Preparing China's yuan for the world stage

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HONG KONG (Fortune) -- President Barack Obama's visit to China this week has increased the spotlight on one of the top hot-button issues in U.S.-China relations: revaluing the Chinese currency.

The U.S. Treasury, European officials, and international finance types have called for China to let the value of the yuan rise against the U.S. dollar, hoping Obama will keep pressuring the resistant Chinese.

Yet what's little known in the U.S. is that China already has underway a unique experiment with floating the yuan -- in Hong Kong. There, the former British trading colony, now under Chinese sovereignty, is the testing ground for moves to ultimately let the yuan float as a freely convertible currency.

China has kept a modern version of the Great Wall around the yuan -- also known as the RMB (which stands for renminbi, or "the people's money") -- since the Communists came to power in 1949. China has fixed the value of its currency at 6.83 to the dollar since July 2008, after allowing it to rise 21% in the previous three years.

The yuan's lack of convertibility on world markets has insulated China from the devastating tsunamis of international capital flows, such as those that hammered its free-market neighbors in the Asian Financial Crisis of 1997-98, as well as in 2008.

But now, as China seeks a greater role on the world financial stage -- including its official pronouncement to make Shanghai a financial center that can compete with London and New York by 2020 -- it recognizes the need for an internationally accepted currency.

In fact, China's central bank governor has been championing a move away from a dollar-centric world. So the Chinese government has been moving to allow banks in Hong Kong to issue bonds, hold deposits, and settle trade with the mainland -- all in RMB.

"If this experiment goes well, it will hasten the pace toward convertibility," says Julia Leung, Hong Kong's undersecretary for Financial Services and the Treasury, who is charged with implementing the convertibility regulations in conjunction with Chinese government officials. "The currency is more or less already convertible in Hong Kong. This is a good way of testing international demand."

Although China has set no official timetable, financial analysts now look to that 2020 date for full convertibility. But it may come sooner -- as soon as China feels it has sufficiently worked out any bugs, as well as liberalized its domestic economy to the extent that the system can handle external shocks.

"Once they have the mechanisms, the machinery, and the infrastructure in place, then they can scale up very quickly," says Enoch Fung, an economist with Goldman Sachs. "This is new, uncharted territory. We can make all the mistakes here, and we will."

Since China began this experiment by approving RMB bond offerings in 2007, banks with branches in mainland China have issued a total worth $5.6 billion in various tranches.

"They've been snapped up," says Shaun Wallis, global head of business management for HSBC, which, like most of the issuing banks, found its second bond offering, this September, oversubscribed by a factor of three to four. "Transactions are beginning to gather some momentum."

However, this June's announcement to allow settlements of international trade denominated in RMB has found a more muted international response. Just $6.3 million worth of trade was settled in the first month.

RMB watchers cite technical teething problems -- and the fact that only 365 companies in four Chinese cities were allowed to participate after going through a vetting process by the Chinese government.

Yet HSBC predicts that within five years, around half of China's cross-border trade will be settled in RMB instead of U.S. dollars, making the yuan one of the top three international currencies in the world. And in September, HSBC announced plans to move its CEO from London to Hong Kong, as "the center of economic gravity" shifts from West to East.

"It's just like the euro," says Wallis. "There were many skeptics when the euro came about. It's now a very large currency around the world. It's the same with the RMB."

To make that true, China needs to further expand the number of companies eligible to participate in trade settlements, as well as begin to allow trade financing. Hong Kong officials are confident that will happen soon enough.

"For the long-term prospect, we're very optimistic," says Peter Pang, deputy chief executive of the Hong Kong Monetary Authority, the equivalent of the central bank. "The demand to increase the use of the RMB as a settlement for trade is tremendous. Hong Kong will benefit in a very big way ... hopefully as the trade settlement hub for the whole region, between Southeast Asian countries and China."

In part, China is merely trying to catch up with demand. Shops in Hong Kong freely accept RMB for purchases, and money-changing booths do a booming cash business. Local Hong Kong media have reported suitcases of RMB flooding over the border from China each day, some to buy property in cash.

That -- along with the IPOs of eight mainland companies in Hong Kong totaling $2.1 billion in the first half of the year -- has fueled a 40% rise in the luxury property market since January. And fears of a bubble have risen, too.

Last month, the highest-priced real estate in the world sold for $57 million -- or nearly $10,000 per square foot -- in Hong Kong to a mainland Chinese in the Mid-levels district.

CCTV, China's state-run television network, reports that customs officers confiscate at least two illegal cash transports, totaling as much as 400,000 yuan, at the border each day. But that doesn't reflect how much is getting through.

"You can't stop it," says Undersecretary Leung, "so you need to find a way to regulate it and monitor it through the banking system so that you can have better control."

But banks in Hong Kong have attracted just 1% of total deposits in yuan so far -- or 58 billion RMB -- in 1.2 million accounts. That's in part due to restrictions on how much money can be exchanged per day and the fact that bank accounts are restricted to individual depositors, not institutions. A cap remains at converting 20,000 RMB per day, but HSBC and other banks offer daily automated exchanges for depositors who request it.

Still, RMB deposits grew nearly 3% in September from the previous month and are expected to continue rising as China indicates flexibility on increasing the value of the RMB against the dollar. The Hong Kong dollar has remained pegged to the U.S. dollar for 28 years, but Fung of Goldman Sachs thinks it's only a matter of time before the Chinese decide to peg it to the yuan instead.

"Once China opens its capital account, this place will be flooded with RMB," says Fung, though he gives no time table (nor does the Hong Kong Monetary Authority's Pang give any indication of flexibility).

"We're all hoping the big bang will come," says Sir David K.P. Li, the chairman of the Bank of East Asia, the largest independent local bank in Hong Kong, which has issued $4 billion in RMB bonds. But China's recent moves are designed to smooth out the kinks --so that when the day of full convertibility arrives, it won't come with a bang, but rather a whisper.