Players in Hong Kong's fast-growing offshore market for China's currency got a rude shock last week. On Thursday evening, the Hong Kong Monetary Authority announced that Bank of China (Hong Kong), appointed as the city's sole clearing bank for yuan trade settlement by the mainland authorities, had exceeded its 2010 quota for yuan conversion. 'Quota? What quota? Who said anything about a quota?' chorused Hong Kong's financiers, unaware until then that the mainland's central bank had imposed an 8 billion yuan (HK$9.28 billion) annual limit on the supply of yuan it is prepared to make available to the Hong Kong market for trade settlements. As it turns out, there is unlikely to be any immediate disruption to yuan payments. The HKMA said it would step into the breach and draw down 10 billion yuan of its existing 200 billion yuan swap facility with the People's Bank of China to meet any shortfalls. But still, back in July when the HKMA announced the suite of liberalisations that ignited Hong Kong's offshore market in the yuan, there was no mention of any quotas. That statement gave the go-ahead to ordinary corporations and non-bank financial institutions to enter the market by allowing them to open yuan-denominated accounts and borrow in yuan for the first time. It opened the door to yuan-denominated investment products, and most significantly, it gave the green light for the development in Hong Kong of a real offshore interbank market in the yuan. Neither investors nor the city's financial sector needed much encouragement. Within days Hong Kong's banks were offering yuan-denominated structured investments to eager punters convinced that the currency is set to appreciate handsomely against an ailing US dollar. Demand for the yuan soared, with the value of yuan deposits in Hong Kong rocketing two-thirds between the end of June and the end of September (see the first chart). Yet although demand rose, the supply of yuan remained constrained. While the demand was coming mainly from investors, the supply of yuan was derived mostly from trade settlements, specifically from mainland importers paying their suppliers in Hong Kong in yuan. And while the value of yuan trade settlements has increased sharply recently - according to media reports only half the 8 billion yuan annual quota had been used up at the end of September - the supply of yuan through the trade conduit has been insufficient to meet ballooning demand. As a result, the yuan's exchange rate in the offshore market in Hong Kong has deviated sharply from the official rates set in Shanghai over recent weeks, with the yuan trading as much as 2.8 per cent stronger against the US dollar in the Hong Kong market than on the mainland (see the second chart). Given many investors' eagerness to hold yuan, that premium is likely to persist despite the HKMA's pledge to provide yuan for trade settlements. But in the longer term, Thursday's revelation that the mainland has set a quota on the quantity of yuan it is prepared to allow Hong Kong threatens to cast a shadow over the city's developing market for financial products denominated in the Chinese currency. It hints that the Hong Kong market isn't developing the way the mainland authorities intended. They wanted to encourage China's export customers to pay for their purchases in yuan, which would help to insulate mainland exporters from currency volatility while promoting China's soft power abroad. But the buyers of Chinese exports aren't very interested in paying yuan. Rock bottom US interest rates mean trade finance is much cheaper in US dollars than in yuan. Instead, what the mainland authorities got was a burgeoning market in yuan-denominated financial products, something they may not be entirely comfortable with. As a result, Thursday's news came as a sharp reminder that despite Beijing's avowed intent to internationalise the yuan, China still imposes tight restrictions on the currency's convertibility. And just in case anyone had forgotten, it rammed home the message that rules set by the mainland authorities are often opaque and frequently subject to arbitrary and sometimes retrospective revision. The yuan market is riskier than we thought.