Beijing's Short Squeeze on Yuan Bears

Look what magic HIGH interest rates can work...

BEIJING last month unleashed a new weapon in its war to curb speculation against the Chinese Yuan, writes Gary Dorsch at Global Money Trends, by secretly purchasing billions of Yuan in the offshore market in Hong Kong.

The People's Bank of China is seeking to foil a burgeoning speculative raid against the Yuan, by driving up the cost of borrowing Yuan to extraordinary heights, and causing maximum pain to currency carry traders, betting on a Yuan devaluation.

The Hong Kong Interbank Offer Rate (Hibor) for overnight loan soared to as high as 68% on January 12th, and one-week deposit rates rose to 34%, as the PBoC's suprise attack caused a panicked scramble to cover short Yuan positions in the offshore market.

The amount of deposits denominated in Chinese Yuan, in the offshore Hong Kong market, is relatively small, at CNY 864 billion ($130bn) at the end of November, a small fraction of the US Dollars available to the PBoC for intervention from its $3.33 trillion stock of foreign exchange reserves.

That means that interventions of $20 billion or more in the offshore market can have a major impact on the Yuan's exchange and short-term interest rates. Within minutes of the heft intervention, the US Dollar fell to 6.60 offshore Yuan (CNH).

That was down from a five-year high as CNH 6.75 on the Friday morning, Jan 8th.
 

 
The People's Bank of China, acting through state-owned banks in Hong Kong, is expected to hold on to its purchases of Chinese Yuan traded in Hong Kong, thus depleting the supply of CNH available for interbank lending.

By jacking up short-term borrowing costs to 34% for 1-week loans, the PBoC put a massive short squeeze on carry traders, who sought to profit from a weaker Yuan. Last year Daiwa Research estimated the "carry trade" into China could be some $3 trillion.

Mid-January it was revealed that China's foreign reserves fell by a record $108 billion in December, reinforcing worries that capital outflows are worsening as spending by the central bank to support the Yuan increases. While China still has $3.33 trillion of foreign reserves, the concern is how long it can continue intervening if capital outflows stay elevated.

To give some idea of the strength of capital outflows, they have come despite China still running surpluses on its balance of payments and foreign direct investment. The problem for policy makers is outflows are hard to control, as it let so much foreign capital in during the good times when the policy-driven Yuan pegged to the greenback was a safe-haven.