Hong Kong's pivotal role in RMB capital flows

China’s yuan has been weakened due to a number of factors including the trade war escalation although it has recovered somewhat from late January as the dollar weakened, and more cross-border portfolio flows have entered China’s equity market. While there has been concern over whether China will use the exchange rate to offset part of the tariffs and maintain export competitiveness, the recent improvement in sentiment and investment into equities has offset the depreciation pressure. In this note, we analyze the yuan's performance and how it interlaces with China's capital flows. More importantly, we argue that it is increasingly important to look at Hong Kong to have a complete picture of RMB capital flows.Poles apart in China’s current and financial accountsChina has experienced a financial account deficit in the onshore market since 2022. However, the rapid increase in the trade surplus in the second half of 2024 has helped mitigate the depreciating pressure on the RMB since. Still, Chinese exporters remain reluctant to convert their FX receipts into RMB. In other words, while there are positive net capital flows into China, the net FX conversion remains negative in 2024 with exception in only a few months.Hong Kong plays a greater role in RMB forex transactionsHong Kong's RMB asset pool is less than 1% of mainland China, but it has an important role in RMB transactions thanks to its major role in the forex market, both in terms of spot but also swap markets (Hong Kong has 25% more spot RMB forex transactions than the mainland and 76% more RMB forex swaps activities). This means that major swings in the forex conversion in Hong Kong can have relevant consequences for the RMB onshore market.Forex activities in Hong Kong turns net RMB conversion into positive, which can in turn support the RMBWe find evidence of a rapid and significant increase in net RMB conversion ($412 billion) in Hong Kong between October 2023 and July 2024, which coincides with the negative net RMB conversion in mainland China ($205 billion). In other words, activities in Hong Kong have turned total RMB FX conversion from net outflows in mainland China to net inflows on an aggregate level.The conversion activity in Hong Kong seems to come from the interbank market as the size outpaces the RMB trade settlements by corporates, and there is a surge in Hong Kong banks' claims on mainland China. It returns to normal when the RMB pressure dissipates in September 2024 as China's trade surplus balloons and the market sentiment improves fueled by the hope of stimulus in China but also potential FED's rate cuts.Conclusion: Hong Kong is vital regardless of intervention or market activitiesWith the limited available data, we can only point to a seemingly stabilizing factor in Hong Kong as far as the RMB is concerned but it is much more difficult to understand the sources of such behavior. If these movements reflect government intervention to smooth the volatility of the RMB, it points to a very important role of Hong Kong beyond RMB internationalization. If it is driven by market activities, it points to how much Hong Kong based financial institutions may influence the value of the RMB.