CNH: decoupling of CNY/CNH bond yields to continue July 18, 2011

Interest rate strategy

CNH: decoupling of CNY/CNH bond yields to continue

DBS Group Research 18 July 2011

Abundant liquidity and elevated commodity prices have driven China's inflation to a 35-month high of 6.4 percent. The People's Bank of China (PBoC) increased interest rates for the third time this year on July 6, making it clear that taming inflation is a top priority even while the economy moderates. As a result, onshore bond yields should continue their upward trend amidst ongoing monetary tightening. Offshore bond yields, however, could go the opposite direction.

Limited correlation between the onshore and offshore bond markets

Onshore renminbi (RMB) bonds are highly susceptible to changes in China's monetary policy. During 2006-08, deposit rates were increased a number of times in response to rising inflationary pressure. The 1-year deposit rate was raised 189bps to 4.14% between Aug06 to Jan08, while 1-year China government bond (CGB) yields have increased 166 bp to 3.89%. Similarly, the PBoC has lowered deposit rates during the financial crisis, and onshore bond yields fell (Chart 1). This correlation between policy rates and bond yields has yet to be seen in the offshore (CNH) market. Since Oct10, there have been nine upward adjustments in the RRR and five hikes in benchmark rates. Although the onshore 1-year CGB bond yields have risen correspondingly, offshore CGB bond yields have not. Instead, they had experienced their steepest decline (Chart 2).

CNH bond yields mainly driven by expectations of renminbi appreciation

Hong Kong's RMB deposits have surged on the back of renminbi settlement of cross-border trade since mid-2010. The fast offshore funding accumulation, however, is not matched by sufficient increase in the supply of offshore RMB investment products. With the five-fold increase in RMB deposits within one year to 548 billion in May 2011, the outstanding amount of CNH bonds stands at only 149

Chart 1: Onshore bond yields are highly correlated with policy rates
% 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 Latest: 18 Jul 2011 0.0 Oct-05 Oct-06 Oct-07 Oct-08 Oct-09 Oct-10 1Y deposit rate CGB (1Y, onshore)

Chart 2: Weak correlation between onshore and offshore bond yields

% 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Oct-10 Latest: 18 Jul 2011

Dec-10

Feb-11

Apr-11

Jun-11

CGB (1Y, offshore)

CGB (1Y, onshore)

Nathan Chow (852) 3668 5693 nathanchow@dbs.com

CNH: decoupling of CNY/CNH bond yields to continue July 18, 2011

Chart 3: HK's Renminbi deposits outstanding

CNY bn 600 500 400 300 200 100 0 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Latest: May 2011

Chart 4: CNH bond outstanding

CNY bn 160 140 120 100 80 60 40 20 0 2008 2009 2010 2011 YTD

billion (Chart 3, 4). The low bond-to-deposit ratio (27%) has led to cheap funding cost in the offshore market. The current low bond yield phenomenon underscores the fact that foreign investors have limited access to alternative CNH investment products and the onshore bond market, which could offer higher yields. For instance, the latest three-year government bond issue is yielding only 1.0% in the CNH market, compared with 3.3% for the onshore sovereign issue (Chart 5). Scarcity of CNH investment products amidst rising appreciation expectation of the renminbi thus depress offshore bond yields even though monetary tightening continues onshore.

CNH bond yields will likely remain relatively low

As onshore liquidity will likely remain tight, the appetite for offshore funding will continue to grow. Offshore bond issuance should become more popular. Meanwhile, as discussed in "Time to re-engage in the CNH-NDF basis trade" (27Jun11), the latest clarification of RMB FDI transactions should prompt more companies to issue CNH bonds. Indeed, many enterprises have already announced such plans and, to our knowledge, the Ministry of Finance is planning its third offshore issuance in Hong Kong. As of June, the gross issuance of CNH bonds stands at 90 billion. It will not be a surprise if it surpasses 150 billion by yearend. Meanwhile, the growth momentum of RMB deposits in Hong Kong will remain strong. Currently only 7 percent of China's trade is settled in renminbi Chart 5: Onshore vs offshore sovereign bond yields (compared with 95 percent % of US's exports and 40 percent 4.5 of Japan's exports invoiced in USD and JPY), and there 4.0 is still a significant scope for 3.5 expanding the size of cross3.0 border RMB settlement (Chart 6). Indeed, it has been reported 2.5 that the PBoC aims to expand 2.0 its cross-border settlement 1.5 plan nationwide this year. The bond-to-deposit ratio 1.0 Offshore sovereign bond is thus expected to remain 0.5 Onshore sovereign bond low to keep funding costs 0.0 low.
3Y 5Y 10 Y

CNH: decoupling of CNY/CNH bond yields to continue July 18, 2011

Chart 6: % of exports invoiced in exporter home In addition, China's currency 2QGDP growth turned out to be better than % expectated, easing 100 concerns of a hard landing. The resilience 80 of the economy suggests policymakers can afford 60 more tightening in 2H11. Stronger rate hike 40 expectations in turn supports further renminbi appreciation. Moreover, 20 US Fed chairman Ben Bernanke recently said 0 that the Fed would US UK EU JP Malay Korea China consider additional stimulus if the US economic conditions continue to worsen. Further US easing would likely bring dollar depreciation against major currencies and commodity prices would likely rebound, fueling the risk of further imported inflation in China. As a result, the demand for RMB-denominated assets will remain robust and that should keep CNH bond yields from rising significantly. It appears that decoupling of onshore and offshore bond yields is set to continue.

CNH: decoupling of CNY/CNH bond yields to continue July 18, 2011

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