The establishment of offshore yuan-trading markets is a vital step in Beijing's push to internationalize its currency. In recent years, many overseas regions have begun establishing offshore yuan-trading markets, for fear of missing opportunities brought about by the yuan's continuous appreciation against the U.S. dollar and its internationalization.

The offshore yuan-denominated and yuan-clearing bonds in Hong Kong, dubbed dim-sum bonds, are not a direct result of the offshore yuan-trading market, but are a window to observe changes.

Since the China Development Bank issued dim-sum bonds in Hong Kong in 2007, all bonds were purchased immediately. According to a senior bonds trader in Hong Kong, dim-sum bonds don't have a very high yield, usually 2-3 percent. Whenever a company issued yuan bonds, market demand would far exceed supply as those investment institutions have a huge appetite for such bonds and can swallow them in no time.

Dim-sum bonds have achieved marked global progress since 2007. Even in 2008 when the global financial crisis rattled the world, the amount of money raised in the dim-sum bonds market totaled 12 billion yuan ($1.96 billion). In 2011, the amount reached 174 billion yuan ($28.36 billion) and the number of issuance entities increased to 100 from only 20 in 2010. In 2012, the amount reached 230 billion yuan ($37.49 billion), up 60 percent. Bond issuance entities expanded from banks to state-owned enterprises (SOEs), private firms and foreign companies. Dim-sum bonds have become a highlight in financing for Chinese firms.

Dim-sum bonds don't have an attractive yield and issuance entities don't have a very great credit ranking. Then why are they so popular? The first reason would be anticipation for the yuan's appreciation. Overseas investors mostly think the yuan has been substantially undervalued and boasts great potential in appreciation. If the yuan continues to appreciate, say 5 percent a year on average, the total return on investment could reach 8 percent (plus the 3-percent interest rate of the bonds). The second reason would be the severe imbalance between a dearth of yuan-denominated investment products and hefty yuan deposits overseas.

Nonetheless, dim-sum bonds have been sluggish during the past two months. According to data supplier Dealogic, no dim-sum bonds have been issued since June 18, the first time that has happened in a four-week period since the launch of offshore yuan bonds in 2010. Prior to that, large-scale selling appeared and the average bond yield surged to 5.71 percent as of the end of May, according to Bank of China.

Investors are losing interest in dim-sum bonds due to several factors. First, the cash crunch at the end of June caused a spike in borrowing rates, leading to a large-scale selling of Chinese stocks and mounting concerns over the health of China's financial institutions. The offshore subsidiaries of Chinese banks withdrew their yuan capital back to the mainland, weighing down liquidity in the Hong Kong market. Second, continuous slowdown in the Chinese

economy dimmed the outlook of the country's capital markets and market anticipation of the yuan appreciation is changing. Finally, global capital is flowing out of emerging markets.

The waning appeal of dim-sum bonds is more evidence of a deteriorating external environment for China. The offshore yuan-trading market may encounter a crisis in the future, compromising its development. Worse still, if the yuan begins to depreciate, the Chinese economy will face new challenges.

This is an edited excerpt of an article by He Jun, a research fellow at the Beijing-based research company Anbound Consulting, published in Securities Times