The Bank of China, the only clearing bank of yuan in Hong Kong, has widened the spread between the cost of buying and selling the yuan from 10 basis points (bp) to 75 bp.

The move was made after the China Foreign Exchange Trading System, the mainland's foreign exchange trading platform, raised transaction costs for conversions between Hong Kong dollars and yuan.

Most of the Hong Kong banks have followed the increase and transferred the cost to customers, with more than 100 bp spread.

For example, as of May 7, the closing price of the yuan buy-sell spread from HSBC in bank notes was 1.1119/1.1299, indicating a spread of 180 bp and interest rate between 0.45 percent to 0.75 percent, depending on the deposit period.

The widened spread has eaten into the yield of yuan investors. Although investors are most likely to absorb the cost, believing the yuan will continue to appreciate as before, it is more of a psychological impact as investors could worry that further measures will be introduced to discourage the one-way bet in the yuan.

Since the mainland abandoned the dollar peg in July 2005, the steady uptrend in yuan has embedded in investors that the yuan appreciation is a certainty and will last almost forever.

As of 2007, the mainland's balance of payment surplus was about $460 billion, of which only $260 billon could be explained by trade.

The rest, $200 billion, was net capital inflow. In Hong Kong, the inflow is even greater. According to the Hong Kong Monetary Authority, yuan deposits rose 73 percent from the end of last year to more than 57.58 billion yuan at the end of first quarter. The market selloff can be the reason for the extraordinary inflow.

However, analysts believe that much of the increase in the mainland's foreign reserves for the first quarter have been coming from Hong Kong.

As investing in yuan is a sure-win play for Hong Kong investors, they can get slightly higher interest rates than with the Hong Kong dollar, and a return from currency appreciation without too much market risk.

Although no one can predict where the level of the yuan and US dollar is headed, investors are estimating from data of relative economic fundamentals or balance of payment that the yuan revaluation is still far from the current level.

Furthermore, since we are pegged to the US dollar, most Hong Kong investors believe that the relationship between the yuan and Hong Kong dollar must be linked with the US dollar in the future.

If Hong Kong uses the yuan (or pegs to the yuan) as its local currency some day, we would use the US dollar peg relationship (the exchange rate) to define the exchange for yuan and Hong Kong dollars.

We have long argued that the actual exchange rate mechanism is still unknown, as the switch from the Hong Kong dollar (or peg to the US dollar) to yuan involves economies between Hong Kong and mainland, not the US economy.

These two concepts have motivated many investors putting their money into yuan. However, the raise in spread is clear evidence to suggest that the central government could apply whatever is necessary rather than satisfy the market perception to stabilize and benefit both economies.

The author is the director at Convoy Asset Management Limited.

(HK Edition 05/13/2008 page1)