). TongYeJieKuan is an OTC-based interbank borrowing and lending product, by which foreign banks with an RMB licence can borrow long term funds from local banks. The minimum tenor of a TongYeJieKuan is four months. Foreign banks may trade only in one direction - borrowing but not lending - through a TongYeJieKuan.

Zhang and Chan, Citigroup: TongYeChaiJie refers to borrowing/lending through the China Foreign Exchange Trading System (CFETS) trading platform of the RMB interbank market. Its transaction rates form the CHIBOR, so TongYeChaiJie is also called the CHIBOR market. SHIBOR is the rate quoted by 16 banks in Shanghai for RMB interbank borrowing/lending.

TongYeJieKuan refers to the facility established several years ago enabling foreign banks to borrow for more than four months from local banks (before 8 October 2006, the CHIBOR market could only process transactions of less than four months). The TongYeJieKuan market is not transparent and there is no trading platform. Deals are conducted through contracts and rates are normally higher as they are related to PBOC loan rates.

After 8 October 2006, the CHIBOR market allowed trades for up to one year, however, due to the foreign bank's lending cap (1.5 times capital) TongYeJieKuan still exists. It is not yet known whether it will close.

Foreign banks also conduct 'interbank deposits' (i.e. they open accounts with each other) to by-pass the CHIBOR limit. Rates can be better than borrowing from local banks through TongYeJieKuan. Some banks have conducted FX swaps to get cheaper RMB funding after they were permitted. The PBOC has not imposed limits on any other means of funding.

Question 4: Does the PBOC intend to keep the new regulations, and could they hinder the development of the RMB money market?

Teoh, HSBC: The PBOC may keep TongYeChaiJie and TongYeJieKuan. We have also seen many initiatives and reforms introduced by the PBOC to speed up the marketisation of the RMB money market. For example, the PBOC has introduced RMB interest rate swaps in the first quarter of 2006; extended the maximum tenor of TongYeChaiJie from four months to 12 months with effect from October 2006; and launched the Shanghai Interbank Offered Rate (SHIBOR) - the RMB interest rate benchmark curve in January 2007.

Question 5: Will the RMB interest rate see further deregulation - if so when and in which direction?

Zhang and Chan, Citigroup: The PBOC's monetary policy is to move towards further deregulation. The PBOC has expressed a desire to develop the CHIBOR / SHIBOR markets, to build up a benchmark yield curve and then further free up deposit/loan rates.

Question 6: Has China liberalized the bank interest conditions on both RMB and foreign currency operating accounts?

Teoh, HSBC: The local regulator has achieved remarkable success in maintaining financial stability and promoting economic development. However, the pace of interest rate liberalisation has not been as quick as market expectations. For RMB deposits, interest rates on operating accounts are set and controlled by the central bank. For high-value deposits (exceeding US$3m) in foreign currency, the interest rate is negotiable. Since November 2004, the interest rate on foreign currency deposits with a value less than US$3m has been determined and announced by the bank itself if the currency is one of four major foreign currencies (US dollar/Japanese yen/euro/HK dollar) with a tenor of two years. Otherwise, the bank should follow the deposit interest rate published by the central bank as the upper limit. We believe that China will gradually and steadily push its market-oriented reform of interest rates together with changes in the macroeconomic environment.

Zhang and Chan, Citigroup: While there has been some liberalization, certain regulations remain. In respect of RMB and FCY deposits of less than $3m, only the interest cap is regulated. For FCY deposits of more than US$3m, the interest rate is negotiable. For RMB loans, an interest floor has been set, below which a bank may not lower interest rates. Although there is no specified interest rate ceiling, there is a regulatory prohibition on interest rates that are not appropriate and which are in excess of market rates.

Question 7: What changes occurred in the currency law in China between 2004-2006? What are the main trends in China's banking system for the 11th five-year plan?

Zhang and Chan, Citigroup: The main trends are a more flexible exchange rate mechanism, more open financial markets and further deregulation of interest rates. To ease pressure on the renminbi, the central bank has steadily relaxed the restrictions on purchasing and holding foreign currency in China. In early 2006, a new regulation update was announced that made it more convenient for companies and individuals to purchase and hold foreign currency, instead of having to convert it to RMB. This is the ninth change to the foreign currency control regulations since 1994 when the control system was set up.

