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China’s Economy

1

1ew developments in the “Panda bond” market

An examination of the current status of Panda bonds

apropos their use as an alternative source of renminbi

funding by Japanese corporations

In October, the Hong Kong and Shanghai Banking Corporation (HSBC) and the BANK OF CHINA (HONG KONG) each issued Panda bonds. Panda bonds refer to renminbi-denominated debt securities that are sold on China’s domestic market by non-residents.1 The Chinese government has advocated a phased approach to the issuance of Panda bonds to date but appears to be working to accelerate enlarging the range of issuers as its markets become increasingly open on the back of ongoing renminbi internationalization. This report examines the current status of the Panda bond market bearing in mind its potential to open up as an alternative source of renminbi funding for Japanese corporations in the future.2

1. Panda Bonds – An Introduction

There are various methods of renminbi-based financing open to global borrowers, including China’s onshore (domestic) and offshore markets, direct and indirect financing (Fig. 1).

Fig. 1: Currently available options for renminbi-based financing

Onshore Offshore

Indirect financing

 Domestic renminbi-denominated (CNY) loans

 Loans are extended by a mainland bank.  With a locally-incorporated subsidiary as

borrower

 Lending interest rates are subject to People’s Bank of China (PBOC) base rate influence.  Various restrictions apply, including a limit

of one credit line per group/corporate, etc.

 Renminbi-denominated offshore (CNH) loans

 Loans are extended by banks outside mainland China (with the funds brought onshore by the borrower).

 Borrowers are non-Chinese corporate entities, e.g. a Japanese parent company, etc.

Direct financing

 Mainland (domestic) bonds

 Bonds are issued on the mainland bond market.

 Issuers are locally-incorporated subsidiaries (i.e. residents).

 Offshore renminbi-denominated bonds  Renminbi-denominated bonds that are issued

on an offshore market, such as Hong Kong, including Dim Sum bonds (issued in Hong Kong) and Formosa bonds (issued in Taiwan), etc.

 Issuers are non-Chinese corporate entities, e.g. a Japanese parent company, etc.

 Panda bonds

 Bonds are issued on the mainland bond market.

 Issuers are non-residents (i.e. a Japanese parent company, etc.).

Source: Prepared by Ken Muramatsu.

1 Note that, whilst Panda bonds are collectively referred to as “international bonds” in some supervisory authorities in China, the term “Panda bonds”

is applied throughout this report.

2 For more detailed information on Panda bonds, readers are referred to two articles by this author: “China removes ban on Panda bonds” (Mizuho

Capital Markets Insight, Vol.13-3, February 14, 2014) and “The establishment of a renminbi-denominated debt securities market” (Mizuho Capital Markets Insight, Vol.14-3, November 5, 2014).

The establishment of a renminbi-denominated debt market: http://www.mizuhobank.co.jp/corporate/world/info/cndb/rmb/pdf/rmbbond.pdf Ken Muramatsu

Securities Division’s Research Team Mizuho Bank, Ltd.

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In the beginning, indirect onshore financing (in the form of loans) was the principal channel to renminbi-based financing, but the ongoing internationalization of the renminbi plus other factors is now opening up the possibility of direct offshore financing. Specifically, direct financing in the form of bond issues on China’s domestic (mainland) bond market reached USD 5.2 trillion at the end of 2014, making it the third-largest bond market in the world, whilst issues of Dim Sum bonds and other offshore renminbi-denominated debt securities are growing at a tremendous rate, both in quantitative and geographical terms. On the other hand, there have only been seven issuances of Panda bonds, and the action is late.

Panda bonds fall into the category of direct onshore renminbi financing and, as mentioned earlier, are issued by non-residents on China’s domestic (mainland) bond market. In saleability terms, Panda bonds are comparable to the Samurai bonds (i.e., yen-denominated bonds that are issued on Japan’s bond market by non-Japanese issuers).

The first Panda bonds were issued in 2005 by the International Finance Corporation (IFC) and the Asian Development Bank (ADB).3 These international development financial institutions have issued bonds on onshore bond markets around the world with the strategic aim of cultivating the money and/or capital markets in these countries, and their Panda bond flotations should be viewed as part of this strategy.4 In response to the IFC and ADB issues of Panda bonds, the Chinese government formulated the Interim Measures for the Administration of

the Issuance of RMB Bonds by International Development Institutions5 in 2010, which prepare the legislative

grounds for regulating Panda bond issues by international development financial institutions.

