Soaring yuan deposits in Hong Kong Commentary: Dealing with one country, three currencies

Craig Stephen's This Week in China

May 15, 2011, 8:12 p.m. EDT
Soaring yuan deposits in Hong Kong
Commentary: Dealing with one country, three currencies

By Craig Stephen

HONG KONG (MarketWatch) — Some times it is the little things that really grab your attention. Last week, the HSBC cash machine offered me a new menu choice — withdrawals in either yuan or Hong Kong dollars. If switching to yuan at the ATM is that simple, just how easily might Hong Kong ditch its own currency in favor of the tender of its giant neighbor and sovereign?

Consensus is that such a day must wait until the yuan is fully convertible, but the implications of a ballooning offshore yuan deposit base in Hong Kong is making analysts sit up now. Rather than one country two systems, thanks to Hong Kong’s currency peg it appears more like one country, three currencies — which has a particularly impermanent look about it.

The use of the yuan in Hong Kong has risen steadily in recent years, buoyed by the influx of mainland Chinese tourists and the new game in town as an offshore-yuan trading center.

By March of this year, yuan deposits in Hong Kong had soared to 451 billion yuan ($69.4 billion), a massive 583% year-on-year increase. That amount is equivalent to 14.9% of Hong Kong deposits, versus just 2.1% at the end of 2009.

The yuan’s 5.2% rise against the dollar since last June means that a switch in currencies has paid off. Yuan deposits pay just 0.629% in Hong Kong, making them only marginally more attractive than Hong Kong dollars.

The scale of offshore-yuan accumulation in Hong Kong is now getting the attention of analysts. Brokerage CSLA, in a new strategy note, highlights potential problems down the road. For one, Hong Kong banks may face a liquidity shortage in terms of Hong Kong dollars — this in theory could push up lending costs, although there is little evidence of this so far.

Longer term, there is also potential for a growing currency mismatch if banks keep taking in yuan deposits but can only lend in Hong Kong or U.S. dollars. Perhaps making it easier to withdraw cash from the ATM is one step to rolling back the yuan deposit pile.

Nomura also tackled the same issue last week in a research note, saying Beijing is concerned about Hong Kong’s surge in yuan deposits, fearing it could undermine confidence in the Hong Kong dollar among local residents.

But it also causes problems for China — making its battle to stem inflows of hot money more difficult. Last week’s column highlighted how offshore lending in Hong Kong was adding to foreign-currency accumulation by the People’s Bank of China. If companies are borrowing dollars to put yuan on deposit in Hong Kong, it’s not quite what Beijing had in mind with its yuan-settlement initiative.

One way to offset foreign currency accumulation is to redirect offshore yuan deposits back into China’s domestic capital markets. This should be happening soon. Last Friday, it was reported that China plans to let its financial companies in Hong Kong start yuan funds that can invest in mainland stocks. The biggest beneficiary is likely to be the Bank of China Hong Kong /quotes/comstock/22h!e:2388 HK:2388 -1.63% /quotes/comstock/11i!bnkhf BNKHF +2.61% , which has about 40%-50% of offshore yuan deposits in Hong Kong.

Currently foreign investment in China’s domestic A-share market is limited to QFII and capped at just $30 billion. If China begins with its own banks, Hong Kong banks could well be next in line to launch similar yuan investment products. This is likely to be positive for A-shares, depending on how extensive the scheme is.

On balance, Beijing is likely to be more driven by its foreign-exchange accumulation problem than a loss of confidence in the Hong Kong dollar. Those who have invested to date in yuan have done well — since 2006, it is now up 23% against the Hong Kong dollar — but the other consideration is the easy gains may have been made. CLSA notes the perception that the pegged Hong Kong dollar is artificially cheap should keep upward pressure on Hong Kong asset prices.

Perhaps the political concern Beijing should be paying more attention to is not the loss of confidence in the Hong Kong dollar, but the painful inflationary consequences on a local population caught in the middle of China’s stumbling transition to a convertible currency. That might ultimately force a change in policy on the currency regime quicker than many expect.

Notably, growth figures for the first quarter in Hong Kong at 7.2% came in ahead of expectations and are likely to reinforce concerns the economy is overheating. The government also raised its consumer price index forecast to 5.4% for the full year, meaning real interests are deeply negative.

For now, many people will likely continue the three-currency carry trade in an attempt at capital preservation: Borrow in U.S. dollars, invest in yuan, Hong Kong equities or property assets, or just wait for their Hong Kong dollars to one day convert into yuan.

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