The offshore yuan market saw a growth spurt in 2013 thanks to continued efforts by policymakers to relax the capital account and expand the use of the yuan in other regional centers. Such efforts have helped the offshore yuan market to complete its transition to a new market development stage underpinned by significant market expansion, rapid product innovation, increased market liquidity and more efficient pricing discovery for all offshore yuan products.

On the regulatory front, policymakers have made significant strides forward in gradually liberalizing capital account flows and opening more channels for yuan liquidity supply to the offshore yuan market, expanding offshore yuan market to more regional centers, opening up domestic capital market to foreign investors, and strengthening the offshore yuan market infrastructure.

The supportive policy environment coupled with strong growth in the underlying demand for yuan trade settlement and investment by corporations and offshore investors naturally led to robust growth in many aspects in the offshore yuan in 2013.

Yuan cross-border settlements have likely grown by 60 percent year-on-year in 2013 and the yuan is increasingly adopted as a global payment and trade finance currency. According to SWIFT, yuan usage in traditional trade finance grew from an activity share of 1.89 percent in January 2012 to 8.66 percent in October. It ranked second after the US dollar, [HK Corporate Registration]which remained the leading currency with a share of 81.08 percent.

SWIFT ranked the yuan as the 12th most used currency for payments in the world, accounting for 0.84 percent of world payments in October. It ranked 20th in January 2012. On the offshore market, yuan deposit base expanded to 1.4 trillion yuan (US$230 billion) in October, and growth has been substantial in turnover, derivatives products and market participation.

In 2014, the offshore yuan market will celebrate its 10-year anniversary (yuan business started in early 2004 mainly for personal banking business), and we believe the offshore yuan market growth will be driven by domestic financial deregulation reforms which focus on four areas: interest rate liberalization, exchange rate liberalization, capital account liberalization and yuan internationalization.

Specific policies

Specifically, we expect the following developments in policies and the offshore yuan market in 2014:

We expect policymakers to start experimenting with a series of financial market reforms in the zone in 2014.

On December 2, the People��s Bank of China issued its opinion of the free trade zone and stated measures within the zone in facilitating yuan convertibility for investment and financing, and permit yuan convertibility for select capital account transactions; promoting the use of the yuan for cross-border transactions by corporations and individuals in the zone; steadily pushing forward interest rate reforms; and relaxing forex control, particularly administrative control for forex transactions.

According to the central bank, detailed policies will come out over the next three months. We think initially it could at least take three to six months for the basic policy framework and operational guidelines to be established and adopted by the market, and we expect the central bank to apply similar policies that prevailed in other offshore yuan markets to the free trade zone.

We think the Shanghai zone should eventually be fungible with other offshore yuan markets, but at this early stage, given its unique regulatory/market/legal infrastructure, it is highly possible that pricing dislocations will be seen between the offshore yuan market and the interest rates and forex pricing in the zone. We expect Hong Kong to remain the pricing center for the offshore yuan market in the next one to three years.

With offshore yuan business having expanded to Singapore and London, and the signing of yuan cross-currency swap agreement between the European Central Bank and the Chinese central bank in 2013, we expect more clearing banks to be set up in Europe and other regional centers.

The clearing arrangement is likely to follow the current arrangement in Taiwan, where the clearing bank (Bank of China, Taipei) will clear cross-border transactions with its onshore counterparty, a commercial bank (Bank of China, Shanghai), not directly with a central bank branch. This will allow the offshore short-term interest rates to be highly correlated with an onshore market-based short-term interest rates, rather than directly determined by the central bank.

Policymakers will further address the offshore liquidity concern by broadening channels of yuan supply to the offshore market. Specifically, policy options include allowing offshore yuan participating banks to issue certificates of deposits in the onshore interbank market, [Hong Kong Company Registration Guide]allowing direct access to interbank term funding by offshore participating banks and bumping up the daily yuan conversion limits by Hong Kong and Taiwan residents.

Larger quota

The other way round, we expect the Renminbi Qualified Foreign Institutional Investor (RQFII) quota to be allocated to foreign investors who apply under the program in London and Singapore and new quotas to be granted to other cities (Taiwan, Frankfurt most likely). We also expect the Chinese central bank to grant a 200-billion-yuan new quota in 2014 under its direct access interbank bond market program.

On the exchange rate, the yuan is likely to continue to appreciate in 2014 despite a strong dollar environment. Although China is moving toward reforming its financial system, we believe the yuan will achieve basic convertibility around 2017, implying that dominant corporate flows will remain the key driver for currency for the time being. With global growth gradually recovering and export growth likely to pick up, China will again record a current account surplus.

From a global perspective, the main downside risk to our forecast is the pace of yuan appreciation, global risk appetite, offshore yuan liquidity and the likely impact of Federal Reserve��s tapering. While from a domestic perspective investors should take note of possible weaker growth momentum given the ongoing funding constraints, new property measures and high cost of capital, driven by the outlook for consumer price inflation and deposit rate liberalization. If these were to occur, we could see possible unwinding of sizable short dollar-offshore yuan positions and a sharp slowdown in global growth will also cut our projected growth of the offshore yuan market by 20 percent.

For now, however, we do think the risk involved in this is quite low.