July 30, 2010 –   * Yuan debt about 80-100 bps cheaper than HKD debt

* Appreciating yuan means companies have to repay more

* Lack of repatriation options slows growth

* Need for reliable benchmark rate to plot yield curve

By Kelvin Soh and Michelle Chen

HONG KONG, July 30 (Reuters) - Companies are eager to issue yuan debt in Hong Kong to take advantage of lower borrowing costs, although expectations of a rise in the currency and capital controls may get in the way of an offshore market.

When Hong Kong signed an agreement with Beijing to allow companies to trade freely in the yuan in the territory and to open yuan accounts, many market participants expected a flurry of new bond issues.

The interest rate differential between yuan and Hong Kong dollar bonds is about 80-100 basis points, and has widened in the past months as investors chase the limited number of yuan bonds on expectations of currency gains.

However, if these borrowers lack revenues in yuan, the cost of hedging would increase their financing costs. Infrastructure firm Hopewell, which was the first company to issue yuan bonds in Hong Kong this year, was able to get around that because a large share of its revenues is in yuan.

"The trend now is to hold yuan assets, not issue yuan debt," said Paul Tang, chief economist at Bank of East Asia. "Owing debt in yuan means you'll have to pay back even more when it's due, and that's not a good thing when you don't even know how much it's going to appreciate by."

Issuers typically limit the tenure of yuan bonds to two to three years to limit their foreign exchange risk.

One-year non-deliverable forwards are at about 6.68 yuan to a dollar, meaning the market expects the currency to appreciate over 1 percent in a year.

This is to say that if Hopewell did not have a natural hedge by way of yuan revenues, it would have ended up paying a coupon of 3.98 percent, factoring in currency appreciation.

Another factor crimping growth is the difficulty in repatriating yuan funds to China, as Chinese regulations technically forbid funds raised in Hong Kong from being transferred to the mainland.

Companies that want to transfer the money raised in Hong Kong to China or vice versa will require approval from the People's Bank of China, further adding to the bureaucratic hurdles that already comes with handling large amounts of yuan.

"If you're a company that needs plenty of money that can be transferred between places easily, issuing yuan bonds in Hong Kong is probably not an option because you need approval to get it in, then approval again to get it out," said Ronald Wan, managing director of China Merchant Securities.

Hopewell was allowed to transfer the money it had raised in Hong Kong back to the mainland as foreign direct investment, those involved in the deal say, but approval is given on a case-by-case basis, and there is little clarity.

A second option, bankers say, is to have the money transferred into China as an interbank transaction, thus sidestepping the rules that stop companies from directly moving yuan in and out of China.

BENCHMARK RATE NEEDED

Yuan deposits make up less than 2 percent of Hong Kong's total bank deposits, or about 85 billion yuan, meaning the territory lacks critical mass for a functioning yuan bond market as issuers are competing for a small pool of money.

Just under 40 billion yuan worth of yuan-denominated bonds have been issued in Hong Kong so far, most of it issued by government-backed banks such as China Development Bank, the Export-Import Bank of China, and by China's Ministry of Finance.

The absence of a Hong Kong interbank benchmark for yuan funds also means there is no pricing reference for these bonds, while the low volume of trade on Hong Kong's yuan market means a reliable benchmark rate -- independent of official Chinese rates -- is yet to be established.

Companies who have issued yuan bonds so far have taken their cue from official government bonds, with coupons ranging from 2.6 percent for HSBC to 2.98 percent for Hopewell.

Zhang Ming, an analyst at the China Academy of Social Sciences says China's Ministry of Finance should periodically issue bonds in Hong Kong for benchmarking purposes.

"Before we can move on to anything else, what is needed right now is for the market to form some sort of a consensus on what the benchmark rate is going to be," said Irina Fan, an economist at Hang Seng Bank.

"From there, we can then move on to pushing those products out." (Additional reporting by Nethelie Wong; Editing by Jan Dahinten)