FROM Shanghai and Hong Kong to Singapore and London, China has recently stepped up its campaign to open new channels for the flow of the yuan across borders.

At the end of February, the Bank of England said it reached a preliminary agreement with China for currency swaps between the two countries, a milestone that is expected to boost the liquidity of the yuan in London.

That followed earlier deregulation allowing Taiwan banks to take deposits in yuan and wrap up cross-Strait trade settlements in the Chinese currency through the Taipei unit of the Bank of China.

In February, China also opened its first clearing bank outside the country, allowing banks in Singapore to settle transactions in yuan via the local arm of the Industrial and Commercial Bank of China.

In the domestic financial centers of Shenzhen and Shanghai, investors and companies now have more options to use offshore yuan funding for mainland investment.

The internationalization of the yuan has been on a slow track for the past five years.

The process started in 2009 in five pilot cities, with cross-border settlement in yuan first offered on a limited basis nationwide in 2011. Last year, the settlements were valued at 2.94 trillion yuan (US$472 billion), comprising 12 percent of total trade volume. That was up 44 percent from 2011.

Dim Sum bonds, or yuan-denominated debt, sold in offshore markets has helped companies replenish capital. The issuance of offshore bonds is expected to increase to 140 billion yuan this year from 120 billion yuan in 2012, according to a Standard Chartered Bank report.

Concerns about the pace of the yuan's deregulation still persist. Analysts point to the lack of full convertibility, the absence of a market mechanism in the currency's interest and exchange rates, and limited international recognition for the currency.

They predict the yuan's offshore use will be limited and the currency will not become a world-class reserve currency until remaining barriers are removed. That is not likely to happen overnight.

Intensified commerce between China and the world, using the yuan as a medium, has ushered in new opportunities and challenges for financial markets in offshore yuan centers.



London:

Currency swap boosts status

On February 22, Chris Salmon, the Bank of England's executive director for banking services, told senior bankers in London that the central bank is prepared, in principle, to become the first in the G7 to enter into a foreign-exchange swap agreement with China, if the two sides settle on details.

Outgoing Bank of England Governor Mervyn King met Zhou Xiaochuan, governor of People's Bank of China, in Beijing on that day to "facilitate" discussions on the yuan-sterling swaps.

Reaching the agreement would enable British banks to access the yuan through the central bank in London whenever a shortage of supply occurred in the market.

"There is a perception that market confidence would be boosted if the Bank of England and the People's Bank of China agreed on a swap line," Salmon said. "The rationale for a swap would be to reduce the tail risk of lost market liquidity."

Last April, with great fanfare, the UK launched an offshore yuan currency and bond market - the first in Europe.

"We have already seen evidence in 2013 of a significant increase in the yuan trade in London, and it is the UK's ambition to build a thriving yuan market in London," George Osborne, British Chancellor of the Exchequer, said after the Bank of England announcement.

For China, always anxious to lift the international profile of the yuan and eventually create a new world reserve currency, the prospect of a currency swap line with a major currency in the world was also welcome news.

China now has about 1.8 trillion yuan (US$ 289 billion) in currency swap agreements with 15 countries and regions, mostly emerging markets with close trade partnerships.

Lu Zhengwei, chief economist at Industrial Bank, said China will be more likely to establish currency swaps with the eurozone after bedding down its agreement with the UK.

Still, the signing of the deal doesn't guarantee full acceptation of the yuan among UK officials and investors.

Earlier UK media reports said bankers have been lobbying for a currency swap with China since last April, but British officials shied away because the yuan is not fully convertible.

Also, the yuan accounts for only a small fraction of financial transactions in London, making a liquidity squeeze in the yuan quite unlikely.

The issuance of Dim Sum bonds in London remains small, compared with the market in Hong Kong. It is limited to a handful of companies, such as oil giant BP and banks that include HSBC.

"Ultimately, the growth of the market will depend on the success of market participants in matching incipient demand and supply for yuan-denominated products," said King, who is due to leave office in June.



Singapore and Taiwan:

Yuan clearing benefits trade

A flurry of announcements in February mapped clearer expansion of the offshore yuan business into Taiwan and Singapore.

On February 8, the People's Bank of China announced that the Industrial and Commercial Bank of China (Singapore) will become the yuan-clearing bank in Singapore, where deposits hit 60 billion yuan (US$9.5 billion) as of last June.

Having a yuan-clearing bank in Singapore will open another channel for Singapore financial institutions to tap the US dollar-yuan market directly for yuan supply, instead of relying on the Hong Kong unit of Bank of China or going via mainland correspondent banks for yuan cross-border trade-related settlements.

Singapore is considered an important gateway to Southeast Asia, and the new bank service is expected to expedite use of the yuan in trading with a region that has supplanted Japan as China's second-largest trading partner after the US.

"China's demand for commodities is expected to remain strong going forward, and China is happy to see more trades settled in yuan," said Nathan Chow, an economist of DBS. "Furthermore, as the yuan's regional influence continues to grow, the yuan-clearing line will be utilized by not just Singapore but its trading partners, too."

Chow said he expects greater transparency in the flow of yuan funds, which will boost market confidence in accepting the yuan for trade settlements.

For Taiwan, the start of yuan trading is expected to enhance already strong economic ties with the mainland and benefit Taiwan companies by providing them lower costs in imports and exports.

