To get a sense of the appetite in Hong Kong for mainland China's currency look no further than the explosive growth of renminbi (RMB) deposits. Overall RMB deposits surged almost 250% year on year in November to RMB 279.6 billion. Adding to that rise: A currency swap in December between Hong Kong Monetary Authority (HKMA), the de-facto central bank, with Beijing, prompting banking experts to predict that renminbi deposits could jump to RMB 800 billion by the end of 2011.

As Beijing seeks to "internationalize" its currency step by step, Hong Kong has swiftly become the world's freest market for the RMB and RMB-denominated products, even more so than the mainland’s own onshore market. “The renminbi in Hong Kong is treated just like any other foreign currency; you can do whatever you want with it. The only limitations are supply and liquidity, and that will grow organically over time,” says Daniel Hui, senior foreign exchange strategist at HSBC in Hong Kong. “You can borrow in renminbi, issue bonds in renminbi, [and] pretty soon we think you’ll be able to issue equity in it. You can settle goods in renminbi and Hong Kong has shops that accept renminbi. For all intents and purposes, it fulfills the basic requirements of an international currency.”

Along with strong retail investor demand for renminbi products, international businesses are also enticed by the territory’s relatively uncomplicated fundraising processes and helping to grow RMB liquidity in Hong Kong. “Hong Kong has become ever more important for multinational companies, when you consider both settlement of trade and alternative financing in the region,” says Jason Wang, chief financial officer (CFO) of greater China for German consumer-goods firm Henkel, which has experimented with RMB trade settlement between its legal entities in Taiwan and mainland China, and is watching the development of Hong Kong’s renminbi-denominated corporate bonds market.

The Big Breakthrough

The rally in the "CNH" market — the term increasingly used for offshore RMB in Hong Kong as opposed to the CNY onshore market — started in late 2009, when Beijing began encouraging companies to settle trade using the mainland's currency. According to the HKMA, the total for monthly settlements in October last year was RMB 68 billion, compared with RMB 4 billion for the entire first six months of last year.

“In 2009, we saw the first genuine breakthrough: The launch of the trade-settlement scheme. That’s the backbone of the whole CNH market development, because that’s what China wants,” says Kelvin Lau, regional economist at Standard Chartered Bank in Hong Kong. “It’s an area that China is comfortable liberalizing, because it [involves] current account rather than capital account. And as long as there is trade-document backing, nothing is effectively stopping corporates using RMB as a means of trade settlement or remitting money into and out of China." He calls the change a "powerful mechanism," allowing money to migrate from China to Hong Kong and beyond.

Enabling trade settlement in RMB helped build up liquidity for the second stage of development, says Lau, giving offshore financial institutions an incentive to develop CNH products, beyond trade-related ones. “The rule of thumb here is that as long as the money stays offshore, the banks can do whatever they want with it,” says Lau. “Investors or companies don’t have to repatriate money to China. Hong Kong has structured CNH deposits linked to the performance of one [currency] or a basket of currencies, a commodity or equities.”

Investor interest is fuelling the rapid development of an RMB-denominated corporate bond market, nicknamed “dim sum” bonds by traders. In August, fast-food giant McDonald’s became the first foreign company to issue such a bond in Hong Kong, followed by U.S. farm-equipment manufacturer Caterpillar, a Macau casino operator and a Russian bank. HSBC estimates that new dim sum bond issues will reach RMB 80 billion in 2011.

Betting on Appreciation

One of the biggest drivers in the retail interest in RMB products is a much-anticipated appreciation of the currency against the U.S. dollar. Many retail investors have already been making daily purchases of the Chinese currency up to the permitted limit of RMB 20,000 per person. Since Beijing ditched the RMB's de-facto peg to the greenback in June last year, China's currency has appreciated over 3%. Optimistic expectations for an accelerated appreciation have been factored into the discount in interest payments on the territory’s RMB-denominated bonds.

On average, dim sum bond issuers save 197 basis points in interest payments by issuing in Hong Kong rather than in Shanghai. Dim sum bonds pay an average yield of about 1.83%, says the Hong Kong’s Treasury Markets Association, which tracks 30 outstanding issues. Bloomberg reports that the average yield paid on three- to- five-year bonds sold by government-linked companies in China is 3.8%, according to the Bank of America Merrill Lynch’s China Quasi-Government Index.

The slow pace of deregulation in Shanghai, which is aiming to become an international financial center by 2020, has worked in Hong Kong's favor. So far, only a handful of foreign entities, all banks, have issued RMB bonds in Shanghai. Meanwhile, the creation of an international board for equity fundraising in Shanghai is equally slow (though talk of a RMB-denominated initial public offering in Hong Kong is increasing). Even bank loans, a relatively straightforward source of onshore corporate funding, are regularly subjected to quotas on the mainland.

While all this bodes well for Hong Kong's quest to be a center of RMB internationalization, roadblocks exist. There is limited RMB liquidity and, importantly for companies, Hong Kong-raised RMB funds can't be use for purposes other than current-account trade settlement. Capital-account convertibility is still a dream for China. “It’s the prerequisite for the RMB becoming an international currency and a possible reserve-currency alternative to the greenback,” says Qian Jun, professor of finance at Shanghai Advanced Finance Institute.

