THE offshore yuan market continued stable but solid growth in 2012. Policy makers in 2012 have focused on removing policy bottlenecks and refining the existing regulation framework with the goal of facilitating cross-border yuan trade and investment, further liberalizing controls over domestic interest rates, exchange rates and access to the domestic capital market and capital account-related transactions.

Supported by the above policy steps, the yuan cross-border settlement (including trade and investment settlements) will likely grow 45 percent year-on-year in 2012 from 2011. From January to October, about 11.4 percent of China's global trade was settled in yuan, up from 8.4 percent in 2011, 5 percent in 2010 and 2 percent in 2008.

The offshore yuan business has expanded to more regions and the total offshore yuan deposit base is about 860 billion yuan (US$137 billion) globally. Since the launch of the yuan business in London earlier this year, the United Kingdom surpassed Singapore in June 2012 for total payment value, according to Society for Worldwide Interbank Financial Telecommunication.

It seems institutional transfers rather than trade settlements drove the adoption of yuan, accounting for 98 percent of total payment value for the UK and 94 percent for Singapore in October this year. We believe the aggregate balance of offshore yuan liquidity in Hong Kong, Taiwan, Singapore and London is about 860 billion yuan, about 4-5 percent higher than in 2011.

Pilot program

The launch of the pilot program to allow yuan cross-border lending by onshore multinational companies marked another significant step towards liberalizing capital accounts. The program, recently introduced in Shanghai, allows multinational corporations registered in Shanghai to lend their own yuan funds to offshore parent companies or related companies within the same group.

Successful implementation of the program may attract more multinational companies to use yuan for cross-border trade settlement and lending. It will help replenish the offshore yuan liquidity pool and is a critical channel in the offshore-onshore yuan circulation mechanism.

Among other progresses, the notional amount of outstanding offshore yuan fixed income instruments was 366 billion yuan by the end of November, up by 62.5 percent from 2011. US dollar/offshore yuan futures and yuan Qualified Foreign Institutional Investors A-share Exchange Traded Funds were introduced in the Hong Kong exchange.

Looking ahead, we believe policy makers will focus on addressing offshore liquidity supply concerns by further liberalizing capital accounts. We expect exciting policy and market developments in the following areas in 2013.

China may make a formal announcement on increasing the quota for Renminbi-QFII(RQFII), the yuan equivalent of QFII, to 270 billion yuan from 70 billion yuan. So far, a total of 21 institutions, out of which nine are fund management firms and 12 are securities brokers, have been granted a cumulative 48 billion yuan RQFII quota, equivalent to 69 percent of the existing quota of 70 billion yuan. We believe roughly 16 billion yuan has been invested in the onshore fixed income market, and the remaining is in the equity market.

We believe both the yuan QFII quota and the quota for onshore interbank bond market access will be increased over time to accommodate demands for foreign investment in the domestic capital market. Specifically, we expect domestic interbank bond market access will likely expand to 100-200 billion yuan per year.

Three potential new measures are expected to broaden the sources of the offshore yuan liquidity supply under capital accounts. Yuan cross-border lending should surge and more regions are likely to join the pilot program of yuan cross-border lending by the onshore multinational companies. Regulators may consider allowing offshore participating banks to access the onshore interbank market for short-term collateralized or uncollateralized funding. We also expect an upward adjustment of the yuan daily conversion limits for Hong Kong residents.

There are likely to be appointments of yuan clearing banks in Taiwan, Singapore and possibly London, and yuan fixed income trading and other yuan business will become operational in Taiwan in the near future. We expect details of the yuan clearing bank arrangements between the mainland and Taiwan markets and relevant offshore yuan programs to be announced in the near future. We expect yuan deposits to grow to 100 billion yuan in the next year, about 40 to 50 billion likely from yuan deposits maintained by Taiwan residents and corporations currently in Hong Kong.

On the market development in 2013, we expect yuan trade settlement volume to increase by 30 percent to 4 trillion yuan. With potential growth of the yuan business in other offshore centers, including Taiwan, Singapore and London, we expect daily offshore yuan trading volume to rise to US$2.5-3 billion.

Greater volatility

China's potential economic recovery next year would boost both expectations of yuan appreciation and appetite for credit exposure. US dollar/yuan fixings have become more positively correlated to the movement in China's trade partner currencies against the US dollar. If China indeed manages the yuan more actively versus a basket and responds to external foreign exchange movements, this should introduce greater volatility in the fixings around their medium-term downtrend

We expect a further doubling of the US dollar/yuan spot intraday trading band to 4 percent in 2013, enabling greater deviation of spot from the fixing and higher spot volatility. Importantly, after the April 2012 band-widening, spot has traded across the full breadth of the 2 percent band. We project the total return of the liquidity offshore yuan bonds at about 4.25 percent next year to offshore yuan-based investors and 5.75-6.75 percent for US Treasury bond-based investors based on 2-3 percent annual rise of yuan against the US dollar.

The key downside risk to our forecast is the pace of yuan appreciation, offshore yuan liquidity and the market credit risk appetite. While tail risk is well-contained, significant downside surprises to global economic growth imply about a 20 percent reduction in our projected growth of the offshore yuan market.