Teoh, HSBC: In the past three years, these are the main changes that have occurred:

1. The central bank raised the rate on deposit reserves several times, and introduced the system of different rates for deposit reserves.
2. The RMB interest rate was adjusted as appropriate, and this has steadily contributed to interest rate marketisation. The bottom line of the RMB lending rate and the upper limit of the RMB deposit rate are still managed and controlled by the central bank.
3. The renovation of the RMB exchange rate formation system has been implemented smoothly and is now in force. Since July 2005 China has started to put a 'floating exchange rate' in place, which is adjusted and managed on a market basis with a basket of currencies as reference.
4. The 'Market Maker Rule' was introduced into the RMB interbank market in November 2005, which has enhanced market liquidity and promoted the development of the market.
5. Other key changes included the improvement of the currency conversion system and loosening of foreign exchange restrictions on overseas investment; raising the ceiling of the foreign currency settlement account in 2005 under current item; the reformation of the policy on purchases by local residents of foreign exchange under the current item.

   Question 8: What does a company have to do to comply with the Pudong Nine Measures?

   Teoh, HSBC: To promote the comprehensive reform of the Shanghai Pudong New Area, the Nine Measures pilot reform for the foreign exchange administration of multi-national Companies (MNCs) was introduced at the end of 2005. These measures are designed to improve the treasury operations of MNCs. To qualify for and benefit from the Pudong Nine Measures, a Chinese or foreign MNC must have a regional headquarters (RHQ) based in the Pudong New Area and manage their group's investments or management regionally.

   Although the Pudong Nine Measures have engendered far-reaching change, regulatory reforms have not been limited to the pilot programme. In May 2006 the Ministry of Commerce (MOC) also introduced the 'Supplementary Provisions on the Establishment of Investment Companies by Foreign Investors'. Subject to the approval of the MOC and the State Administration of Foreign Exchange (SAFE), an investment company that is determined to be an RHQ that functions as a treasury service centre may centrally manage foreign exchange within the group. In September 2006, the Tianjin Binhai New Area also announced seven measures of foreign exchange administration reforms, which include centralising the management of foreign exchange funds. All of the above heralded a revolution in the country's foreign exchange regime. Foreign investors should consider their own business model and circumstances to decide whether to comply with these foreign exchange reform policies immediately or to await further liberalisation of the market.

   Zhang and Chan, Citigroup: The Pudong Nine Measures are regulations permitting various Pudong-based companies to conduct certain financial operations not yet permitted nationwide. The Nine Measures are not requirements in themselves, but are only available to companies with specific classifications. Each classification has its own distinct requirements.

   • Pudong regional headquarters (RHQ) may conduct foreign currency cash pooling;
   • Pudong RHQs may concentrate FCY funds from overseas subsidiaries;
   • Pudong MNCs may transfer undistributed RMB profits and distributed, un-remitted RMB profits, to overseas subsidiaries;
   • Pudong Chinese companies have easier approval requirements for transferring funds to overseas subsidiaries;
   • Pudong RHQs that have a treasury centre status may centrally manage domestic payments and collections for an overseas parent company;
   • All Pudong-based companies benefit from simplified non-trade related foreign currency payment processes; and
   • Any company with FCY collections greater than US$2.5bn is permitted to access China's Foreign Exchange Trading System (CFETS) to conduct FX transactions.

   To obtain Pudong RHQ status there are a host of requirements that need to be met. The most important basic requirements are:

   • The company must be a legal entity in China;
   • The parent company must have minimum total assets of US$400m;
   • The parent company must have made a minimum total investment in China of US$30m; and
   • A minimum of three legal entities is required in China.
   There are no specific requirements necessary to become a treasury centre.

   Question 9: What are the benefits of operating as an FIE in China?

   Teoh, HSBC: As China's strength in the global economy continues to grow, businesses need to consider the prospect of establishing or operating a foreign investment enterprise (FIE) in China in order to deal successfully with business partners. Doing business in China through an FIE can be advantageous, and sometimes a necessity, for overcoming certain legal and business restrictions. Although both FIEs and domestic companies are governed by China's Company Law, FIEs are also governed by specific FIE-related laws that subject them to additional or different rules and regulations. Nonetheless, operating an FIE in China allows MNCs to access a huge and high potential market and enables them to be better connected with their downstream or upstream business partners who have already entered the Chinese market. Furthermore, local incentives such as favourable tax rates and lower labour costs will continue to attract more MNCs to invest in China.

   These answers are intended to provide an overview of some key regulatory issues faced when undertaking financial activity in China. Due to the complexity of the regulatory environment, these answers can only provide an outline of the issues. The information is provided for your reference only, and does not construe any form of legal, financial or other professional advice.

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