China’s restrictions on foreign direct investment (FDI) inflows are another barrier — albeit not an insurmountable one. Allowing foreign parties with RMB in Hong Kong to re-invest the currency in China would increase the incentive for holding RMB offshore. While repatriation of funds is possible, the process is far from streamlined, and clips the wings of companies wanting to use funds raised from CNH issues.

“[Authorities] are still keeping a pretty tight grip on money flowing out of and returning to the mainland, so Hong Kong-issued bonds still have to go through hoops to get the money back into China,” says Standard Chartered’s Lau. In a sense, offshore RMB is being treated like a foreign currency. “Much like any other FDI that goes into China, whether through shareholder loans or equity capital injections, approvals are required or quotas of some form apply," he says. "So the current mechanism seems to assure China that the offshore market can continue its pace of development without triggering too much volatility.”

Even with approval to allow CNH funds in principle to be invested in China, the slow process to do so makes it unattractive, says Zhang Jun, China CFO of Salim Group, an Indonesian conglomerate that has been experimenting with RMB cross-border settlement. “We’ve already applied to the central bank to use offshore RMB as FDI in China,” he notes. “We’ve received a verbal agreement from Beijing, but no approval yet and we submitted the application in June 2010." He says that is much slower than when the company, for example, seeks U.S. dollar-denominated FDI.

Two Markets. One Currency

Over the longer term, being the primary center for global RMB trade could broaden the RMB’s internationalization. Hong Kong’s CNH market will likely help the gradual formation of a more market-oriented mechanism to set an offshore RMB exchange rate than what's used today, which deviates from the official rate set by the People’s Bank of China (PBoC). Such a deviation already exists between the so-called non-deliverable forward market in offshore RMB forwards and the onshore market. A blossoming of the offshore RMB market could increase pressure on Beijing to allow a faster appreciation of the RMB than has been the case in recent years.

“In the medium term, I'm looking for spot USD/CNH to converge with spot USD/CNY as the CNH pool continues to expand," says Frances Cheung, Crédit Agricole’s senior Asia (ex-Japan) strategist for fixed-income markets research. "For now, CNH will probably trade at a premium over [onshore] CNY, due to the limited supply of CNH and its favorable feature – ‘convertibility’.”

As for CNY and CNH rates, she says she expected a convergence "but it has been developing in the opposite direction. CNH rates are falling, as demand for CNH products has been overwhelmingly strong,” she adds. ”Supply is simply way below demand. It takes time for CNH rates to catch up with CNY rates.”

What can help the CNH market develop? The Hong Kong Ideas Centre, a think tank, offers several suggestions. One includes developing a cross-border RMB payment and settlement network, which would also handle regional currencies, such as the New Taiwan dollar and Korean won. Another is allowing RMB-denominated FDI into China in seven emerging industries. The latter would encourage greater issuance of corporate bonds and assist companies in Guangdong seeking to do overseas direct investment via Hong Kong.

Some of these steps are within the reach of the institutions and regulators of Hong Kong's special administrative region (SAR). But long term, Hong Kong’s role as an offshore RMB center hinges on the pace of deregulation in Beijing. If the mainland drags its feet on streamlining policies on RMB inflows from Hong Kong, the market will be handicapped. But if internationalization of the currency is accelerated — by lifting capital-account restrictions or granting markets the same RMB privileges as Hong Kong -– the SAR risks losing its special status. Neither of these prospects seems likely in the near term.

“The offshore renminbi market will be relevant because China won’t open up the capital account for quite a while,” says HSBC’s Hui. “There is a lot of opportunity in Hong Kong, but less if you believe they may open up the same rules in, say, Singapore. Then, Hong Kong would be no different than other financial centers that deal with the renminbi.”

He reckons that while the mainland experiments with its currency's internationalization, Hong Kong will keep its privileged position since China’s authorities have a degree of oversight over it. “What China does well is allow markets to develop without ever losing control,” Hui says. “Maybe one day, they need to let go to get past a certain point for market development, but for the time being, they can get quite a bit [of development] without relaxing control, and that makes them feel comfortable.”

In the long term, the free use and deepening liquidity of the RMB in Hong Kong may undermine the rationale behind the Hong Kong dollar’s greenback peg. With the RMB’s potential as a reserve currency, experts say the time may come to switch the Hong Kong dollar's peg from the U.S. dollar to the RMB given the territory’s close ties with China. But that day is still far away.

“We believe that ‘renminbization’ will indeed be the end game for the HK dollar,” Standard Chartered says in a research report. “However, that will happen only under the right conditions — a fully convertible and highly internationalized CNY; improved monetary transparency, credibility and stability on the mainland’s part; and low transaction costs relative to the HK dollar — and for the right reasons.”

For now, the bank sees Hong Kong’s stable currency regime and dollar peg as “essential to the smooth functioning of an international financial center, and as a key testing ground for Beijing’s CNY internationalization experiment.”