In March 2014, German car manufacturer Daimler AG (Daimler) became the first private corporation to issue Panda bonds. HSBC and BOC Hong Kong also won approval to issue Panda bonds in September amidst lively discussions as to whether to include the renminbi in the International Monetary Fund’s (IMF) Special Drawing Rights (SDR) basket.

Japanese companies have had little need to access renminbi financing in the current conditions, but given the growing scope for renminbi utilization in light of the size of China’s markets and the business opportunities available therein, and the ongoing internationalization of the renminbi, a broader base for renminbi financing could well become a more pressing issue for Japanese companies, too. Panda bonds, which give issuers using parent company credit access to the renminbi financing that is available on mainland China, where liquidity of abundant renminbi is needed, have the potential to serve as an effective financing tool for Japanese companies.

The following paragraphs offer a review of the Panda bond issues by Daimler and the HSBC and BOC Hong Kong, and examine the challenges facing Japanese companies in tapping into this channel to renminbi financing.

3 Following the issue in 2005, the IFC issue took place in 2006, and the ADB issue in 2009.

4 For example, the ADB was the first issuer of Samurai bonds in Japan (in 1970), whilst the second issuer was the International Bank for

Reconstruction and Development (part of the World Bank Group; 1971).

5

People’s Bank of China, Ministry of Finance, National Development and Reform Commission, China Securities Regulatory Commission Announcement [2010] No. 10

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Fig. 2: Panda bond issues to date

Amount of issue

(RMB/billion) Terms approval date Term (years) Interest rate (%)

IFC 1.13 October 10, 2005 10 3.40 ADB 1.0 October 13, 2005 10 3.34 IFC 0.87 November 10, 2006 7 3.20 ADB 1.0 December 4, 2009 10 4.20 Daimler 0.5 March 14, 2014 1 5.20 HSBC 1.0 September 29, 2015 3 3.50 BOC (HK) 1.0 September 29, 2015 3 3.50

Source: Prepared by Ken Muramatsu from various materials.

2. Daimler’s Panda bond issue

In March last year, German car maker Daimler AG became the first private corporation to issue Panda bonds. Specifically, it sold a one-year RMB 500 million bond at an interest rate of 5.2%. The interest rate was lower than the average rate on bonds issued during this period by leading state-owned enterprises, making the Daimler issue an advantageous finance in relative terms.

The Chinese government’s intention in approving the Daimler Panda bond issue is seemingly to open the domestic bond market to a non-resident issuer with sophisticated behavior in the expectation that this will facilitate the maturation of the local bond market and allow the issuer to serve as a medium for financial business growth in China. An official visit to Germany by Chinese president Xi Jinping at the end of March that year is also believed to have played a significant role in the decision to approve the Daimler issue.

At the same time, the Daimler Panda bond issue raises a number of issues, of which (1) accounting standards and (2) foreign debt management are of particular importance in terms of the utilization of this renminbi financing channel by Japanese corporations.

Looking first at the issue of accounting standards, Daimler prepares its financial statements in accordance with the International Financial Reporting Standards (IFRS), and the Chinese government had already recognized the IFRS as being equivalent to the People Republic of China Generally Accepted Accounting Principles (PRC GAAP). The company simply appended an explanation of the differences between the two sets of reporting standards when the company made its disclosure for the Panda bond issuance, thus obviating the need to reinterpret existing consolidated financial statements on the basis of Chinese accounting standards.

In terms of foreign debt management, the problems of issuing Panda bonds are clear. In practical terms, funds raised through Panda bonds are Chinese domestic funds, but the Chinese government handles them as “external debt” that is extended (in the form of Panda bonds) by a parent company to its Chinese subsidiary. Accordingly, where the parent company as issuer extends a loan (in the form of Panda bonds) to its Chinese subsidiary to meet the renminbi financing needs, such funds will misappropriated into the foreign debt quota of the Chinese

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subsidiary.6 Daimler’s Panda bond issue is believed to form part of fundraising efforts on behalf of its auto financing subsidiary in China, which has a massive need for renminbi financing, but since the use of foreign debt is banned under China Banking Regulatory Commission (CBRC) rules, by which Daimler’s auto financing subsidiary is governed, Daimler was seemingly unable to use the renminbi that it raised through the issue of a Panda bond to extend a direct loan to its China-based auto financing subsidiary.

