It seems that Hong Kong has won the initial battle with Shanghai over where the yuan-denominated bond market will expand next, as the Chinese government attempts to keep idle money offshore. But don't rule out Shanghai as the final victor.

The nascent market for yuan bonds in Hong Kong received another multinational thumbs-up this month, with United States-based Caterpillar Inc selling 1 billion yuan (US$150 million) of two-year notes with a 2 percent coupon.

The debt issue came after McDonald's Corp sold 200 million yuan of three-year notes in September, the first sale of yuan bonds by a foreign company in Hong Kong after China deregulated the market early this year.

Undoubtedly, there is a pent-up demand for yuan-backed debt in Hong Kong. While anticipating an appreciation in the yuan's value, holders of Chinese currency assets also hope to find channels that could provide steady returns.

According to Bloomberg data, about 41 billion yuan worth of yuan-denominated bonds have been floated in Hong Kong this year, mostly by state-owned enterprises on the Chinese mainland.

By comparison, the pool of yuan deposits in Hong Kong more than doubled in the six months through September to 149 billion yuan, according to the city's monetary authority.

The demand for yuan debt will likely be amplified in the next few months, when the Chinese government lifts its temporary delay to the start of a new program allowing yuan deposits in Hong Kong to flow back into mainland equity markets.

The so-called mini-QFII program, which was originally scheduled to debut by the end of the year, would allow brokers and institutional managers to raise yuan funds in Hong Kong and invest the money in mainland-listed shares and bonds.

Why has Beijing suddenly become so pro-active in developing an offshore debt market for the Chinese currency? Part of the reason could be persistent worries about a massive money influx into the mainland market.

For the moment, the Chinese government seems content to keep overseas yuan deposits offshore, at least temporarily, and to gauge the eagerness of foreign capital toward the Chinese currency via bond issuance in Hong Kong.

On November 30, just before Caterpillar's debt sale, China's Ministry of Finance announced an 8 billion yuan sovereign bond issue in Hong Kong, with mixed maturities of up to 10 years. That was seen as a move aimed at helping establish a benchmark yield curve in the city.

Happy arrangement

The ministry's only previous sale in Hong Kong, in October 2009, tapped the debt market for 6 billion yuan. It comes as little surprise that China's second sovereign issue in the offshore market was met with aggressive demand.

For the time being, all parties involved seem happy with the arrangement. Issuers are getting strong responses, investors are getting stable returns, Hong Kong markets are receiving a boost amid concerns about playing second-fiddle to Shanghai, and the Chinese central bank is monitoring and even absorbing speculative money knocking at the mainland's door.

For issuers, strong demand for the yuan debt in Hong Kong is helping lower borrowing costs. China Development Bank this month sold 3 billion yuan of bonds in Hong Kong at 2.7 percent, 38 basis points cheaper than a 20 billion yuan sale on the mainland in October, according to Bloomberg News.

Investors in Hong Kong are willing to buy yuan debt with low risks and steady rates of returns. HSBC now offers an interest rate of 0.71 percent on deposits of 500,000 yuan or less for a year.

According to Bloomberg calculations, an investor who bought China's one-year offshore bond a year ago would have earned a return of 2.7 percent.

Despite the rosy prospects, some challenges still lie ahead for Hong Kong to develop the yuan bond market and secure its status as a well-established offshore center for the Chinese currency.

For one thing, Hong Kong is facing some difficulties in boosting the supply of yuan bonds as well as investor confidence. Media reports have said that even banks and fund managers helping manage yuan savings for clients are now approaching potential issuers for more debt sales.

So far, only a handful of foreign firms have publicly shown interest in the program. US retailer Wal-Mart Stores Inc said in March it was considering selling bonds in yuan, and Russian aluminum giant United Co Rusal said in September that its officials have met with bankers to learn more about the market.

The biggest concern of those firms, I assume, is whether the use of the yuan proceeds will be influenced by Beijing in one way or another. Unfamiliarity with the market also contributes to hesitancy.

Media reports said Caterpillar has received permission from Chinese authorities to transfer proceeds from its yuan bond sale to the mainland and will use the money to support a leasing unit.

The Chinese government is apparently willing for offshore yuan capital to flow into legitimate business operations but wants to prevent it from chasing mainland equities and properties, exacerbating already stubborn asset price bubbles.

Growth questioned

With channels mostly blocked to convert the yuan proceeds into other currencies, foreign companies interested in selling yuan-backed debt in Hong Kong are those with mainland expansion plans.

I don't doubt the yuan bond issuance in Hong Kong will be expanded considerably next year. But the key question is whether such growth can be sustained as many investors in the city now prefer to hold yuan debt instead of trading it as they bet on the yuan's appreciation. That could hinder the long-term growth of the yuan-bond market.

We also don't know when authorities will resume the mini-QFII scheme, which will divert part of the yuan assets from the debt market. If inflationary pressure eases in the first half of 2011, the program may operate on trial on a small scale.

Don't dismiss Shanghai's role in the process of market deregulation.

The mainland is gearing up to establish an international equities board to let foreign companies sell yuan-backed shares on it as early as next year. The Shanghai stock exchange is also seeking government support to develop an exchange-based bond market and is close to talks with large state-owned enterprises to possibly issue debt on it.

China needs Hong Kong and Shanghai and no matter which city wins, the yuan's influence will be gradually bolstered. That's Beijing's ultimate goal.