Offshore Yuan Strengthening Continues Amid Tight Liquidity

(Beijing) — Analysts say efforts by China to tighten liquidity in Hong Kong’s offshore yuan market have driven sharp gains in the currency, burning short sellers and reflecting the central bank’s growing strength in defending the yuan overseas.

China’s offshore yuan continued to strengthen against the U.S. dollar on Thursday, with the exchange rate dropping to as low as 6.7863 yuan per dollar in afternoon trading before bouncing back a little. That means its value strengthened against the greenback by more than 2%, including the previous day’s gain. That is the biggest two-day increase in the offshore yuan’s value since records began in 2010, according to Bloomberg LP.

The yuan’s onshore exchange rate, which is more influenced by the Chinese central bank, strengthened too, but not as much as it did in the offshore market. The difference between the two, referred to as the spread, widened to more than 1,000 basis points in the afternoon and marked the first time since 2010 that offshore investors placed a higher value on the Chinese currency than mainland traders by such a wide margin.

The exchange rate movements were accompanied by a surge in the cost to borrow yuan outside the mainland, with the benchmark overnight Hong Kong Interbank Offered Rate rising to the highest level in more than a year and the overnight deposit rate surging intraday to an all-time record of 100%.

“The tightened supply of liquidity in offshore markets indicated the central bank is intentionally driving up the cost for short-selling the yuan,” said Zhang Lu, analyst with think tank Caixin Insight Group.

Short sellers of the yuan profit when the yuan’s value falls because they essentially borrow yuan to buy another currency, and when they later sell the other currency, they get back more yuan than they had borrowed. But when the interest on the loans to borrow yuan increases, the short sellers are less likely to make a profit.

Capital flows out of China, fueled by potential greater returns on dollar assets and pessimism about the Chinese economy, drive down the yuan’s value against the dollar. And this can become a self-fulfilling prophesy because as the yuan depreciates, more people will want to convert their wealth into dollars.

China has taken a slew of measures recently to stem capital outflows, including tightening restrictions on domestic enterprises’ investment overseas and requiring banks to strengthen scrutiny of individuals’ requests for foreign exchange.

Beijing affects the offshore yuan market mainly by controlling the supply of yuan loans, of which the biggest providers are the Hong Kong branches of Chinese banks. With less yuan available, loan costs increase.

This strategy has become more effective since August 2015 because the pool of offshore yuan deposits has shrunk by more than a third under the influence of the central bank, according to Chi Guangsheng, an analyst at Industrial Securities. The amount of yuan funds in offshore bank accounts in Hong Kong was less than 630 billion yuan ($91 billion) in November, down from nearly 1 trillion yuan in 2015.

“Shrinking deposits in offshore yuan accounts mean that the Hong Kong market has considerably fewer yuan funds to tap,” he said, “meaning that the Hong Kong market is growing ever more reliant on the central bank to meet its demand for yuan.”

Zhou Hao, Commerzbank’s economist on Asia, wrote in his column on Caixin’s Chinese website: “As long as the central bank does not want to provide the offshore yuan market with liquidity relief, the tight situation will continue, and the cost of shorting the yuan will increase.”

This may well have reflected the central bank’s “new attitude” regarding the offshore yuan market, he wrote.

Contact reporter Wang Yuqian (yuqianwang@caixin.com)