The use of Panda bonds by Japanese corporations as a channel to renminbi financing thus bears considering in light of Daimler’s recent experience. In the first instance and with regard to accounting standards, the Japanese Generally Accepted Accounting Practice (J GAAP) and the Generally Accepted Accounting Principles of the United States (U.S. GAAP) that are used by numerous Japanese corporations as the basis for financial statement disclosure are not recognized in China, meaning that any Japanese corporation seeking to issue Panda bonds will need to be reporting in accordance with the IFRS. Secondly, insofar as the funds of a Panda bond issue continue to be treated as foreign debt, there is little evident difference between this and an offshore issue of renminbi-denominated debt, which involves a relative simple issuance procedure to organize in terms of foreign debt management, which basically means that corporations lack any incentive to issue Panda bonds. This matter also requires careful consideration given that many corporations (i.e., non-financial) with a foreign debt quota reserve this quota for procuring financing from overseas for emergencies. Moreover, auto financing companies, which are governed by the CBRC, tend to be alert to any expansion in the channels to renminbi financing in light of their relatively insatiable demand for renminbi, but since such companies are not allocated a foreign debt quota, the renminbi funds obtained from a Panda bond issue cannot be utilized by the Chinese subsidiaries of such companies. Given this, the use of Panda bonds as a means for raising renminbi finance by Japanese corporations is likely to hinge on the potential to utilize J GAAP and U.S. GAAP for the treatment of domestic debt within China’s foreign debt administration framework.

Fig. 3: The terms of Daimler’s panda bond issue

Issuer Daimler AG

Type PPN (Private Placement Note)

Currency CNY (renminbi)

Term 1 year

Amount RMB 500 million

Interest rate (p.a.) 5.2%

Value at par RMB 100

Issuer rating AAA (credit rating in respect of Chinese bonds)

Lead-managing underwriter

Bank of China

Date of issue March 14, 2014

Investors Five leading banks (primarily)

Source: Mizuho Bank research

6 Under Chinese rules on foreign debt administration, where a Chinese subsidiary takes on foreign debt via a loan from the parent company, etc., such

debt falls within the scope of its foreign debt quota (or the difference between its total investment and its registered capital), and must be registered, in total, with the State Administration of Foreign Exchange (SAFE).

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3. The HSBC and BOC Hong Kong panda bond issues

The HSBC and BOC Hong Kong issued Panda bonds in September and October, respectively, and against this backdrop of events. Clearly, this latest development is closely linked to the discussions of the inclusion of the renminbi in the IMF’s basket of SDR.

The SDR was created by the IMF in 1969 as a means of supplementing the foreign currency reserve assets of member countries; today, the basket comprises the euro, the Japanese yen, pound sterling, and the U.S. dollar. The composition of the SDR basket is reviewed every five years (by the IMF’s Executive Board), with the latest review scheduled to take place this year (2015). The Chinese government views the renminbi’s inclusion in the SDR basket as an indication of its eligibility to serve as a global reserve currency, and is unlikely to tolerate a decision by the IMF to push back SDR inclusion for the renminbi in anticipation of another bid by China to win recognition for the renminbi as a reserve currency in 2020. According to media reports, the Chinese government is thus actively pushing for the IMF to include its currency in the SDR basket.

There are two criteria for SDR basket inclusion: The export criterion, which assesses the “volume of trade” (specifically, the value of exports of goods and services over a five-year period), and the “free usability” criterion, though it is the latter criterion that is likely to be disputed by the IMF Executive Board in its latest review. The opening of China’s capital markets is critical to demonstrating the “free usability” of the Chinese currency, thus prompting the assumption that the Chinese government sees the opening of its Panda bond market as good PR in its bid to win SDR inclusion. The IMF is expected to make its decision on the inclusion of the renminbi in the SDR basket by the end of the year, suggesting that the timing of the recent Panda bond issues (September/October) was scheduled with the IMF’s review in mind.

It is worth noting that the selection of Hong Kong-based companies as issuers is believed to have been made based on the equivalent between mainland regulations and those in force in Hong Kong. The accounting standards issue, as commented above on the Daimler’s issuance of a Panda bond, are expected to pose hurdles for audits and other matters, not only for disclosure requirements. Given that the decision by China’s financial regulators to approve as issuers affiliated companies that are based in Hong Kong, where institutional arrangements guarantee to remain closest to those on the mainland, was made in light of the IMF’s impending review of its SDR basket, it should be seen as quite rational. Moreover, the fact that the two latest issuers selected within a limited amount of time are financial institutions is being viewed as a combined bid to establish the need for renminbi financing coupled with the relatively strong creditworthiness of the issuers and their experience with bond issuance process.

