CNY trade settlement volumes are increasing， and the pilot programme has been expanded

Regulatory complexity is an issue as different localities issue different guidance

Hong Kong has moved to allow more local CNY products and will likely become the key offshore CNY centre

Chart 1: Breakdown of Guangdong's CNY trade settlement volume by type of transaction

(Total cumulative volume for Jul-09 to Jan-10 = CNY 5.66bn)

Source: The Finance Affairs Office of the Guangdong Province

Chart 2: Breakdown of Guangdong's CNY trade settlement volume by cities

(Total cumulative volume for Jul-09 to Jan-10 = CNY 5.66bn)

Source: The Finance Affairs Office of the Guangdong Province

It ain't easy replacing the US dollar. Some see the Chinese yuan (CNY) as the imminent replacement of the US dollar (USD) as the world's dominant reserve currency. However， those involved in the CNY's first forays overseas as a means of invoicing and payment for cross-border trade have known from the start that this process will take some time. Nine months into the CNY trade settlement pilot scheme， this seems like a good time to report on the progress and examine the outstan-ding challenges.

The idea is simple: encourage firms to use the CNY as their invoicing currency， and then set up the systems to allow trade payments to be made in CNY. Two locations in China - Guang-

dong province and Shanghai - were selected to take part in Phase 1. Hong Kong has taken the lead offshore， and some ASEAN countries are also involved. Given the size of China's cross-border trade and the attracti-veness of the CNY， one would have expected this scheme to grow rapidly. But you might be surprised at how many systems (both within companies and for international payments)， laws and regulations， and tax practices need to be altered in order for this to happen on any significant scale.

Since the experiment began in July 2009， the broad rules have been clarified and some restrictions have been relaxed. In recent months， the pace of the increase in cross-border trade volume settled in CNY has clearly picked up. Yet challenges remain. Invoicing behaviour is difficult to change - firms need a good reason to change their habits. It is easiest to switch to CNY settlement for trade between related companies - and we believe this should be further incenti-

vised. While the programme's experi-mental approach creates space for innovation， each mainland pilot city or province has issued its own guidelines， and Hong Kong has now come up with its own guidance as well. So it gets complicated quickly.

In this report， we aim to show the 'big picture' of the CNY trade settle-ment pilot scheme by piecing together key recent developments， organised around five questions and answers.

1.How has the pilot scheme performed so far?

Data on CNY trade settlement volume is limited; no one reports it on a regular basis. The general perception is that settlement under the scheme has been underwhelming so far， but we believe the momentum has picked up recently after a slow start.

According to the Hong Kong MonetaryAuthority (HKMA)， the vo-lume of CNY trade settlement - pre-sumably between Hong Kong and the mainland - reached CNY 378mn (USD 55mn) in November 2009 and CNY 1.36bn in December. This followed a cumulative amount of only CNY 115mn between July and October 2009. The number of Hong Kong-based institu-tions engaging in CNY trade settlement increased to 52 in Q4-2009 from 32 in Q3.

The momentum continues to build. People's Bank of China (PBoC) Deputy Governor Su Ning stated recently that the cumulative volume had surpassed CNY 10bn at the end of January and CNY 11.6bn by the end of February (which was a slow month for trade due to the Chinese New Year holiday). The Finance Affairs Office of Guangdong province reported a cumulative volume of CNY 5.66bn through mid-February for the province， which amounts to 52% of the national total. The Shanghai authorities have said that the city's CNY trade volume was CNY 2.1bn in 2009.

The national total of CNY 11.6bn worth of CNY invoicing accounts for only 0.1% of China's total trade over the period， or 0.25% of the total trade of Shanghai and Guangdong. Similarly， Guangdong's CNY 5.66bn was only 0.2% of the province's total trade. These are small numbers， but the amount of CNY trade seems to be picking up every month. This may be partly due to the general improvement in global trade. But we think the expanded scope of the scheme is the main driver of increased volume.

2.How has the programme's scopeexpanded in the past nine months?

On the face of it， the scope of the pilot scheme has not changed much， although this is clearly set to change:

The number of mainland desig-nated enterprises (MDEs， ormainland enterprises eligible for the scheme) has been kept at around 400 since day one. However， this will soon change: Guang-

dong is reported to have submitted a second batch of MDEs， numbering more than 3，000， for PBoC approval， and has started the selection process for the third batch.

