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With $79 billion of yuan deposits as of April 30, Hong Kong is the largest repository for China’s currency outside of the mainland, and the only place the yuan is commonly used or traded that is free from Beijing’s strict capital controls.

According to Wall Street Journal’s Peter Stein, Hong Kong will let Chinese officials test how the yuan can function in an international setting, helping them prepare for the day when China lifts its restrictions and the currency becomes widely convertible.

Though part of China, Hong Kong’s legacy as a British territory means it has its own laws, its own political system and its own currency, which is freely convertible and pegged to the U.S. dollar. But at the same time, banks in Hong Kong issue billions of dollars of yuan bonds and recently underwrote the first yuan-denominated share offering to take place outside of Shanghai or Shenzhen.

“Hong Kong is geographically, culturally and transactionally closer to China” than any other financial center, says Donna Kwok, Greater China economist at HSBC Holdings PLC.

Many Hong Kong residents keep at least some of their wealth in yuan, also called the renminbi, motivated largely by expectations that it will continue to strengthen against their own currency, which earns nearly zero interest in Hong Kong bank accounts. Like the greenback, the Hong Kong dollar has been weakening against many other global currencies.

“Obviously, I think [the yuan] is going to rise in value,” says David Lau, a 35-year-old investor who says he keeps about 10% to 15% of his bank deposits in yuan. “I have some cash, and I don’t want to see it eaten up by inflation.”

Hong Kong residents have had special rights to exchange their currency for yuan since 2004, and other measures since then have helped gradually broaden the currency’s usage within the territory.

Mainland Chinese tourists, for instance, are encouraged to buy gold jewelry and luxury handbags in shops using yuan instead of Hong Kong dollars. But the biggest changes took place last year, pushing the market into high gear.

Among other things, businesses and individuals in Hong Kong were freed to transfer yuan funds between bank accounts without going through any intermediaries. That meant people and companies could enter into currency contracts such as forwards or swaps with one another, much as they could with the euro, the Japanese yen and other currencies.

Yuan deposits in Hong Kong have surged as China has loosened rules.

Beijing also ramped up its efforts to promote the use of yuan to settle China’s trade invoices. Because about 30% of China’s global trade passes through Hong Kong, more settlement of trade in yuan meant more yuan flowing into the Hong Kong bank accounts of businesses exporting raw materials, machinery and other goods to China.

The new trade measures and expectations that the yuan would rise in value have fostered a surge in renminbi bank deposits. As of April 30, they stood at 511 billion yuan, about eight times their level at the beginning of 2010. The growing pool of renminbi, and the easing of restrictions on what to do with it, have allowed banks to expand their range of offerings.

Liberalisations last year allowed McDonald’s Corp., Caterpillar Inc. and the Manila-based Asian Development Bank, among others, to tap into rising Hong Kong yuan deposits by raising funds through so-called dim sum bonds that previously only banks and Chinese government bodies could issue. For the issuers, the strong demand from investors for the yuan-denominated bonds keeps interest rates on these bonds low, reducing the companies’ borrowing costs.

These securities also help Chinese policy makers get a better sense of how their currency might eventually gain broader use in global capital markets. The latest experiment took place in April, when the billionaire Li Ka-shing launched a yuan-denominated share offering on the Hong Kong stock exchange, the first Hong Kong stock traded in renminbi. Hui Xian Real Estate Investment Trust, backed by Li’s best-known real-estate holdings in Beijing, raised 10.48 billion yuan ($1.61 billion), but has met with a tepid response in the market since then. It closed Wednesday about 6% below its offer price.

Bankers say a key reason for the negative response is concern that investors who might want to trade the shares won’t be able to obtain the yuan they need to do so, an issue the exchange is hoping to address soon by helping people buy yuan shares even if they don’t own renminbi.

An issue for Hong Kong’s bankers themselves, meanwhile, is a cap on yuan trading put in place by the Hong Kong Monetary Authority late last year, effectively limiting the banks’ ability to make bets on the renminbi’s future direction. The authority, Hong Kong’s central bank, limited each bank’s forward contracts in yuan to 10% of its assets or liabilities denominated in the currency.

The authority’s move means that a promise of a new profit source for Hong Kong bankers and currency traders for now remains just that—a promise. Fees for underwriting yuan bonds are slim by comparison, and banks don’t earn much for offering yuan deposit accounts to their customers. – More at Wall Street Journal

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