If a currency represents a country's standing on the global stage, then China has been poorly represented until now.

Loosely pegged to the U.S. dollar and subject to tight capital controls, the yuan or renminbi -- the people's money -- is today anything but an international currency.

But with little fanfare last year, Beijing embarked on the first step on a long road toward making the yuan one of the world's top currencies, allowing Chinese exporters and importers to start settling trade in yuan rather than dollars.

The shift will not only make China a bigger force in global markets, but may also reshape Hong Kong's role as a financial center and tie it even tighter to China's economy.

China's leaders need a friendly testing ground for loosening tightly controlled interest and exchange rates without threatening domestic policymaking. Hong Kong, a special Chinese territory since 1997, can offer it both that security and the benefits of its expertise in freewheeling international markets.

In the long term, no financial center can ignore the renminbi as one of the very major currencies in global financial markets, said Stanley Wong, director and deputy general manager at ICBC Asia in Hong Kong. Hong Kong cannot afford to not be involved in the development of the RMB business.

Trade settlement means more yuan will pile up in the Hong Kong banking system as deposits, and those deposits will serve as the seeds for full-fledged yuan markets in bonds and other instruments -- the lifeblood of a capitalist economy -- for the first time outside Chinese borders.

HSBC has estimated that yuan trade settlement could blossom to 40-50 percent of Chinese foreign trade, or nearly $2 trillion, in the next three to five years, while others say the rise of such a market would be akin to the rise of the dollar LIBOR money market in London that helped build its status as a global financial center.

Bankers say the trade settlement scheme may ultimately lay the groundwork for the yuan to replace the Hong Kong dollar, which has long been pegged to the U.S. dollar.

It could also lead to the People's Bank of China eventually assuming monetary policy for the Special Administrative Region, a former British colony where many citizens still feel proudly independent of the mainland.

A recent Reuters poll found most analysts believe the yuan will be freely traded by 2020, the target date set by Beijing to make Shanghai an international financial center.

From a long-term perspective, trade settlements are not enough if a yuan market is to take shape; there must be capital account liberalization eventually, said Qing Wang, economist at Morgan Stanley in Hong Kong.

For a graphic on yuan deposits in Hong Kong, click on: http://r.reuters.com/jyc46g

YUAN GOES GLOBAL

In July Beijing authorized 400 Chinese firms in five coastal cities to use the yuan to settle transactions with businesses in Hong Kong, Macau and ASEAN countries under a pilot scheme. So far the number of transactions have been small, but the scheme is expected to extend to all mainland companies before long.

An offshore yuan market will gradually take shape as China starts to promote its currency to challenge the dollar's global dominance while also developing a deep yuan market outside the mainland -- including regular currency trading and related derivatives.

Beijing realizes that it needs to open its largely sheltered financial markets and make the yuan more convertible to achieve its ambitions for the renminbi.

But the absence of yuan derivatives such as forwards and swaps for risk-hedging could hamper Beijing's plans, said Zhao Xijin, an economist at Renmin University in Beijing.

One big motivation for China is to stem the rapid dollar inflows that have pumped up foreign exchange reserves to $2.3 trillion, by far the world's largest, as its virtual currency peg forces it to absorb the flow of dollars.

The reserves, of which 70 percent are held in U.S. Treasuries and other dollar assets, are threatened by the dollar's steady slide as Washington prints money to spur the U.S. economy.

For a graphic on China's top trading partners, click on: http://r.reuters.com/syc46g

THE NEXT LIBOR?

All of this could play to Hong Kong's benefit as it worries about being usurped by brash financial up-and-comer Shanghai.

Yuan bond issuance in the territory has slowly taken root this year, including the sale of China's first yuan sovereign bond, and mainland financial institutions and the mainland branches of Hong Kong banks can now issue yuan bonds there.

Indeed, economists at Goldman Sachs said Hong Kong was in the pole position to develop a critical mass for an offshore yuan interbank market.

Chen Lu, chief economist at Haitong Securities in Shanghai, said Hong Kong's role may be similar to that of London when the LIBOR (London interbank offered rate) market developed due to certain financial controls in the United States.

Even if Shanghai rises as another yuan offshore market one day in future, it will be a long time away, Chen said.

The process may see Hong Kong gradually establishing a system of benchmark interest rates for China, similar to the LIBOR's function to dollar lending.

Such a move would re-affirm Hong Kong's status as a global financial center despite the expected rise of Shanghai as a future financial star in global markets.

Of course, China is also trying build a similar benchmark interest system in Shanghai, called SHIBOR, but with little success so far.

The Chinese government has repeatedly said that its plans to make Shanghai an international financial center should not jeopardize Hong Kong's status, a claim greeted with some skepticism in Hong Kong's financial community.

But having two international financial centers could serve China well: Shanghai has the advantage of being close to Chinese clients but Hong Kong has the historical links to the outside world.

As long as we grab every single opportunity, Hong Kong will seize a major share of the renminbi business, said Wong at ICBC.

(Additional reporting by Kevin Yao in Singapore; Editing by Kim Coghill)

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