There are still only five pilot cities (Shanghai， Shenzhen， Guangzhou， Dong-guan and Zhuhai). There is much demand， though. Heilongjiang province in north east China， forinstance， is eportedly seeking approval to conduct CNY trade settlement with Russia.

Having said that， thePBoC has in fact expanded thescheme in several ways:C N Y invoicing is nowapplicable for cross-border trade in services rather than just goods.

The PBoC is considering allowing certain Chinese importersnot on the MDE list to participate. Why only importers? Apparentlybecause of the simpler settlement operationsinvolved (on theexport side， there are compli-cated export tax rebate implications).

The number of overseas counter-parts has been expanded beyond Hong Kong， Macau and ASEAN to all other geographical areas， as long as there is a justifiable need (the PBoC decides on this on a deal-by-deal basis). Standard Chartered facilitated a China-South Korea settlement transaction earlier this year.

It appears that the CNY is also starting to be used for selective capital account ransactions. Hong Kong Chief Executive Donald Tsang mentioned in December 2009 that Beijing would explore the use of the CNY for project financing and for direct investment in Hong Kong.

Charts 1 and 2 show the break-down of Guangdong's CNY trade settlement numbers. Note the following:

The much larger share of imports than exportst

The sizeable share of trade in ser-vices

The participation of non-pilot cities

A small slice for \"outward direct investment under the capital account'

3.What has the HKMA done recently to facilitate the programme?

The HKMA issued a clarification in February of what firms in HongKong can and cannot do under the pro-gramme. This was a big positive， in our view， for the following reasons:

3.1 Hong Kong banks' lives got easier. Before February， they needed to check that every CNY trade transaction was in accordance with mainland rules. Now this burden has been shifted to the mainland authorities and banks. Banks in Hong Kong now need only process CNY trade transactions as they would any other transactions - manage credit risk， guard against money laundering， etc. This change reduces the risk that a Hong Kong bank will reject a CNY trade transaction on account of regulatory risk.

3.2 The HKMA clarified the principles governing the use of CNY fundsthat flow into Hong Kong via trade transactions. Specifically， participa-tingbanks can now \"develop [CNY] business based on the regulatory requi-rements and market conditions in Hong Kong， as long as these businesses do not entail the flow of [CNY] funds back to the mainland\". The positive here is that Hong Kong banks can nowdevelop CNY products in Hong Kong without having to apply for permission from Beijing each time. The downside is that some Hong Kong corporates operating in the mainland would like to be able to use CNY sourced from Hong Kong， and this cross-border f low， while not completely banned， now needs to be approved on a case-by-case basis.

3.3 The HKMA has allowed an expansion of CNY business in Hong Kong， as follows:

CNY bonds: The range of eligible issuers， issuance arrangements and investors can now be determined in accordance with the applicable regula-tions and market conditions in Hong Kong.

Lending: Banks can now extend CNY loans or financing to local corporate customers. Banks in Hong Kong have been aggressively pushing CNY trade financing of late， by establishing pricing benchmarks of their own and offering interest rate discount promotions.

Deposit-taking: The ability to open CNYaccounts in Hong Kong has been extended to all corporates that have merchandise and/or services trade needs with the mainland.

These moves should lead to greater use of the CNY in Hong Kong， which， over time， should increase the currency's circulation in the banking system and incentivise the switch to CNY invoicing.

4. How do 'non-resident ac-counts' for offshore companies fit in?

In December 2009， the PBoC-began allowing offshore companies to open so-called 'non-resident accounts' in the mainland. The idea is to create another outlet for CNY funds received from trade transactions which would otherwise be stuck in offshore markets. These accounts also give overseas companies with limited access to CNY banking services (e.g.， CNY account opening) in their home countries an additional channel through which to conduct CNY trade settlement.

Non-resident accounts can curren-tly only be opened in Shanghai， Shenzhen and Guangdong. What they can be used for varies significantly from city to city， and many of the regulations are still quite broad and are subject to further clarification. In Guangdong， the non-resident account (NRA) system works like this:

Chart 3: China's exports to ASEAN have undergone phenomenal growth

Export value by destination (inde-xed: Jan-1997 =100)

Sources: CEIC， Standard Chartered Research

AlthOugh thE CurrENt

level of CNY traNsaCtioNs is small， we are startiNg to see more， iNCludiNg a few iN reCeNt weeks with CouNtries like siNgapore.