Looking ahead, attention is likely to focus on the whereabouts (destination) of the renminbi funds of these latest Panda bond issues. Foreign financial institutions on the mainland do not have flexible use of their foreign debt and the parent company’s use of renminbi funds to extend loans to a mainland subsidiary is expected to prove impossible in practical terms. Given this, HSBC will be the one to watch over the coming months.7

7

With regard to BOC, it has been reported that the bank will use the renminbi funds of its Panda bond issue by the Hong Kong unit to fund its overseas business operations.

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In light of the possibility of SDR inclusion for the renminbi, the Chinese government has a powerful incentive to encourage more foreign borrowers to issue Panda bonds, and it is expected that the issue of Panda bonds will continue. China generally uses pilot projects as a test bed for the drafting of various rules. Currently the only law (administrative regulations) governing the Panda bond issuance process concerns international development financial institutions, suggesting that China will now begin the process of developing the necessary regulatory system for non-financial corporate issuers and clarifying the various rules, such as issuer criteria.

4. A summary of the current situation apropos the use of Panda bonds as a source of renminbi funding by Japanese corporations

This final section summarizes the current situation concerning the use of Panda bonds as channel to renminbi financing by Japanese corporations.

Whilst Japanese firms currently have little need to secure renminbi financing, there is a strong probability that a need for widening the channels to such financing will pose a financial challenge at some point in the future, given the size of the Chinese markets and the business opportunities they represent. Panda bonds give international issuers a means of using parent company (head office) credit, as opposed to the credit owned by a China-based subsidiary, to tap into the abundant liquidity available in China’s mainland capital markets, which, given China’s economic and financial environment – the expected growth of institutional investors on the back of the nation’s current account surplus and the development of social welfare systems – and the ongoing internationalization of the renminbi, is expected to serve as a strategic means of raising renminbi finance.

The hurdles to Panda bond issuance by Japanese corporations are high, however. Although the number of Japanese companies that have adopted the IFRS is on the increase, many continue to use J GAAP and/or U.S. GAAP, meaning that disclosure requirements pose one hurdle. Another hurdle not addressed in this report is the practical side of the Panda bond issuance process, including audits, credit ratings and the need to provide Chinese translations of relevant documents, which apply in respect of IFRS-conforming companies as well. Again, as explained above, Chinese rules on foreign debt management constitute a third hurdle to Panda bond issues. Whilst companies other than auto financing companies have the option of using their foreign debt quota in the form of loans extended by the parent company, etc., the unattractiveness of this option and the difficulties of responding flexibly are likely to prove problematic.

There have been signs of a resumption of dialogue between Japan and China in this year. A second summit meeting has taken place most recently, and in June Chinese and Japanese finance ministers met in Beijing for discussions. Moreover, the recent G20 summit saw Japanese finance minister Taro Aso put his request for RQFII status and the establishment of a renminbi clearing bank for the Tokyo market to Chinese finance minister Lou Jiwei. The importance of China to the Japanese economy is unquestionable and, as efforts to narrow the political distance between the two nations continue, Panda bond issues are likely to take on greater significance for Japanese corporations. Many hurdles remain and their resolution is expected to necessitate tricky institutional

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reform. The hope is that private-public initiatives can be brought into play to resolve the various challenges.

Caution

1. Legal or accounting advice: The information included in this material does not contain any advice on respective professional advisors.

2. Confidentiality: The information included in this material is disclosed to you on the premise of your confidentiality obligation, and should be used for internal purposes only. Disclosure of the contents herein to a third party is prohibited. 3. Copyright: Copyright of the information included in this material belongs to the bank, in principle. You are prohibited to

make a copy of, make a reproduction of, quote, reprint, translate, loan, or in any way exploit the content of this material in part or in whole, by any means, for any purpose, without our permission.

4. Indemnity: The information included in this material is obtained from various sources that the bank believes are reliable. However, the bank shall not guarantee its correctness, trustworthiness, or integrity. The bank shall also not be liable for any damage, whatsoever, arising from this information.

5. This publication is not deemed to constitute advice, solicitation or recommendation to sell financial assets.

6. This document is a translation of the Japanese original, and the original will take precedence in the event of any difference between the two versions.

References

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