With foreign companies establishing and expanding their China-facing operations, a growing number of RMB products are becoming available to investors including, for the first time, mainland-registered Yuan-denominated assets.

The evolution of China’s financial markets is heavily dependent on greater currency liberalization. But while government officials have long acknowledged this, previously implemented reforms have generally lagged behind strong demand for deeper and more diverse investment options. Now, with Hong Kong and other cross-border renminbi markets taking shape, the first flowering of similar mechanisms within China itself suggest that the trend of gradual expansion of financial markets supported by controlled currency deregulation is likely to continue.

While inflationary pressures and the inefficiency of capital investment in the Chinese economy continue to cause concern, investor sentiment on the emerging giant seems largely undiminished. Last year, fixed asset investment was up 23.8%, while foreign direct investment rose 17.6%, including 30% growth in service sector FDI. The presence of foreign entities throughout the financial sector has expanded, and 2010 saw yet more high-profile players boost their China operations and enhance their investment suites.

The RMB’s function as a currency for international trade is expanding rapidly. The number of value RMB cross-border transactions carried out in 2010, the first full year in which such transactions were possible, topped 500 billion. This growth looks set to continue as the government has just announced it is expanding the trade settlement scheme nationwide.

Evidence suggests the gradual appreciation of the RMB is continuing. Since Beijing loosened its crawling peg last June, the RMB has risen 4% against the dollar. Data compiled by Bloomberg this month suggests that trading of twelve-month non-deliverable forwards reflects market opinion that the currency will strengthen a further 2.5% from its current spot rate by year end.

Market sentiment and the increasing internationalization of the RMB is also driving in a growing appetite for RMB-denominated investment products of all kinds. Following the loosening of restrictions, the value of RMB deposits in Hong Kong rose by 250% last year. In HSBC Singapore’s RMB savings suite attracted over 1 billion RMB in its first month, and DBS, which already offers a RMB bond fund in Hong Kong, recently launched offshore renminbi (CNH) structured notes and unit trusts for private banking customers.

The National Development and Reform Commission, the country’s top planning authority, has also given its support to the further expansion of Hong Kong’s role as an RMB-trading center. Bank of China (Hong Kong) recently announced it will offer securities repurchasing and lending facilities to facilitate intraday liquidity management for banks in the cross-border RMB clearing system. This opens the door for further RMB products in Hong Kong, including a possible move towards RMB-denominated IPOs on the HKex.

Private equity products are also multiplying. Reports this week suggest the latest PE firms to consider setting up a China fund is UK-based 3i. Meanwhile, a former D.E. Shaw partner and Greater China CEO has teamed up with a former co-head of Goldman Sach’s Asian Special Situations Group, to launch their own investment firm. The pair, Meng Liang and Kevin Zhang, are thought to be launching a new investment house and are seeking around $500 million to place in China.  In February, the government sanctioned China’s first

However, if 2010 was year zero for greater cross-border RMB mobility and the entrenchment of offshore markets, 2011 may prove to hold the same significance for foreign access to RMB-denominated assets on the mainland itself. The Qualified Foreign Limited Partner (QFLP) scheme being piloted in Shanghai - with rumors of a Beijing equivalent to follow shortly - allows foreign entities to become LPs in mainland funds for the first time.

QFLP has relatively stringent entry criteria. Applicants must hold at least $500 million assets owned or $1 billion assets under management, have experience of investing in China, and no regulatory penalties worldwide. It is open to foreign sovereign wealth funds, pension funds, endowment funds, charitable funds, funds of funds, insurance companies, banks and securities companies. While still a tentative measure, QFLP is the first of several such schemes muted by the government to reach pilot stage, and media reports suggest it could soon be extended to Beijing.

Although details have yet to be confirmed by the State Administration for Foreign Exchange (SAFE), a report by China Law and Practice magazine states participants will receive a quota of RMB which can be converted into foreign currency. This capital will be maintained by qualified domestic bank, and its allocation subject to regulations. The move means foreign private equity can now invest RMB in the PRC without the need for domestic limited partners such as the state pension fund or local government.

Taken together, these developments suggest the Chinese government is actively exploring ways of expanding domestic capital markets and the role of foreign investors within them. The potential of China’s financial sector has been well documented, but the pace of market-orientated reforms has slowed in recent years.

Now, however, a new generation of policy makers is emerging – China’s leadership transition involves not only a changing of the political guard, but also a major shake-up of personnel in the influential sector-specific regulatory bodies tasked with leading economic modernization. Initial indications suggest that, in the financial sector at least, policy makers are experimenting with multi-directional reforms aimed at improving the efficiency and diversity of capital allocation in China.

With the 12th Five-year plan now in place, moves towards greater convertibility of the RMB and a growing array of investment possibilities available to foreign entities suggest this trend will continue, and foreign partners will play an important role in the deepening and diversification of China’s financial markets.

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