Forty-six banks in Taiwan have signed yuan-clearing agreements and opened clearing and settlement accounts with Bank of China (Taipei). On February 6, when the yuan business in Taiwan officially began, deposits totaled 1.3 billion yuan.

Previously, Taiwan's banks were only allowed to undertake yuan transactions through offshore banking units.

"Taiwan's manufacturers will benefit from lower exchange rates associated with US dollar volatility," said Chow. "They will also benefit from lower transaction costs. Also, Taiwanese enterprises operating in Chinese mainland are now able to repatriate their yuan funds back to Taiwan directly."

Liu Linan, an economist with Deutsche Bank, said he expects yuan deposits in Taiwan to reach 100 billion yuan by the end of 2013, with up to 50 billion yuan of that volume likely to be transferred from Hong Kong.

He projected in a report that yuan deposits in Taiwan will grow to about 200 billion yuan in the next two or three years.



Shanghai and Shenzhen:

Rivalry heats up, risks remain

Shanghai and Shenzhen, home to the mainland's only two stock exchanges, have long competed as major onshore financial centers in China. The two cities, each with its own advantages and drawbacks, are finding it no easier with yuan reforms.

Shenzhen's Qianhai area made headlines in January with an aggressive pilot program that allows offshore banks for the first time to extend yuan loans at their own rates to companies and projects based in the area.

The move is expected to provide nearby Hong Kong financial firms access to the mainland market, and to benefit Qianhai-based companies with the lower borrowing rates usually offered by offshore banks.

Shenzhen, which likes to think of itself as the Manhattan of the Pearl River Delta, and Hong Kong sit next door and have a long history of close ties in healthcare, education and digital technology development. More importantly, the National Development and Reform Commission has confirmed that Shenzhen will be a testing ground for freer convertibility of the yuan.

HSBC Hong Kong chief executive Anita Fung hailed the Qianhai project as a milestone for new opportunities.

"It will allow banks in Hong Kong to offer cross-border yuan loans to Qianhai companies," Fung said. "This is a breakthrough that will benefit not just the banks, but also marks an important step forward in the internationalization of the yuan."

But other economists consider the 15-square-kilometer development zone only a minor player in yuan internationalization. Without stronger policy support from the China's central government, the pilot project could prove either inefficient or risky, they warned.

Shanghai, on the other hand, has world-class financial transaction volume, but recently has lagged Shenzhen in terms of eye-catching innovative programs.

Yang Maijun, head of the Shanghai Futures Exchange, said last week that Shanghai needs to create more financial products, interact more actively with foreign investors and attract more professional talent to realize its ambition to become a top global financial center.

Toward the end of 2012, Shanghai quietly launched a new pilot project called the RMB Qualified Foreign Limited Partner program. It permits qualified foreign fund managers and asset management companies to raise offshore yuan from offshore investors to invest in yuan private equity funds set up in Shanghai.

It was an extension of Shanghai's Qualified Foreign Limited Partner program, which began in 2011 and allows fund and asset managers to invest in yuan funds in Shanghai only after converting their foreign currency capital into yuan.

The two programs are supplements to the Qualified Foreign Institutional Investor program and its yuan equivalent program.

"These general efforts to promote the internationalization of the yuan will assist in increasing the channels for offshore yuan to flow back into China," said Yong Ren, a partner at Mayer Brown LLP.

But the impact of the program on the private equity industry in China may be limited because the new program offers limited investment options subject to strict regulation, analysts said.

Hong Kong:

Test ground has an upper hand

Hong Kong was the first offshore center to benefit from deregulation of the yuan, giving it an eight-year headstart. Its dominance in the market is expected to continue despite new competition.

An important doorway to the mainland, Hong Kong currently handles more than 80 percent of all yuan payments and processes more than half of all letters of credit sent by banks on the mainland.

The city has long been a favorite test site for mainland liberalization programs.

Hong Kong was the pilot city for the Qualified Foreign Institutional Investor program, the Qualified Domestic Institutional Investor program and the yuan equivalents for both programs. It will almost certainly be the first place China policymakers open when such investment options are extended to individual investors.

"China's policymakers want to relax currency controls without creating unforeseen negative consequences," Chow of DBS said. "Hong Kong, as a Special Administrative Region of China under the framework of 'one country, two systems,' serves this goal well."

However, for Hong Kong financial institutions, the success of the city's special place as an incubator of yuan internationalization will depend on the pace of reform and acceptance of the yuan globally.

In a February 26 report, Fitch Ratings said it expects revenue from offshore yuan activities, including Dim Sum bond underwriting, trade settlements, and lending and deposits, to remain limited in the next two years.

"A pickup in yuan loan demand is likely to have the biggest impact on profitability, but we do not foresee this over the next two to three years," said the report authored by Sabine Bauer and Jin Hur. "Demand from outside China may be subdued due to currency risks and restrictions remaining for cross-border yuan lending."

They pointed out that yuan loans in Hong Kong accounted for only 13 percent of total deposits of 603 billion yuan (US$ 97 billion) at the end of 2012, much lower than the 80 percent for the Hong Kong dollar and 67 percent for all other currencies.

The report said regulatory and political risks, collateral enforcement, limited transparency and, at times, lax corporate governance are much tougher issues for financial institutions to mitigate.