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Why is tiny Luxembourg key to China’s global plans?

Luxembourg has become a powerhouse when it comes to Chinese dim sum bond listing

An unlikely partnership between China and Luxembourg? The numbers say otherwise.

It might seem curious that China, a country of 1.4 billion people, should even notice Luxembourg’s half a million residents. But since Beijing’s decision to establish the tiny country as one of a few global trading hubs through which the RMB is being gradually internationalised, Luxembourg has emerged as a heavyweight in RMB investment fund administration, dim sum bond listing and facilitating investment into Europe.

Luxembourg has virtually no domestic market and can’t offer the scale of London, Frankfurt and Paris. Despite this, it has carved out a niche as a cross-border problem solver and an international fund hub, largely using the Undertakings in Collective Investments and Transferable Securities (UCITS) brand, which allows investments to be marketed across the EU. The country has also become the leading European renminbi fund centre with 296 billion yuan in assets in domiciled funds at the end of 2014. It is an expert in administering funds centrally before they are distributed cross-border, and is the world’s second largest fund domicile.

“The locations chosen so far [to facilitate RMB internationalisation] have really been driven by trade and bilateral relationships,” said Yang Du, China Desk Head at Thomson Reuters.

A world awash with Chinese yuan

Dim Sum bond
Dim sum bonds are bonds denominated in the Chinese yuan but issued outside of China. The first Dim Sum bond sale took place in Hong Kong in 2007.

Launched in December 2011, the so-called “renminbi qualified foreign institutional investor” (RQFII) scheme initially enabled a small number Chinese financial firms to establish renminbi-denominated funds (dim sum bonds) in Hong Kong for investment into the mainland. After testing the waters, quotas of 50 billion-80 billion yuan were then granted to other jurisdictions in 2013 and 2014 (UK, Singapore, France, Korea, and Germany, with Canada receiving 50 billion yuan in December 2014).

“Amongst all types of international investors, it is clear that the Chinese government wants to open its arms to long-term investors in the domestic market,” said Yang. The scheme has been central to the emergence of an international RMB investment fund market allowing overseas investors to use offshore renminbi deposits to invest in mainland securities.

“We just don’t see other jurisdictions having a similar impact.” – Dariush Yazdani, PwC Luxembourg

While asset managers in some countries have struggled to use their quotas, Luxembourg has provided an outlet. “A German quota applied to German funds can only be sold to Germans, but using Luxembourg’s cross-border model enables these funds to be sold worldwide,” said Chris Edge, Managing Director, of HSBC Bank Luxembourg. In fact, other jurisdictions’ RQFII quotas are being used for Luxembourg funds.

“Already, Luxembourg has a leading position in Europe, as we just don’t see other jurisdictions having a similar impact,” said Dariush Yazdani, partner at the consulting firm PwC Luxembourg. For the most part, the widely-respected, regulated UCITS vehicles are being used for this cross-border work, but there are also some unregulated funds for exclusive use by institutional investors.

Luxembourg-based dim sum bond listing activity is on the move too. The stock exchange has been hosting debt instruments denominated in world currencies since the early 1960s, and has been doing the same with RMB since 2011. “In previous years, it was mainly European corporates raising renminbi, but we are now seeing Chinese banks entering this market,” noted Victor Chan Yin, a partner at the consultants KPMG Luxembourg. Nearly 35 billion yuan was issued in 2014 via 45 listed bonds, double the amount of two years previously. By the third quarter of 2015 the number of bonds had risen to 60. Though relatively small, the numbers mark potential, especially if China-based corporates start seeking European capital. Competition is strong in this market, but even a small share of this potentially major business would be lucrative.

Luxembourg rising

In April 2015, Luxembourg was finally awarded its own quota of 50 billion yuan from the People’s Bank of China. “It was a surprise for Luxembourg to be down the queue because there is massive interest from asset managers of all types,” said Edge of HSBC Luxembourg. Although 50 billion yuan represents around only one hundredth of a percentage point of all fund assets based in the Grand Duchy, supporters are looking to the substantial long-term prize on offer.

Already, China’s six largest banks have (or are soon to have) their EU headquarters in Luxembourg, and the country also made a splash in May 2015, when it was (by a matter of hours) the first non-Asian country to be accepted as a member of the Asian International Investment Bank (AIIB). Seen by some as a rival to the likes of the IMF, World Bank and the Asian Development Bank, it is controversial, and has been opposed by the US government. There is talk of the AIIB’s European office being located in the Grand Duchy.

Other figures also appear atypical at first glance for such a small country – the Grand Duchy was the largest recipient of China’s outward foreign direct investment (FDI) into Europe in 2012 ($8.98 billion U.S.) accounting for one-quarter of all FDI into Europe and nearly half of that into the eurozone. By 2014 the country had attracted the largest pool of RMB deposits in Europe (61.5 billion yuan) and the largest RMB loan portfolios (61.1 billion yuan), according to PwC.

The RMB in Luxembourg

The history of the RMB in Luxembourg begins in 1979

RMB developments in Luxembourg accelerate from 2010-2011

China's Luxembourg dim sum bond strategy unfolds in 2014

Being so small has also given the country a degree of political and economic neutrality, which was a major factor in opening the country to Chinese authorities. “Luxembourg is respected for its open financial environment,” noted Yang of Thomson Reuters. “Chinese banks can benefit from obtaining a full banking licence via Luxembourg and are therefore potentially able to operate their entire business there spanning retail, wholesale and asset management.”

Relaxed immigration policies have also resulted in 80 per cent of the financial sector being staffed by non-natives, allowing organisations to speak to clients in several languages and be sensitive to cultural differences. It is believed that about 1,000 people work in the Luxembourg offices of the big Chinese banks, roughly 3-4 per cent of the country’s banking workforce.

Looking forward

The country’s next step may be been to launch a new fund through the Luxembourg quota, but the prospect has so far hit regulatory hurdles. In particular, the public and private sectors are cooperating to explain EU regulations to the Chinese authorities. Although funds are based and administered in the Grand Duchy virtually all the investment decisions are taken by non-resident managers in Europe and beyond. EU law also allows for third party management companies, which enable asset managers to outsource much of the back office work.

“These concepts are not common in China, so the regulator, the government and industry are working to explain the situation to their Chinese counterparts,” said Valerie Arnold, a partner with PwC Luxembourg. There is confidence that once understood, this model could open interesting possibilities. “Third party management companies could potentially offer access to a quota as a service,” added Chan Yin of KPMG Luxembourg.

Luxembourg hopes that at some stage, its UCITS funds could be sold into China, maybe via Hong Kong. As yet, this prospect is some way off. There has also been a lot of talk about establishing an Asia rival to UCITS. However, China is not part of these discussions and some analysts are skeptical that these discussions will bear fruit.

The moves all appear to be about getting Chinese players comfortable with Luxembourg’s way of working, as well as establishing a market position. For supporters, this summer’s equity and currency market turbulence is largely irrelevant – they’re looking at the long-term potential of investing into the world’s second largest economy.