Institutional investors have talked a lot about the so-called “yen carry trade” over the past couple of years. But that’s really just been a warm-up act for a much bigger story.

I’m talking about the “yuan carry trade.”

You’re hearing about it here first. But I promise that you’ll soon be hearing about it virtually everywhere.

Let me explain.

China’s New Profit Catalyst

Most investors are aware of China’s massive profit potential. But what they may not understand is this: Before all that potential can be transformed into actual profits, this Asian giant needs to develop a modern, fully functional financial system. That obviously can’t happen overnight, and China’s been smart – and avoided making major mistakes – by not rushing things.

In fact, despite some stinging criticism from the West, Beijing has held its companies and its financial markets in check to ensure an orderly development. It’s even left some protectionist measures in place to make sure that opportunistic foreign firms don’t overrun its markets.

Naturally, there’s been a near-term cost. It’s held some China-based companies back, making them less competitive in such developed markets as the United States and Europe. Chinese firms were severely limited in their access to funding, meaning they were also limited in their ability to capitalize on business opportunities in these overseas markets.

But I could see that the long-term profit potential for these companies was huge – and I’ve repeatedly said so to the audiences that I’ve spoken to at events all around the world, or that I’ve written to via my columns here in Money Morning. In both venues, I’ve told listeners and readers that the day would come when these companies were able to raise enough investment capital at home to finance their forays abroad.

The day that occurred, I’ve said, is the day when the real fireworks would begin.

Beijing finally lit the fuse.

By announcing the launch of a new market for dollar-denominated bonds that are issued by non-financial firms, China has now taken a major step toward modernizing its capital markets. The move hasn’t made much of a splash here in the United States. But I was in China, heading my annual investment tour of that country, when the announcement was made. And believe me when I tell you that China’s company executives, investors and government officials fully understand the implications of what’s just been done.

The move is very shrewd, for it brings about the confluence of highly complimentary trends.

• For China-based companies that want to invest abroad, or that want to buy foreign companies, product lines, or other assets, these new dollar-denominated bonds will make it possible to do these deals more easily, and at a much lower cost.
• Beijing had already launched an official campaign that urges “Corporate China” to acquire overseas companies and assets. But there had to be a liberalization of the financial system for this to happen. So back in August, in fact, for the first time in 11 years, China’s government eased rules governing its foreign-exchange systems. 
• These new regulations permit companies to retain foreign-exchange income offshore, if they want, and thus helped pave the way for the new bond market because it stokes potential demand for dollar-denominated investments.
• And that comes at a perfect time for – up until now – the ongoing global financial crisis, which has made Chinese investors wary of buying foreign-currency bonds that were issued outside China. But these dollar-denominated bonds will be created inside China, effectively short-circuiting that worry.

Given what we know about China’s global natural-resource-acquisition ambitions, the first entrants into this new market will likely be one or more of China’s huge natural-resource concerns that are presently scouring the globe, creating captive supplies of the very commodities that will be necessary to ensure China’s future growth. My experience here suggests that high-tech and infrastructure companies will follow almost immediately. Many of those firms may head straight for Taiwan, thanks to newly inked agreements that make it easier for Mainland China companies to invest across the Taiwan Straits for the first time in decades. After that, these firms will direct their appetites for acquisitions elsewhere around the world.

Just how big could this new dollar-denominated financing market turn out to be?

At a time when Western debt markets remain mired in muck, it’s too soon to tell for certain. But Bank of China Ltd. analyst Shi Lei estimates that non-financial Chinese firms may issue as much as $30 billion during the next two quarters alone.

That amount tallies closely with China’s estimated $23 billion pipeline of outbound mergers-and-acquisitions deals that have been announced this year, but not yet consummated – especially if you factor in the $9.7 billion worth of deals that were announced in the past three years, but that are still pending, Thomson Reuters reports.

Could New Financing Deals Accelerate the U.S. Recovery?

Many Americans will clearly view a big uptick in investments from China with significant fear – especially if they remember the late 1980s Japanese shopping spree that sent ownership of Rockefeller Center, Columbia Records, Universal Studios and the Pebble Beach Golf Course back to Tokyo.

This is different. In fact, I think the new rules are likely to create entirely new funding sources that will boost international trade and that could actually accelerate the U.S. economy’s recovery from the global financial crisis. In fact, it’s entirely possible that this new form of financing will help facilitate a post-recovery golden age of expansion led by such as-yet unsaturated markets as China.

Call it the “Mother of All Carry Trades” – only this time it will be yuan-based, instead of yen-based.

