HSBC Securities Services

A Sovereign Landmark

Anita Fung, Chief Executive Officer of HSBC Hong Kong, discusses the increasing appetite for sovereign debt, particularly in Asia, and the significance of the offshore RMB market in Hong Kong.

Debate surrounding the health of sovereign bond markets has unsurprisingly been raging globally. Driven by Standard & Poor's move on 5 August to downgrade the US sovereign credit rating from AAA to AA+, global equity and bond markets have experienced wide-spread volatility last seen in 2008.

However, the US ratings downgrade is not diminishing appetite for sovereign debt, particularly Asian sovereign debt. In fact, the US ratings downgrade could trigger a healthy diversification by institutional investors to Asia, driven by risk aversion sentiment in the market and an eye on emerging economies. To cater to demand, Asia's sovereign bond market must mature and that catalyst will likely be driven from Hong Kong.

Overshadowed by the US debt ceiling debate and Eurozone debt market issues, Hong Kong observed a landmark anniversary in mid-July - the first birthday of the offshore renminbi (RMB). While official celebrations were quiet, in the context of global bond markets, the significance of this anniversary cannot be understated.

In global financial markets, a lot can happen in a year, especially when China is concerned. Since the creation of the offshore deliverable RMB (CNH) FX market in July 2010, the offshore RMB has flourished and firmly positioned Hong Kong as the global gateway of RMB internationalisation. Its standing is poised to become even more conspicuous with an expanding deposit base and the evolution of the offshore RMB ('dim sum') bond market.

To fully understand the significance of the offshore RMB market in Hong Kong and its maturing status within the international bond market, its first-year achievements must be considered. Comparatively, the RMB deposit base in Hong Kong is in its infancy, but is hardly insignificant. Total RMB deposits stand at RMB550 billion at the end of June. While month-on-month deposit growth moderated in June to 0.9%, total RMB deposits are increasing at around RMB40 billion per month, on average.

HSBC expects Hong Kong's RMB deposit base to grow in the coming months, reaching over RMB800 billion by year's end. As a result, current and the projections of future deposit growth have now created a very real market for enhanced RMB products.

This dim sum bond market represents an encouraging development within the larger RMB internationalisation picture. Additionally, it provides a risk aversion tool for global investors looking to diversify allocations, especially those with a view on RMB appreciation.

Issuer reception to the dim sum bond market has been extremely promising. In 2011 alone, 38 entities issued RMB bonds, excluding certificates of deposit (CD), totalling RMB42.7 billion in Hong Kong, the majority of which are corporate issuers, eclipsing the RMB35.8 billion raised by 16 issuers last year. HSBC estimates that by the end of 2011, the total issuance size of dim sum bonds could reach between RMB180-230 billion.

This target will become more achievable as the dim sum bond market enters its next evolutionary phase this month. On 17 August, China's Ministry of Finance will issue dim sum bonds for the third time in Hong Kong. This issuance is slated to become the most significant offshore RMB bond issuance yet and one of the most significant Asia's landmark sovereign deals in recent memory.

Firstly, the size of the tranche sends a clear message that the China's government wants to widen its sovereign debt issuance beyond its onshore market. At RMB20 billion, the issuance size trumps the Ministry of Finance's two previous Hong Kong deals and will clearly aid in developing an offshore market for government debt.

In its previous sovereign bond issuance in Hong Kong in November 2010, the Ministry of Finance brought RMB8 billion in bonds to the market, of which RMB5 billion were allocated to institutional investors and RMB3 billion for the retail tranche. In September 2009, the ministry sold its first sovereign bond in Hong Kong raising RMB6 billion.

Secondly, the structure of the issuance is also indicative of a maturing market. According to the Ministry of Finance, it plans to sell RMB15 billion worth of bonds with maturities of three, five, seven and 10 years to institutional investors and RMB5 billion worth of two-year bonds to retail investors. The fact that the issuance comprises of RMB sovereign bonds of three-year, five-year, seven-year and 10-year tenors for institutional investors represents a wider range of tenors available previously to cater for diverse risk tastes. The decision to extend maturities will also help set the benchmark yield for RMB bonds in Hong Kong, which needs firming up.

Furthermore, the selection of banks involved demonstrates that the Ministry of Finance is tapping a broader investor base. Breaking with previous protocol, foreign banks, including HSBC, were mandated by the Ministry of Finance to arrange and lead manager the deal. On the previous Ministry of Finance issuances, mainland banks took leadership roles, with the intended investor base coming more from the Hong Kong retail market.

The move to issue on 17 August is a well-timed decision, irrespective of last week's US downgrade and the Eurozone issues. Over the past few months, the sovereign debt space has consistently proven its resilience due to the strength of fundamental credit metrics and the diminished corporate and financial sector supply coming to market.

This landmark deal is also consistent with regional sovereign issuance trends in Asia Pacific and the healthy deal pipeline we expect throughout the remainder of 2011. According to HSBC Research, Asian sovereign issuance in 2011 has already been exceptionally strong, with the USD7 billion year-to-date total already crossing full year targets. Even more significantly, Asian sovereign gross issuance will likely be down approximately USD2 billion from 2010, further highlighting the asset class's lower volatility, which is certainly striking a chord with the global investor space.

Performance of Asia sovereign bonds is also playing to the Ministry of Finance's issuance timing. While the region is hardly immune to global shocks, compared to more mature markets, the economies in Asia generally have lower debt-to-GDP ratios. For example, Korea's debt-to-GDP stands at 32.1% compared to three figure ratios in Europe. Even China's hotly debated debt-to-GDP ratio, officially touted at around 19% by the International Monetary Fund, provides confidence for global bond investors looking for attractive yet safe yields.

So where is this appetite for Asian sovereign debt coming from and will this benefit the Ministry of Finance's upcoming issuance? In our opinion, we anticipate that central banks will look favourably on this China sovereign issuance. Additionally, the Ministry of Finance issuance in Hong Kong will also draw strong orders from more institutional investors and fund managers, many of whom have been aggressively launching emerging market and RMB bond funds.

At a time when the health of global sovereign bond market is under heavy scrutiny from ratings agencies, investors and regulators, confidence in the offshore RMB bond market, as with the Asian sovereign bond space, remains justifiably high. By tapping Hong Kong's capital markets with its largest issuance, the Ministry of Finance has signaled its clear intention to diversify its investor base and we expect investors to respond. This issue will once again send the clear message that the Asia sovereign bond market is healthy and firmly on the radars on investors globally.