But others say incremental changes in Chinese regulations are creating more channels for investors to move yuan between domestic and offshore markets, pointing to a growing market in Hong Kong that Beijing is using as a testbed for far-reaching reforms which could one day see the yuan become a global reserve currency.

"The landscape has changed for the better," said Tee Choon-Hong, regional head of capital markets, North Asia at Standard Chartered Bank, referring to the recent introduction of new guidelines allowing companies to invest yuan in China.

While many of the earlier deals in the offshore yuan market (CNH) were driven by speculation that China would allow faster appreciation of the yuan, Tee and others said that is no longer the single driving factor behind the market's growth.

Multinationals such as heavy equipment maker Caterpillar (CAT.N) are eager to plough more money into the country to fund expansions. While capital controls still make it tough to get offshore yuan back into the China, their gesture of selling yuan-denominated bonds is unlikely to go unnoticed by Beijing.

"A market that has previously blown hot and cold due to shifts in yuan gain expectations has made the transition to a more sustainable growth trajectory," said Tee, who shepherded McDonald's (MCD.N) first yuan bond in Hong Kong in July 2010.

For the offshore yuan market, that marks a sea change. It is now the more developed, liberal counterpart to China's still tightly controlled domestic market, and recent reforms show authorities are more confident about its prospects.

Indeed, some economists argue that the rapid expansion and development of the offshore yuan market could give Beijing enough confidence to speed up broader reforms domestically, by giving sophisticated investors more access to relatively underdeveloped mainland markets, though full convertibility of the yuan may still be a long way off.

Conversely, unruly expansion of the offshore market could alarm Chinese policymakers into thinking they were losing control of the currency, and prompt them to take steps to stamp out volatility.

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Latest CNH Tracker: r.reuters.com/tuj56s

Breakdown of yuan swap lines: link.reuters.com/dab46s

Offshore yuan deposit growth: link.reuters.com/raw46s

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TRADE FLOWS FLOURISHING

London, New York and other major global financial centers are eager for a piece of the fast growing market in yuan-denominated assets, but Hong Kong's status as a special region of China is likely to ensure it will be the biggest beneficiary of further moves by Beijing to internationalize the currency.

Offshore yuan deposits in Hong Kong banks have already expanded by a factor of 10 in two years, though they are still equivalent to less than one percent of China's total yuan bank deposits.

December monthly figures for trade settlement and offshore yuan deposits are a case in point for the market's potential.

Even as a more than 6 percent monthly drop in CNH deposits in December to 588 billion yuan ($93 billion) grabbed headlines, monthly trade volume settled in yuan jumped to its highest level since the market began in June 2010, indicating two-way trade flows between the mainland and Hong Kong are flourishing.

That is a big change. Growth of the offshore yuan market previously leaned on a larger number of mainland importers settling more of their bills in yuan because of the cheapness of the dollar abroad and relying on yuan-hungry investors to buy yuan debt, or so-called "dim sum" bonds, sold in Hong Kong.

But as hopes of hefty appreciation in the yuan melted after a global market selloff in the second half of 2011, giving a heavy jolt to the nascent CNH market, Beijing realized that it was equally important to allow the yuan to flow back into the mainland to keep the yuan trade settlement alive.

Recently, the pace of these reforms has only accelerated.

In less than two months, Beijing has taken the covers off a long-awaited cross border investment scheme (RQFII), streamlined a yuan-denominated inward foreign direct investment scheme, signed swap lines with more countries and eased regulations and trading limits on yuan transactions for banks in Hong Kong.

Daryl Ho, head of market development at the Hong Kong Monetary Authority, the territory's central bank, said at a FinanceAsia conference last week he wasn't worried about December's drop in deposits.

"There are more bilateral flows now in yuan and that is a increasingly healthy sign," Ho said.

REFORMS: CHINESE STYLE

The percentage of trade settled in yuan to total China trade has grown to nearly 7 percent in 2011 compared to less than 1 percent in the June quarter of 2010.

But as Beijing signs more trade deals and extends yuan swap lines with other countries, companies and investors are demanding more access to renminbi assets to give them an incentive to switch their trade settlements to yuan from U.S. dollars.

Last Wednesday, China more than doubled its swap line with Malaysia to 180 billion yuan, taking the total amount of swap lines signed with its trading partners to nearly 1.5 trillion yuan, representing a quarter of its global trade.[ID:nK7E7ND00O]

Some of those demands have also come from countries seeking to diversify their currency reserves. Japan wants more access to Chinese markets to boost trade and help its moribund economy, while Nigeria has hopes to hold as much as 10 percent of its reserves in yuan. [ID:nL4E8D81WX]

And China is heeding those calls. A long-awaited plan to allow Hong Kong-based financial institutions to invest their CNH proceeds in the mainland finally took off in December with authorities granting quotas amounting to 20 billion yuan.

Chordio Chan, head of investments at Bank of China Hong Kong (2388.HK), the territory's only clearing bank for yuan transactions, said Beijing will sign more yuan swap lines and award more yuan investment quotas this year to boost the offshore market.

USEFUL SIGNALS

In developing Hong Kong as an offshore trading hub for its currency, while maintaining a tight grip on the yuan at home, China has turned a longstanding, evolutionary model of offshore foreign exchange markets upside down.

Countries such as the United States and Germany developed their domestic markets long before the use of their currencies flourished overseas.

Under Beijing's plan, Chinese banks and companies can learn to handle their currency and interest rate exposure without the risk of causing lasting damage to mainland markets, Sebastian Mallaby and Oli Wethington said in an essay published in Foreign Affairs.

"The system can be tweaked and tested before it is rolled out on the mainland, and in the meantime, it may generate price signals useful to China's government." For a link: r.reuters.com/raf56s

(Editing by Kim Coghill)

• A Permanent Economic Emergency