According to Bloomberg calculations, an investor who bought China's one-year offshore bond a year ago would have earned a return of 2.7 percent.

Despite the rosy prospects, some challenges still lie ahead for Hong Kong to develop the yuan bond market and secure its status as a well-established offshore center for the Chinese currency.

For one thing, Hong Kong is facing some difficulties in boosting the supply of yuan bonds as well as investor confidence. Media reports have said that even banks and fund managers helping manage yuan savings for clients are now approaching potential issuers for more debt sales.

So far, only a handful of foreign firms have publicly shown interest in the program. US retailer Wal-Mart Stores Inc said in March it was considering selling bonds in yuan, and Russian aluminum giant United Co Rusal said in September that its officials have met with bankers to learn more about the market.

The biggest concern of those firms, I assume, is whether the use of the yuan proceeds will be influenced by Beijing in one way or another. Unfamiliarity with the market also contributes to hesitancy.

Media reports said Caterpillar has received permission from Chinese authorities to transfer proceeds from its yuan bond sale to the mainland and will use the money to support a leasing unit.

The Chinese government is apparently willing for offshore yuan capital to flow into legitimate business operations but wants to prevent it from chasing mainland equities and properties, exacerbating already stubborn asset price bubbles.

Growth questioned

With channels mostly blocked to convert the yuan proceeds into other currencies, foreign companies interested in selling yuan-backed debt in Hong Kong are those with mainland expansion plans.

I don't doubt the yuan bond issuance in Hong Kong will be expanded considerably next year. But the key question is whether such growth can be sustained as many investors in the city now prefer to hold yuan debt instead of trading it as they bet on the yuan's appreciation. That could hinder the long-term growth of the yuan-bond market.

We also don't know when authorities will resume the mini-QFII scheme, which will divert part of the yuan assets from the debt market. If inflationary pressure eases in the first half of 2011, the program may operate on trial on a small scale.

Don't dismiss Shanghai's role in the process of market deregulation.

The mainland is gearing up to establish an international equities board to let foreign companies sell yuan-backed shares on it as early as next year. The Shanghai stock exchange is also seeking government support to develop an exchange-based bond market and is close to talks with large state-owned enterprises to possibly issue debt on it.

China needs Hong Kong and Shanghai and no matter which city wins, the yuan's influence will be gradually bolstered. That's Beijing's ultimate goal.