“If you want to see capitalism in action,” said Milton Friedman, “go to Hong Kong.” Beijing is taking him up on that. As it seeks to broaden ownership of its currency, China is using the special administrative region as a giant petri dish. It wants to observe how this profoundly consumerist culture absorbs the renminbi as a medium of exchange, as a store of value and as a unit of account.

As the renminbi goes global and is used in transactions from Europe to South Asia, traders around the world are using the Chinese currency for financial speculation. A report in the Financial Times explains how – Excerpts –
A hint of this came on December 23, when the Hong Kong Monetary Authority – the territory’s monetary guardian, which is working closely with the People’s Bank of China – sent a cautionary letter to banks in the territory.

As well as announcing technical adjustments to the rules governing the use of renminbi in the special administrative region, the HKMA made it clear banks must boost their efforts to prevent companies from using phoney trade documents to gain access to the mainland currency.

“Particular attention should be paid to transactions in large amounts requested by new customers, or transactions between entities that are related to each other,” said the HKMA.

Illegal yuan transaction under the guise of trade are common between Hong Kong and the Mainland, where investors have since long taken advantage of the difference in exchange rates.  However after mid-2009, since when imports and exports could be settled in the peoples currency, hedging between the two territories has risen significantly.

“The capital controls in China mean there is a huge arbitrage opportunity for anyone who can get past them,” says John Greenwood, Invesco chief economist and architect of Hong Kong’s exchange rate mechanism told the Financial Times.

International trade worth Rmb340bn was settled in renminbi between June and November 2010, compared with zero before July 2009, when Beijing moved to reduce its reliance on the US dollar and allowed the renminbi to become an international medium of exchange.

The major catalyst for the scheme came in July, when regulators lifted a raft of restrictions blocking the free flow of the renminbi in Hong Kong. Since then, the territory’s renminbi-denominated financial markets have blossomed. Critically, renminbi exchange rates and interest rates in Hong Kong have departed from those on the mainland, which are subject to government control.

“This market is growing at breakneck speed,” says Sundeep Bhandari, Asia head of markets at Standard Chartered.

Fervent demand for renminbi from international investors has driven down rates in Hong Kong and thereby created incentives for companies considering using the renminbi for trade or financing. Foreign exporters have cottoned on to the fact that the renminbi-dollar exchange rate is at a premium in Hong Kong compared with the mainland (see chart). To arbitrage the two markets, these companies accept renminbi as payment from Chinese importers, then swap the cash into dollars at the more attractive offshore exchange rate.

“There’s an incentive for the Chinese importer and foreign exporter to settle in renminbi and split the difference,” Dariusz Kowalczyk, a strategist at Crédit Agricole told the Financial Times.

In an area that is being scrutinized by regulators, some large companies with operations in both Hong Kong and the mainland are even using the trade settlement scheme, in conjunction with currency derivatives, to capture the difference between onshore renminbi interest rates and the much lower offshore dollar interest rates.

“It’s true that six months ago, almost all of the renminbi so-called trade flows that you saw were this arbitrage game. But now the genuine trade flows are becoming as important if not more important than the arbitrage flows,” says a Hong Kong banker.

As Hong Kong’s renminbi markets expand and more companies adopt the renminbi for trade, Beijing is likely to find the distinction between “genuine” trade flows and the more speculative equivalent ever harder to distinguish.