S.Korea c.bank, regulator inspect 4 banks on yuan products - sources

(Refiles to fix headline formatting)

* Branches of three Chinese banks, one other under inspection

* Regulators express concern about recent spike in yuan deposits

* Unclear whether regulators will take measures after inspection

By Joyce Lee and Christine Kim

SEOUL, March 19 (Reuters) - South Korea's authorities are inspecting units of four foreign banks over a spike in yuan holdings, regulatory sources told Reuters on Wednesday, reflecting Seoul's concern about potential risks posed by the rapid rise in exposure to China's markets and its currency.

Yuan holdings by South Korean residents soared to an equivalent of $7.62 billion at the end of February from $310 million six months earlier as Chinese banks aggressively raise funds overseas in response to tighter credit back home.

Because the won can't be directly converted into yuan, the deposits are built through a structured product using dollar-won and dollar-yuan swaps.

Such products have been popular with institutional investors, attracted by higher interest rates than won deposits offer.

The total amount is still much too small to pose any systemic threat to South Korea's $1.1 trillion economy, but given its past episodes of financial turbulence, the authorities are highly sensitive to rapid changes in cross-border flows.

"The inspection was initiated due to concerns that the sharp increase in yuan deposits could lead to an increase in external debt as well as risk of losses for depositors stemming from increased credit risk in China," one person familiar with the matter told Reuters, adding that it would take considerable time for the regulators to assess the impact of yuan deposit growth.

"This inspection doesn't mean that some measure on suppressing yuan deposits is on our minds. This is about fact-finding," he said.

Officials have in the past expressed their concern about potential losses for local investors if their deposits are used to fund risky loans in China that subsequently go sour, noting that Chinese banks were using money raised in South Korea to lend in China.

NO OFFICIAL COMMENT

The four banks being inspected are Bank of China Ltd. , Industrial and Commercial Bank of China Ltd. , China Construction Bank Corp and Barclays PLC (LSE: BARC.L - news) , three regulator sources familiar with the matter said. The sources declined to be identified because of the sensitivity of the issue and declined to comment on why Barclays was part of the inspection.

The Bank of Korea and the Financial Supervisory Service (FSS) are jointly conducting the inspection, which is due to run until March 28, the sources said. Both the central bank and the FSS declined to comment when contacted by Reuters.

The yuan holdings account for only 14.5 percent of all foreign currency deposits in Korea, and the total pales in comparison with about $144 billion worth of such deposits in Hong Kong at the end of January or the $32 billion held in Singapore at end-2013.

Nevertheless, if deposits kept growing at current pace -- an almost 25-fold increase over six months -- they could turn into a major external liability.

"I think the probe stems from the fact that the yuan is depreciating. Losses are likely if this decline becomes a trend, so the authorities are probably looking to see what exactly is going on," said Park Sang-Hyun, chief economist at HI Investment & Securities in Seoul.

On Friday, Taiwan's central bank urged investors to exercise caution in the face of risks posed by the Chinese currency's recent decline.

BANKS TOLD TO SLOW DOWN

An official at Industrial and Commercial Bank of China's South Korean subsidiary said it would cooperate with regulators, while a Barclays media official in Hong Kong declined to comment. Local (Frankfurt: OTQ.F - news) branches of the Bank of China and China Construction Bank could not be immediately reached for comment.

The foreign banks are authorised to raise foreign currency deposits. The FSS instructed the Chinese banks to slow their yuan deposit-building late last year. The regulator also wants to limit how much of the funding can be used overseas, though it is unclear whether such a measure will be implemented.

Worries about exposure to China's credit risks come as China recorded its first domestic bond default this month when Shanghai Chaori Solar Energy Science and Technology Co Ltd missed an interest payment.

According to Chinese regulations, Chinese banks can only use funds raised through offshore yuan markets for domestic loans in relatively small pilot-zones such the Qianhai economic zone in Shenzhen, which may reduce default-related risks for Korean investors. But in practice, banks are able to find ways to bypass these regulations.

($1 = 6.1920 Chinese Yuan) (Additional reporting by Lee Shin-hyung in SEOUL, Xie Heng in BEIJING, Saikat Chatterjee in HONG KONG; Writing by Se Young Lee; Editing by Choonsik Yoo, John Mair and Tomasz Janowski)