Renminbi world denomination — one year on

Almost exactly one year after the first renminbi eurobond, the issue by Hopewell Highway Infrastructure in July 2010, China underlined just how far the market has developed by signing a Rmb20 billion four-tranche sovereign bond in Hong Kong.

If the first few months of the new dim sum bond market were beset by concerns about the depth and liquidity it offered, the success of this Rmb20 billion blockbuster has provided a clear demonstration of the market’s ability now to absorb large-scale issuance.

As if the sovereign bond itself were not a sufficient demonstration of support for the offshore renminbi, the package of initiatives announced after the signing ceremony in Hong Kong by PRC vice-premier Li Keqiang spelt out the continuing importance of the offshore renminbi to China and to Hong Kong. The announcement of the new measures (See “August initiatives” below) was not expected and drew generally warm praise. The opinion column of one Hong Kong newspaper was less impressed: “Li Keqiang is no Santa Claus: Christmas hasn’t come early.” True, but the package is nevertheless a welcome first birthday present!

In a piece published in May, we offered the contention that “offshore renminbi is here to stay: though often referred to as an experiment conducted in China’s convenient offshore financial laboratory of Hong Kong, the political and economic stakes are too high for the experiment to fail or to be reversed”.

Perhaps the most significant aspect of vice-premier Keqiang’s announcement is the very clear message it imparts about the importance to the PRC of the internationalisation project and the political will to see it through.

In two further contentions, we argued that the offshore renminbi must be available worldwide and that a single international financial and settlement centre would greatly help the development of an international capital market in renminbi. The Hong Kong focus of many of the new measures lends support to Hong Kong’s pre-emptive claim to be the premier offshore renminbi business centre.

The measures themselves range from a widely expected expansion of the trade settlement scheme to the whole of China to the announcement of pilot and trial schemes allowing access for mainland investors to Hong Kong listed securities and vice versa. The announcement also promised the establishment of a much-needed formal system for the remittance of offshore proceeds into China.

The package of initiatives will clearly take time to implement and it is only to be expected that some of the proposals will prove easier to implement than others. It is certainly very encouraging to note the brisk progress on matters related most closely to the internationalisation of the renminbi: expansion of the trade settlement scheme is already effective; and the Ministry of Commerce (MoC) published draft regulations relating to the use of offshore proceeds for onshore investment very quickly (See “Formalising onshore use of proceeds: Draft MoC rules” below). The People’s Bank of China (PBoC) is separately working on draft regulations that aim to simplify the onshore remittance.

Dim sum direct?
One of the most exciting initiatives is the brief statement that PRC enterprises will be permitted to issue bonds in renminbi in Hong Kong. The expectation is that direct access to the dim sum market for PRC enterprises will be subject to regulatory approval within a quota — Rmb25 billion for 2011 was the magic number given by the governor of the central bank. Since 2007, PRC banks have, of course, been permitted under a similar quota-controlled scheme to issue renminbi denominated bonds in the Hong Kong market. Extension to other enterprises marks a further significant development in the internationalisation project. At the macroeconomic level, direct issuance facilitates (crucially, within existing capital controls) the flow back into the PRC of renminbi from the offshore pool or the use of the currency by PRC corporates offshore. This helps push along the “virtuous cycle” of currency circulation, promoted so far mainly through the trade settlement scheme, which must be initiated if internationalisation is to work and which is a milestone condition for the smooth introduction of full convertibility.

This development should also allow access to debt capital for onshore enterprises that are increasingly feeling the effects of the crimping of easy credit within the PRC as PBOC battles rising domestic inflation.

The drying up of liquidity onshore is already proving a powerful incentive for PRC enterprises to tap renminbi funds in the offshore market. The absence of any regulatory permission to access the market directly has, as usual, led to the development of “structures” designed to allow access within the existing regulatory framework. We review some of the most common structures below — but as a general comment it must always be desirable in the interests of simplicity and transparency that direct issuance should replace structured issuance in the crevices of which can lurk difficult-to-spot credit and regulatory risks.

Sure it is offshore?
The cleanest and simplest way for an onshore enterprise to tap the offshore market is to issue a bond offshore through a suitable offshore subsidiary, guaranteeing payments through a direct guarantee from the onshore parent. This easy to understand, and internationally common, structure is illustrated in diagram A.

In the event of default by the bond issuer, bondholders have direct recourse on the guarantee to the onshore parent. The credit underlying the bonds is clear. The issue of the guarantee by the onshore parent will need the approval of, and registration with, SAFE. The SAFE approval and registration however provide a legitimate and “safe” channel for the onshore parent, within the existing foreign exchange controls, to remit payments outside China to service its obligations under the guarantee. A variation of the guarantee structure is illustrated in diagram B.

Under this structure, however, the funds raised in the offshore bond issue must remain offshore and it is therefore suitable for use only by enterprises that have offshore funding needs. Further complexities may sometimes need to be tackled relating to the guarantee itself. Current SAFE regulations, for example, largely assume that offshore borrowings and guarantees will be foreign currency denominated and it may well be the case, therefore, that the legal documentation will need to match a guarantee that is regulatorily capped at an amount in US dollars with an obligation denominated in offshore renminbi. Investors are also increasingly demanding an escrow of issue proceeds pending completion of the SAFE registration.

