HONG KONG/SINGAPORE, March 26 (Reuters) - Turbulence in Chinese financial markets, reflecting growing worries about investing in the country's assets, could slow the yuan's rapid emergence as a major international currency.
Over the past five years, the yuan has gone from being a thinly traded currency to a major one for trade settlement, retail and institutional investment and arbitrage activity. A host of financial and commodity linked derivatives are tied to it.
Analysts said two changes this year in Chinese policy have highlighted risks that could slow down the yuan's march towards internationalisation: the widening of the yuan's daily trading band and a toughening of Beijing's attitude towards defaults.
The People's Bank of China (PBOC), the central bank, this month doubled the daily permitted trading band for the yuan to 2 percent from 1 percent either side of a reference rate. It also pushed the currency lower in a bid to shake hot money out of the market to make clear the yuan is no longer a one-way upward bet.
The shake out saw the yuan fall at the end of last week to its lowest level in a year, marking a decline in 2014 of almost 3 percent - an unusually sharp move for the currency that wiped out all of 2013's gains.
Beijing has also indicated it will no longer automatically bail out companies that default on their debts, turning on its head the nature of credit risk in China.
The country recorded its first default on a domestic bond earlier in March, after which Premier Li Keqiang said defaults in some cases "are hard to avoid."
Investors said that while the yuan's importance as an international currency would over time match China's economic rise, the currency and debt developments could slow down how quickly the yuan becomes used internationally, especially if the volatility continues.
"It is not necessarily a roadblock to yuan internationalisation," said Ngan Kim Man, head of RMB business strategy and planning at Hang Seng Bank, since eventually Beijing intends to allow the currency to be fully convertible on the capital account anyway.
"Some investors are yet to be adaptive to the new situation and their pessimistic sentiment will continue for a while."
More than a trillion yuan ($160 billion) in bank deposits and money market instruments circulate within Hong Kong's banking system. Most is trade related, but some is positioned to take advantage of the higher onshore yields and a currency that has gained more than 30 percent since a landmark revaluation in 2005.
Deposits globally outside mainland China total more than a trillion yuan, up from just a few million yuan five years ago before the start of China's internationalisation drive.
Investors said yuan internationalisation could slow as losses incurred on yuan-related products mounted and investor appetite for them waned.
"In the near term, the fall of the yuan is likely to curb investors' interest in yuan products," said the treasurer at a Chinese bank in Hong Kong.
Most of the products were sold betting on yuan appreciation, a reasonable bet since the currency has risen steadily since the 2005 revaluation. The sudden drop in the yuan has put these products under pressure.
"These are leveraged products which were originally designed to hedge FX risks for exporters, yet they have been sold to investors without hedge demand as investment products."
Another reason for pause is that regulators in South Korea and Taiwan have flagged potential risks associated with a more volatile yuan by looking into the rapid rise of yuan deposits in their banking systems.
Yuan deposits in South Korea, via structured products, have soared eight-fold since September to $7.56 billion at the end of January, prompting the Korean central bank and financial regulator to inspect the units of four foreign banks.
Taiwan's financial regulators are likewise checking seven banks to see if they properly advised clients about the potential risks of currency investments after receiving complaints about losses incurred on structured products due to the yuan's fall.
Given that exposure to the yuan is small relative to the Korean and Taiwanese banking systems, regulators are more likely to be concerned about investor losses, especially retail investor losses, rather than any systemic risk these exposures may pose.
Regulators in the two biggest offshore yuan centres - Hong Kong and Singapore - have not expressed concern about the rise of yuan deposits in their banking systems. Both said they had not received any complaints from investors about losses on yuan-related products.
To be sure, analysts say longer-term pressure on the yuan is upwards, so the currency's decline so far this year is likely to be temporary.
Every country in Asia counts China among its top three trading partners, helping to explain Beijing's strides in persuading them to conduct trade in the yuan.
The dollar's share in settling trade within Asia fell to below 80 percent as of September 2013 from more than 90 percent in January 2012, SWIFT, an industry body that tracks trade flows, says.
Kevin Tay, the Singapore-based regional chief investment officer of wealth management at UBS, argues the outlook for the yuan is clear given China's current account and trade surpluses, currency reserves of $3.8 trillion and low foreign debt.
"If you focus on that, there is absolutely nothing you should be worried about with regards to where the yuan is going to be moving to," Tay said. (Additional reporting by Saikat Chatterjee in HONG KONG and Faith Hung in TAIPEI; Editing by Nachum Kaplan and Neil Fullick)