LONDON London launched an offshore yuan currency and bond market to great fanfare six months ago, but the bond side will struggle to develop unless British and Chinese authorities take steps to make trading easier.
The need for such measures has become even greater this year as potential investors have been discouraged from buying yuan bonds by China's slowing economic growth and by a slump in one-year yuan non-deliverable forwards to price in a depreciation.
The nascent offshore bond market, part of China's gradual move towards the convertibility of its currency, could grow with the help of a foreign exchange swap line between the Bank of England and the People's Bank of China and with the establishment of a local clearing bank in London.
Market participants say restrictions on trading, clearing and investment remain a problem, even after governments in Britain and Hong Kong, the main centre for the offshore yuan market, have worked to develop London as an offshore centre.
"Liquidity in and out of China is the crucial thing, and the Chinese government controls it," said Yongmai Cai, a partner at law firm Simmons and Simmons in Beijing.
"Further relaxation steps from the Chinese government may be crucial for London."
Issuance of London-listed yuan bonds has been limited to a handful from the likes of oil major BP (BP.L) and banks HSBC (HSBA.L) and ANZ (ANZ.AX).
By comparison, the Hong Kong yuan bond market has grown to around 350 billion yuan ($55.7 billion) outstanding in a little over two years, according to Thomson Reuters data, with over 260 bonds issued so far this year.
Analysts estimate it will reach 1 trillion yuan by 2015, when China aims to make its domestic currency basically convertible. The offshore yuan market is considered a testbed for the opening up of the currency.
The Chinese government has been opening its financial markets gradually and now allows all companies to pay for exports and imports in yuan. It also has raised the ceiling for overall investment by international companies in its domestic stock and bond markets.
As the restrictions lift, companies active in the Chinese market are more likely to hold offshore yuan deposits and to borrow or invest in offshore yuan bonds. Yuan deposits in Hong Kong have grown by ten times since late 2009, according to a report by Royal Bank of Scotland.
CURRENCY TRADING YES, BONDS NO
On the currency side, London-based yuan deposits and trading volumes have surprised to the upside.
A survey by Bourse Consult for the City of London, published in April, found deposits totaling 109 billion yuan in London.
Yuan trading has increased to daily turnover levels of up to $900 million, compared with $1.5 billion in Hong Kong, Raymond Sabbah, a partner at Bourse Consult, said in late September.
Trading volumes have been helped, if anything, by the fact that the currency has become more of a two-way trade.
"Today the renminbi appreciation is no longer strong, the same number of participants play the depreciation story," said Augosto King, head of debt capital markets Asia at RBS.
On the bond side, however, buyers of yuan-denominated bonds are no longer making a one-way bet that the yuan will appreciate, in the near term or even the longer term.
"For me the appreciation story is over," said David Pavitt, head of emerging markets foreign exchange trading at HSBC.
"You will buy bonds because they are investments, it's not all about currency appreciation."
The small, illiquid market needs a boost from moves such as the creation of a foreign exchange swap line between the People's Bank of China and the Bank of England. That would enable the BoE to intervene to smooth out discrepancies and instability, giving investors confidence.
The PBOC has around 20 such swap lines around the world, mainly with Asian central banks. But the BoE is seen as reluctant to sign such a line for a non-convertible currency.
Woon Khien Chia, head of local markets strategy for emerging Asia markets at RBS, said it was possible that the two central banks could sign a swap line as early as next year.
"When the currency becomes very actively traded, in the interest of making this market sound and stable, the BoE may have to take that step," Chia told a briefing recently, adding that this is not likely to be an urgent matter for the bank.
The Bank of England declined to comment.
As for clearing, Hong Kong has extended its settlement hours so that offshore yuan trades can be settled throughout the London trading day. But clearing still can only take place through one bank - Bank of China (Hong Kong).
The British and Chinese governments need to reach another agreement for a London clearing bank to be established.
"There is no quick win here," Stuart Fraser, deputy policy chairman for the City of London, told a recent conference regarding development of the offshore market. ($1 = 6.2849 Chinese yuan)
(Additional reporting by David Milliken; editing by Jane Baird)