It seems that Hong Kong has won the initial battle with Shanghai over where the yuan-denominated bond market will expand next, as the Chinese government attempts to keep idle money offshore. But don't rule out Shanghai as the final victor.

The nascent market for yuan bonds in Hong Kong received another multinational thumbs-up this month, with United States-based Caterpillar Inc selling 1 billion yuan (US$150 million) of two-year notes with a 2 percent coupon.

The debt issue came after McDonald's Corp sold 200 million yuan of three-year notes in September, the first sale of yuan bonds by a foreign company in Hong Kong after China deregulated the market early this year.

Undoubtedly, there is a pent-up demand for yuan-backed debt in Hong Kong. While anticipating an appreciation in the yuan's value, holders of Chinese currency assets also hope to find channels that could provide steady returns.

According to Bloomberg data, about 41 billion yuan worth of yuan-denominated bonds have been floated in Hong Kong this year, mostly by state-owned enterprises on the Chinese mainland.

By comparison, the pool of yuan deposits in Hong Kong more than doubled in the six months through September to 149 billion yuan, according to the city's monetary authority.

The demand for yuan debt will likely be amplified in the next few months, when the Chinese government lifts its temporary delay to the start of a new program allowing yuan deposits in Hong Kong to flow back into mainland equity markets.

The so-called mini-QFII program, which was originally scheduled to debut by the end of the year, would allow brokers and institutional managers to raise yuan funds in Hong Kong and invest the money in mainland-listed shares and bonds.

Why has Beijing suddenly become so pro-active in developing an offshore debt market for the Chinese currency? Part of the reason could be persistent worries about a massive money influx into the mainland market.

For the moment, the Chinese government seems content to keep overseas yuan deposits offshore, at least temporarily, and to gauge the eagerness of foreign capital toward the Chinese currency via bond issuance in Hong Kong.

On November 30, just before Caterpillar's debt sale, China's Ministry of Finance announced an 8 billion yuan sovereign bond issue in Hong Kong, with mixed maturities of up to 10 years. That was seen as a move aimed at helping establish a benchmark yield curve in the city.

Happy arrangement

The ministry's only previous sale in Hong Kong, in October 2009, tapped the debt market for 6 billion yuan. It comes as little surprise that China's second sovereign issue in the offshore market was met with aggressive demand.

For the time being, all parties involved seem happy with the arrangement. Issuers are getting strong responses, investors are getting stable returns, Hong Kong markets are receiving a boost amid concerns about playing second-fiddle to Shanghai, and the Chinese central bank is monitoring and even absorbing speculative money knocking at the mainland's door.

For issuers, strong demand for the yuan debt in Hong Kong is helping lower borrowing costs. China Development Bank this month sold 3 billion yuan of bonds in Hong Kong at 2.7 percent, 38 basis points cheaper than a 20 billion yuan sale on the mainland in October, according to Bloomberg News.

Investors in Hong Kong are willing to buy yuan debt with low risks and steady rates of returns. HSBC now offers an interest rate of 0.71 percent on deposits of 500,000 yuan or less for a year.