A carry trade is an investing strategy in which an investor takes advantage of interest rate differences between two countries. He’ll borrow money in a country where rates are low and invest it in another market where rates are higher, profiting from the difference. The rate disparities are often caused by the respective central banks; one may be trying to combat inflation with high rates even as another is trying to nurture economic growth by reducing rates.

There are no actual examples to point to, yet, since the market isn’t yet up and running, but we can draw some inferences based on who’s filed to issue this dollar-denominated debt, and look at who’s likely to file in the months to come.

According to The China Daily News, China National Petroleum Corp., the Red Dragon’s biggest oil company, is planning to issue $3 billion in dollar-denominated bonds and is planning to auction as much as an additional $1 billion in three-year floating debt, whose rate will be tied to the London Interbank Offered Rate (LIBOR).

Traders familiar with the new market suggest that CNPC will probably pay a coupon of 60 basis points to 80 basis points (0.60% to 0.80%) more than six-month LIBOR – a much lower cost than the 2.8% coupon for the $2.93 billion worth of yuan-based, three-year, fixed-rate, medium-term bills issued back in December.

Last year, China’s yuan had appreciated steeply against the U.S. dollar, meaning funding costs were high for Chinese companies. Now, however, the situation is reversed, and companies can issue huge amounts of expansion debt for comparatively little money.

As a byproduct of all this, companies that take advantage of the new dollar-denominated funding markets help take the strain off of the People’s Bank of China, the central bank that has shouldered almost all of the dollar-based exchange risk to date.

In Shanghai, which is China’s financial capital, my trading contacts tell me that six-month dollars – which were quoted at 0.40% earlier this year in China, now reflect approximately 0.80%, which is roughly in line with onshore-dollar yuan forward rates for the same time period.

By comparison, the six-month implied forward rates hit 15% in March 2008. So you can see why Chinese companies have such a powerful incentive to use this new funding venue – especially when so many otherwise-solid global companies have been brought to their knees by the credit crisis.

The Three Keys for Investors

So what does this mean for investors?

In a word, plenty.

First, it’s conceivable that the sheer volume of dollar-denominated bonds could indirectly prop up the U.S. dollar. Not only would that potentially wreck traders who are betting that it’s headed the other way, it could actually solidify U.S. and global markets that are still searching for an anchor. By implication, this could also wreck the “gold bugs” who are betting the farm, instead of investing in the precious metal as part of a disciplined investment strategy.

Second, for those on Wall Street who continue to believe they are the “masters of the universe,” the strength and ferocity with which China’s dollar-denominated bond market may develop will probably come as a rude shock. Not only are the vast majority of Wall Street firms likely to be cut out of the underwriting process, but chances are very good that they’ll probably be relegated to the back seat when it comes time to pony up in the never-ending game of global one-upmanship.

And third, depending on the ultimate size of this new bond market, the prices of resource-based companies and commodities could go sharply higher as investors realize there is a potentially unlimited source of funding chasing relatively few quality assets. To the extent that Chinese companies mirror Beijing’s plans for the future, the same will be true for technology, medical and infrastructure plays.

Will this happen immediately?

Probably not. Even though the market is potentially huge (like just about everything else here in China), Beijing will almost certainly keep its hand on the throttle, meaning it will grow at a reasonably impressive – albeit measured – pace.

Beijing is very aware that an imprudent use of debt was a key part of the elixir that created the global financial crisis, meaning government officials will work hard to make sure the tiger stays in its tank – so it can’t bite anyone.

Over the long haul, however, there’s no question that this new market is an important – and much-needed – step in China’s continued development into a global financial juggernaut that investors cannot afford to ignore.

News and Related Story Links:

• Money Morning News:
  What Companies Are Profiting From China’s Commodities Crusade?
• Money Morning News:
  China/Taiwan Investment Accords Will Lead to Profit Plays for Investors.
• Thomson Reuters:
  New dollar bond market to help fund M&A quest.
• ChinaDaily.com:
  China allots $9.2b on key technology R&D.
• Money Morning News Analysis:
  China Imports Record Amounts of Copper and Iron Ore, but Exports Drop on Slack Global Demand.
• Money Morning News Analysis:
  The Lost Decade: How the U.S. Financial Crisis Resembles Japan’s Ten Years of Misery – And How to Play it  (Part I of II).
• Money Morning News Analysis:
  ABN AMRO Deal Points to Next Ways to Profit From China.
• Wikinvest:
  Carry Trades.
• Wikinvest:
  London Interbank Offered Rate