By Se Young Lee and Michelle Chen
HONG KONG/SEOUL, March 6 (Reuters) - Deposits denominated in the Chinese currency have exploded in South Korea as local subsidiaries of Chinese banks tap into Korean investors' hunger for higher-yielding assets.
It has also opened a channel for the Chinese lenders to raise cheap yuan funds and use them in their domestic market to extend loans, enjoying fat margins amid the backdrop of tight monetary conditions in the world's second-largest economy.
The fast pick-up of yuan deposits in Seoul has left market participants wondering if the yuan pool there will exceed that in more established centres such as Singapore and London, despite a dramatic slump in the "redback" in the past two weeks.
Yuan deposits by local residents in South Korea stood at the equivalent of $7.56 billion at end-January, more than eight times that at end-September, data from its central bank showed.
That amount is already quite competitive compared to London, which saw yuan deposits from personal and corporate accounts only at 3.1 billion yuan ($504.64 million) at the end of last June.
What makes yuan deposits in Seoul different from those in Singapore or London is that the won cannot be directly converted to yuan, making yuan deposit transactions there complicated.
Yuan deposits in Seoul were built through a structured product scheme in which a local brokerage sold asset-backed commercial paper to raise won from local institutions such as insurance companies.
The proceeds were then swapped into dollars, before they were converted to yuan and put in local subsidiaries of Chinese banks, which then send the money back to China to fund their business there.
These structured products generate an annual return in the low 3 percent range, better than won deposit products which usually offer returns in the high 2 percent range, according to bankers in South Korea.
"The Chinese banks will send the money back to their headquarters," said a Bank of Korea official who spoke on condition of anonymity because he was not authorised to talk to the media.
"I understand there is an increase in higher-rate loans in China due to a shortage of funds, so the Chinese banks end up with a substantial margin even if they offer comparatively higher interest rates on deposits in Korea," the official said.
China's central bank is expected to keep a relatively tight monetary stance after two cash squeezes it engineered last year to discourage banks from riskier lending. Funding costs on the mainland also face upward pressure as Beijing accelerates reforms in the domestic financial market.
Analysts say demand for yuan products in Seoul is likely to be sustained, given favourable currency swap rates will continue to bring returns from these products, but the pace may be slow as regulators have expressed concern about the rapid growth.
The Financial Supervisory Service, a South Korean financial regulator, already instructed Chinese bank branches in Korea to slow their yuan deposit-building late last year. But officials say that any change in regulation or new rules in response to the yuan deposit growth are unlikely at present.
FAVORABLE SWAP RATES
The yuan was a regional bright spot last year, gaining nearly 3 percent against the dollar, outperforming most of its emerging market peers.
But it has retreated sharply in recent weeks, with the central bank believed to be punishing speculators who are making one-way appreciation bets on the currency.
Still, most analysts believe its long-term appreciation trend remains intact as Beijing encourages broader international usage of the currency to rival the dollar.
Greater volatility is unlikely to affect the enthusiasm for yuan-structured products sold in South Korea, as foreign exchange rate risks have already been hedged by cross currency swaps (CCS), analysts say.
Moreover, they believe the low level of dollar/yuan CCS rates at present will boost sales of yuan deposit products in the country.
"Right now investors can get a hedge premium on the dollar/won swap, and a cost on the dollar/yuan swap. But the premium from the dollar/won side outweighs the costs," said a banker in South Korea.
Investors who buy one-year yuan deposit products and swap them to the won can enjoy a yield pick-up of about 90 basis points (bps) over conventional won deposits, while the pick-up was non-exist half a year ago, said Becky Liu, a strategist at Standard Chartered Bank in Hong Kong.
"The current favourable swap levels could benefit a continuing strong demand by local investors to pick up the additional return," Liu said.