China may have taken two steps forward but one step back in recent weeks as it works toward its goal of internationalising the yuan. 

The People's Bank of China issued a reminder to foreign banks earlier this month, which was made public last week, urging them to tighten checks on clients' offshore yuan transactions to ensure any trading of the currency is backed by actual goods and services trade or business needs.

In other words, China was saying don't speculate in the offshore yuan (CNH) market.Even though most of the PBOC's circular was a reiteration of known rules, the timing of the release was significant, as it came at a time when the growth of the market was accelerating. 

 A Reuters story on Monday revealed that Chinese regulators have been indeed working behind the scenes to tighten control of the CNH market through derivatives regulation and financial bureaucracy. But separating speculation and the use of currencies for business transactions is easier said than done in the foreign exchange market. 

Since a landmark change in rules a year ago allowed the offshore yuan market to flourish in Hong Kong, the puzzle of how to boost the Chinese currency's use in global trade without allowing speculative inflows to swamp its underdeveloped markets has bedeviled Beijing. 

China has strictly controlled the flow of yuan across its borders, confining remittances largely to trade and working capital purposes, but it has hitherto done little to restrict its yuan capital movement outside the mainland. 

The rapid growth in yuan deposits in Hong Kong, which has far outpaced the growth of yuan-denominated assets, may have taken Chinese authorities by surprise. And so this week's news may mark the peak in yuan deposit growth, for now.

That does not mean that China has lost interest in the offshore yuan market. On the contrary, in a nod towards the problems faced by companies in remitting yuan, the PBOC provided guidelines for the very first time on yuan-denominated inbound foreign direct investment, which according to some bankers can be also extended to repatriation of "dim sum" bond proceeds. 

Meantime, the only other existing avenue to raise funds in the CNH market seized up briefly, in the form of bonds or "dim sum" as they are colorfully known. The issuance pipeline for offshore yuan debt, or dim sum bonds, ground to a halt last week after a Hong Kong-based short-seller Muddy Waters accused Toronto-listed Sino-Forest of exaggerating the size of its forestry assets, spooking investors with regard to Chinese credit.    

It took Fonterra Co-operative Group, New Zealand's biggest company, to crack open the market again with a 300 million yuan bond offer that received blockbuster demand. The ultimate objective for Chinese authorities is to see the circulation of yuan pick-up outside its borders, David Wong, deputy chief executive of the Bank of China Hong Kong said at a seminar last Friday.

But for that to happen, the documentation process for remitting yuan must be streamlined and market imperfections ironed out, he said from his perch as the second most powerful banker at the territory's only yuan clearing bank."Regulators on both sides of the straits are working hard on this. We should see something evolve soon," Wong told Reuters.     

Players in the market are keeping their fingers crossed

WEEK IN REVIEW: 

    * High grade, high demand. Fonterra's dim sum bond was priced at 1.1 percent after initial guidance of 1.2 percent, and the final order book at 1.75 billion yuan was almost 5 times oversubscribed. It was well supported by real money demand among 40 accounts. 

    * Bank of China Hong Kong is interested in offering yuan clearing facilities in Singapore, which is keen to become an offshore trading hub. When asked about the bank's plans, David Wong, deputy chief executive of the bank, said: "We would love to do so but the final call is with the regulators." 

    * As offshore yuan volume has risen dramatically, companies offering FX trading on their platforms like ICAP, the world's biggest interdealer broker, have benefited. ICAP reported a record volume of $92 million in trades last Friday with more than 110 institutions trading on its EBS platform. 

    * Norman Chan, the chief executive of Hong Kong's central bank, has been busy trying to convince the Russians recently on the potential of the offshore yuan market. That seems to be bearing fruit. Both VTB and Vnesheconombank have shown interest in issuing dim sum bonds soon.  

    * The rise of high-yield issuance in the dim sum market means that more rigorous credit analysis is needed before investing in these credits because the default risk is real, HSBC said. High-yield bonds comprise about 14 percent of total outstanding issuance compared to nil in January. The bank leads the dim sum league tables. 

Saikat Chaterjee

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