In this scenario, the offshore subsidiary may be unable to issue bonds itself (it is not uncommon for example, for a Hong Kong subsidiary to have been incorporated as a private company). Here the bond issue is pushed one step further down the corporate tree. The bond issuer then lends the proceeds of issue of the offshore bonds to the offshore subsidiary. The credit of the onshore parent is transmitted by guaranteeing the repayment obligation of the offshore subsidiary under the on-loan. The offshore bonds are then secured by an assignment of the on-loan (plus guarantee) and, most likely, by a pledge of the shares of the bond issuer.

The giving of the offshore guarantee raises similar issues to those noted above and, again, the proceeds of the offshore bonds and the on-loan must be retained for offshore use — they cannot, under the regulations that permit the guarantee, be remitted for onshore use. While it achieves its purpose, and has been accepted by investors in the market, it should be clear that this structure requires a considerable increase in the complexity of the legal documentation. Bondholder recourse to the onshore parent is no longer direct under this triple-decker structure but mediated through two offshore entities.

An onshore guarantee is not always available — perhaps the parent has used up its available quota or cannot get SAFE approval in time, or at all for other reasons. Deploying a guarantee also means that use of the proceeds must be supervised offshore by the parent. An alternative, sketched in diagram C is for the onshore parent to provide a keepwell agreement or a letter of support to the offshore subsidiary issuing the bonds.

An advantage for the onshore parent is that, in principle at least, it is possible to repatriate the proceeds of issue, with the appropriate regulatory approvals, in contrast to the offshore guarantee approach in which use of the guarantee effectively precludes onshore use of proceeds. These structures, however, are rather harder to analyse from a credit point of view for the bond investors.

The nature and level of credit support offered by the onshore parent must be carefully reviewed. A “letter of support” may be addressed to bondholders or may be addressed only to the offshore subsidiary issuing the bonds. Either way, the promised support may amount to little more than confirmation that the parent is aware of the debt being raised coupled with a more or less vague reassurance that it will ensure the subsidiary is in a position to service and pay back the bonds.

Letters of support do not under PRC law give rise to enforceable legal obligations. Investors are effectively being invited to purchase bonds simply on the faith of the “name” of the parent. A keepwell agreement, by contrast, is designed to give rise to enforceable obligations but should not be confused with a guarantee. Keepwell agreements vary in form and content, but a typical agreement would be concluded between the onshore parent and the offshore subsidiary: in it, the parent agrees to ensure that the subsidiary will always have positive net assets and if necessary will inject fresh capital to make it so.

The principle is that by this means the subsidiary will always be in a position to service and pay back the bonds. Note, however, that the keepwell agreement is not always directly enforceable at the behest of bondholders; and even if it is, enforcement will be by means of recapitalising the issuer rather than enforcement of amounts due on the bonds.

Holders of bonds supported by an enforceable keepwell agreement should factor in as part of their credit analysis the probable necessity to liquidate the offshore subsidiary and enforce the keep-well agreement onshore through the liquidators. As the letter of support or keepwell agreement does not amount to a guarantee, no SAFE approval is required. However it also means that in order to fulfil its promises, the onshore parent will need to be able source renminbi through its offshore income stream or inject capital into the subsidiary (which is itself subject to the usual PRC approval/registration requirements for overseas investments by onshore entities).

A fourth possibility handily combines aspects of the offshore guarantee and the letter of support structures, as illustrated in diagram D.

In this variation, the onshore parent provides a letter of support or a keepwell agreement, but boosts the credit of the bonds by purchasing third party credit support from an onshore PRC bank. The credit support might be provided in the shape of a guarantee in favour of bondholders or, a device gaining in popularity, by means of either a standby or a direct draw letter of credit. This structure offers quite significant advantages. It provides directly enforceable credit support from a PRC bank. The bank credit may well be better, and better known, than the corporate credit of the onshore parent. This structure also allows, in principle at least, for the remittance of proceeds back onshore. However, specific SAFE approval is now needed for PRC banks to provide offshore guarantees and/or letters of credit for an offshore corporate bond issue. In addition, the rating agencies are yet to come up with a uniform rating methodology in respect of this structure and the issuer itself has substantial assets and liabilities (not usual if the issuer is, for example, a window company of the onshore parent).

It is to be hoped that effective implementation of a channel for direct issuance by onshore borrowers in the offshore renminbi market will not only further the political and economic goals of the internationalisation of the renminbi but will also help limit and provide perspective on some of the borrowing structures that have been developed in the absence of such a direct issuance channel. However, until the channel is made available, the perfect storm of pent-up supply from onshore issuers starved of credit and desperate desire from offshore investors to deploy their offshore renminbi mean that we will probably continue to see further “innovations” being made and new “alternative” structures being deployed.