First， an offshore company that has CNY funds in its offshore accounts (whether from export receipts or via trade financing) can remit them to its same-name onshore NRA in mainland China. It can thereby enjoy higher deposit rates (onshore CNY interest rates are higher than offshore ones， which arenow less than 0.86%， the interest rate participating banks get when they place their CNY liquidity with the Hong Kong clearing bank). An NRA can take the form of a current or savings account; in Guangdong， fixed deposits are also allowed.

Second， CNY trade settlement can be done through an NRA. Anoffshore exporter can ask its mainland coun-terpart to pay CNY directly into its NRA. In Guangdong， exporters are allowed to remit some or all of their proceeds back to their offshore same-name CNY accounts. Offshore importers can remit their offshore CNY deposits to their same-name NRAs in the mainland， and use the funds to pay their mainland counterparts. The NRA allows trade financing in CNY， and the balance in the NRA can be pledged for the company's offshore financing.

The catch is that CNY funds in the NRA cannot be used for purposes other than trade settlement. Funds need to be remitted out of the NRA (if allowed) before they can be converted into other currencies. An offshore company can only open one NRA in Guangdong province， and it can settle trade with both MDEs and non-MDE importers located in the same province as the NRA. Whether it can settle trade with firms outside of Guangdong is less clear.

5.Does CNY invoicing work

differently outside China and HongKong?

China's trade with ASEAN is growing fast， as Chart 3 shows. The China-ASEAN Free Trade Agreement came into effect in January 2010 and will drive further integration. Although the current level of CNY transactions is small， we are starting to see more， including a few in recent weeks with countries like Singapore.

As far as we can tell， China-ASEAN CNY invoicing works pretty much the same as CNY invoicing between China and Hong Kong. The mainland rules that determine the scope of the pilot scheme with ASEAN are the same as those explained under Question 2 above. For example， ASEAN firms deal with firms on the MDE list， and all remittances require trade document backing. In theory， ASEAN companies can open NRAs in the mainland and， under the HKMA clarifica-tion， can issue CNY bonds in Hong Kong. To make it work， participating banks in ASEAN， like those in Hong Kong， need to open a 'nostro' account with either the clearing bank in Hong Kong - which is Bank of China (Hong Kong) - or one of the agent banks in the mainland.

According to the HKMA， the number of overseas banks that have signed the clearing agreement with the clearing bank in Hong Kong rose to 15 in Q4-2009 from two during the previous quarter.

The main difference with CNY invoicing between Hong Kong and mainland China is that participating banks in ASEAN can offer very limited non-trade CNY services to CNY deposit holders. This is because of the lack of CNY liquidity in ASEAN. For example， an ASEAN exporter being paid in CNY has only two choices: leave the funds in its local CNY account and earn a little interest， or convert the funds into its local (or another foreign) currency.

In theory， ASEAN exporters can also open offshore CNY accounts in Hong Kong and conduct CNY trade settlement there if they want to use the CNY receipts to， say， buy CNY bonds in Hong Kong.

Summary

In contrast with the lukewarm re-ception some think the CNY pilot scheme is receiving， much has in fact happened since its launch. Not only havevolumes picked up in recent months， but we have seen considerable progress on the regulatory side too. Some restrictions have been relaxed， allowing for more experimentation. That said， things are also getting complicated quickly.

While ASEAN is involved in the pilot programme， Hong Kong has clearly pushed forward on a number of fronts and is eager to establish itself as the main offshore CNY market. Rising competition for CNY trade financing among local banks has already driven CNY lending rates lower (though there is still some debate abouthow such products should be priced， given the lack of an offshore CNY interest rate curve). We look forward to the intro-duction of more CNY-denominated investible assets in Hong Kong. As that happens， Hong Kong will likely become a CNY fundraising and investment hub for many regional corporates once holdings and use of the CNY outside Hong Kong become more widespread.

(author: standard Chartered Bank， hong kong regional economist )