No Easy Ride for Yuan Through Hong Kong

By ALEX FRANGOS

When is a yuan not a yuan? When it is in Hong Kong.

Bankers are giddy with excitement over the recent liberalization of trading in the Chinese currency in Hong Kong, even raising notions that a flood of yuan into the city will erode the logic behind the Hong Kong dollar's peg to the greenback.

It is unlikely the territory's vaunted peg—in place since 1983—is going anywhere soon. Hong Kong Monetary Authority Chief Executive Norman Chan has four criteria before Hong Kong will switch currency allegiances. These include an open capital account in China, a freely convertible currency, a mature financial system and a Hong Kong economy more closely aligned with China's. How many have been met? None, he says.

Still, the yuan certainly is flooding in. Deposits of the Chinese currency in the Hong Kong banking system have mushroomed to the equivalent of $32.6 billion in October, up from $8.4 billion a year earlier.

Partly this is a result of a Chinese regulatory change in July, which freed the yuan to be used for private investment, setting off a parade of bond issuances in the Hong Kong market by companies, most recently including a Russian bank and a Macau-based casino. Caterpillar andMcDonald's have also tested the market with yuan-denominated bond issues to help fund their China operations at lower interest rates. Billionaire Li Ka-shing is said to be planning the first Hong Kong yuan-denominated IPO tied to a collection of mainland real estate holdings.

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Deposits of the Chinese yuan in the Hong Kong banking system have mushroomed to the equivalent of $32.6 billion in October, up from $8.4 billion a year earlier.

An even bigger factor was China's expansion of a trade-settlement program that lets Chinese companies pay for imports with yuan instead of dollars. As a result, foreign companies and individuals in Hong Kong are building up yuan deposits, figuring it is a currency that is only going up.

But here is the rub: Only a limited amount of yuan can be brought from Hong Kong to China and vice versa without permission. That means little has actually changed when it comes to China's steel-gated policy of controlling capital flows and investment. As HSBC currency strategist Daniel Hui writes, the Hong Kong yuan "is effectively a separate currency," that while it allows exposure to China's currency, it is "not a perfect proxy."

The spread between the value of the Hong Kong yuan and the onshore variety is small and shrinking. The only means for moving Hong Kong-based yuan onshore is through the trade-settlement program or with permission from authorities in Beijing. Hong Kong government officials are hopeful any spread between the two versions of the currency will be arbitraged away as mainland companies exploit the difference by choosing one market over the other in deciding where to raise yuan-denominated capital or which currency to use when settling trades.

Still, the opposite could happen. In the absence of a true free flow of capital, financial markets can do funny things. Investors looking at the Hong Kong version of the yuan might consider the gap in valuations between Chinese companies with shares listed in both Hong Kong and Shanghai. Right now those traded in the closed-off Shanghai market trade roughly at par with their brothers in Hong Kong. But the difference was as wide as 23% higher in early 2010 and a distorted 108% in January 2008.

It won't get that bad when it comes to the different flavors of the yuan. But investors looking to ride China's currency through Hong Kong should still mind the gap.