China's market turmoil since the start of the new year has put the spotlight on a not-much-noticed quirk of trading the mainland's currency: the offshore yuan doesn't always want to stay in tune with its onshore peer.
What's the difference between the onshore and the offshore yuan?
While China has slowly been opening its markets, the country still doesn't allow a completely free flow of capital across its borders. The onshore yuan, also called the renminbi, is constrained by a trading band: China's central bank, the People's Bank of China (PBOC), lets the rise or fall a maximum of 2 percent against the dollar, relative to the official fixing rate, which is set daily.
But the offshore yuan, abbreviated as the CNH, trades freely, based on market forces.
The offshore market was created in 2010 to help "internationalize" the currency for purposes such as hedging and investment, but not trade. Trade settlement can be done through a designated clearing bank in Hong Kong.
Why were China's policymakers so concerned?
In November, the International Monetary Fund (IMF) agreed to add the renminbi to its Special Drawing Rights (SDR), a type of international reserve asset. It will join the euro, yen, pound and dollar in the reserves basket. The yuan will have about an 11 percent weighting in the SDR. The renminbi's addition will take effect in October.
That means the renminbi is now officially recognized as a reserve currency, in a reflection of the changing dynamic of the world's economy.
But one of the requirements of the SDR is that the onshore and offshore yuan need to converge toward a free floating rate. As markets sold off this month, the two currencies diverged.
The dollar was fetching as much as 6.7511 yuan offshore on January 7, compared with 6.5926 yuan onshore, a large spread. At Wednesday's close, the dollar was worth 6.5648 yuan offshore and 6.5743 yuan onshore.
What did China's policymakers do?
The PBOC intervened in the offshore market, sopping up yuan there. That caused the cost of borrowing offshore yuan in Hong Kong's interbank market to surge earlier this week as the amount of spare renminbi in the banking system declined. The Hong Kong Interbank Offered Rate (Hibor) tied to the offshore yuan surged as high as 67 percent for overnight lending, the highest since it was established in 2013. That put the squeeze on speculators who were selling the yuan short on expectations the currency would fall further. Speculators may have also been purchasing yuan in the offshore market and then selling it in the onshore market to take advantage of the arbitrage.
"We believe China is sending a strong message to speculators and trying to stabilize renminbi depreciation expectations," HSBC said in a note Tuesday.
While the CNH overnight Hibor had already eased to 3.60550 percent by Thursday, that doesn't mean offshore yuan are about to become plentiful.
"If it is the PBOC's intention to keep CNH Hibor high to make it expensive to short the offshore renminbi, then renminbi liquidity is unlikely to be forthcoming," HSBC said in a separate note Wednesday. Those higher offshore rates aren't likely to be transmitted to onshore channels or to have much impact on the real economy, HSBC said.
"Neither Hong Kong's economy nor China's economy is heavily reliant on CNH Hibor funding," it said.
Offshore-yuan Hibor borrowing likely isn't all that large. Bank of China estimated in March that daily volumes in the offshore yuan interbank market were $5 billion to $8 billion on average. That's a fraction of the more widely-followed Hong Kong dollar-tied Hibor.
Why were markets unsettled by this?
Last week, policy makers at the central bank, the People's Bank of China (PBOC), tinkered with the currency without providing much indication to the market about its endgame -- one factor in the China market selloff that spurred a global stock rout.
The markets' reaction may have been driven by fresh expectations the renminbi will fall, Capital Economics said in a note Tuesday.
"Many saw the official comments last month that the renminbi's value should be measured relative to a basket rather than the dollar as a precursor to devaluation," Mark Williams, chief Asia economist at Capital Economics, said.
"Investors believe the PBOC will choose or be forced to allow the currency to weaken in the future even if that is not its plan today," he said. That gives investors an incentive to sell now, rather than wait, Williams said.
"The renminbi will remain under pressure as long as investors question how committed the People's Bank is to holding the currency steady."
DBS was more blunt about how markets interpreted policymakers' moves: "After the renminbi was included in the SDR, authorities announced they would pursue the basket strategy they should have pursued all along. Markets interpreted the divorce with the dollar an official wish for a weaker currency and wasted no time in granting it," the bank said in a note Thursday.
What may happen ahead?
China's policy makers are likely to continue their gradual process of liberalizing the currency toward a market-determined exchange rate.
"The first order of business is to shift the 'stable CNY' bias from the U.S. dollar towards a weighted basket of currencies," DBS said in a separate note Wednesday.
That's already in process.
In August of last year, China shifted the market mechanism for setting its daily fixing, saying it would set the spot rate based on the previous day's closing, theoretically allowing market forces to play a greater role in its direction.
That resulted in an effective 2 percent devaluation in the currency, a move which sparked fears of a "currency war" to make Chinese exports more competitive. China is also now looking at its currency against a basket of its trading partners' currencies, rather than the U.S. dollar exclusively.
"The next order of business is to keep the CNY-CNH rates close to each other ahead of the yuan's official entry into the SDR," DBS added.
But in the larger picture, while the process may be worrying investors in the short term, what China's policymakers are doing may not be terribly unusual.
"All countries go from a domestic currency to gradually internationalizing. All the largest countries in the developing world and Asia have done this," Ganeshan Wignaraja, an advisor to the Asian Development Bank's office of the chief economist, said. "It's inevitable. It's the second largest economy in the world. It's going to be a major trading currency eventually."
-Neelabh Chaturvedi and Jacob Pramuk contributed to this article
—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1