Contrary to the view of some market watchers that the central government's move to issue sovereign bonds in Hong Kong could boost yuan convertibility, the move may actually serve as a step to establish a parallel system that will sfunction as an alternative to full convertibility for some time.

It is no secret that the central government wants to promote a wider use for the yuan globally, particularly in international trade settlement in order to lower the forex risk faced by its huge and ever-accumulating trade surplus.

To succeed in this pursuit, Beijing needs to implement full convertibility for the yuan. Without full convertibility, acceptance for yuan globally will be limited and foreign-trade partners will be reluctant to use the yuan as a trade-settlement currency, analysts say.

As evidence of this reluctance, market response to the recently-implemented pilot program of yuan settlement for trade between five mainland cities and the special administrative regions of Hong Kong and Macao has been lukewarm.

As of the middle of this month, total trade value settled in yuan under the pilot scheme amounted to only 70 million yuan since the central government gave the go-ahead in July, Guo Qingping, assistant governor of the People's Bank of China, told the media earlier this week.

However, full convertibility for the yuan is obviously not a smart proposition for Beijing right now as the country's financial system is still in the process of perfecting and strengthening itself.

"Implementing full convertibility for yuan onshore will expose the country's financial system to potential speculative attacks from the external world," said Daniel Chan, senior investment strategist at DBS Bank.

Moreover, Chan says, the financial system is still not ready to withstand other external shocks, such as the Asian financial crisis in 1998 and the financial meltdown that hit the world last year.

Underscoring the idea that it is too early for full implementation, Premier Wen Jiabao admitted at the Summer Davos in Dalian city last week that it will still take time for the yuan to fully become an international currency.

This creates a challenge for the central government: how can it promote a wider use of the yuan as a settlement currency for international trade while keeping its capital account safely under control until the country's financial system is ready to face external shocks?

To deal with this dilemma, Beijing has charted a course to implement an innovative strategy that will build a parallel system for the yuan in Hong Kong aside from the existing system on the mainland.

In other words, the city will operate as a parallel yuan market rather than just serving as an overseas yuan settlement hub.

Under this parallel system, full convertibility for the yuan will be realized in the special administrative region to promote wider acceptance for the currency, while, in the meantime, the State keeps its onshore capital account under control.

To make this parallel system work, there must be a large enough yuan-asset market in the city, providing sufficient investment outlets for yuan holders on the one hand and financing channels for overseas importers on the other.

In its latest move to expand the yuan-asset market in Hong Kong, the Ministry of Finance announced earlier this month that it would sell six billion yuan in renminbi-denominated bonds in the city on September 28.

The bond issue will enhance the international role of the yuan and provide a pricing benchmark for other yuan bonds issued in Hong Kong, it said in a statement, adding that it would promote the issuance of yuan bonds in Hong Kong by other mainland institutions.

This will be the nation's first sovereign bond sale outside the mainland. In the past, the State has approved the launch of other yuan-denominated financial products, including yuan bonds issued by mainland and local banks and yuan deposits.

The next step that the central government will likely take in expanding Hong Kong's yuan-asset market is to allow the trading of locally-listed shares in yuan.

Upon creating all the yuan assets that are necessary for a parallel yuan market in the city, the central government's remaining job will be adjusting and fine tuning the size of the market.

This could be readily accomplished by fine control of the flow of renminbi into and out of the city.

One of the key control elements was put in place after the People's Bank of China, the country's central bank, and the Hong Kong Monetary Authority, the city's de facto central bank, signed in January this year a currency swap agreement that can provide liquidity support up to 200 billion yuan to Hong Kong banks when needed. The ceiling can be adjusted at the central government's free discretion, making it an effective valve to control the yuan liquidity in the city.

Given the fact that Beijing has set a precedent in the political domain - the "one country two systems" innovation, one should not be too surprised to see another innovation, but economic, rather than political.

(HK Edition 09/18/2009 page3)