Hong Kong's Waning Yuan Business Seen Damaged by PBOC's Meddling

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Would Devaluation Help or Hurt Yuan?
  • Central bank mopped up currency to squeeze out bearish bets
  • Market confidence suffered a blow, CBA's Andy Ji says

As China’s policy makers wield a big stick to bring the offshore yuan in line with their idea of where the exchange rate should be, it’s Hong Kong’s reputation as a free market that’s taking a beating.

The People’s Bank of China launched a two-pronged attack last month on global investors betting on depreciation by choking off the supply of funds from the mainland and buying the currency offshore, causing yuan borrowing costs in Hong Kong to spike to unprecedented levels. The move dealt a blow to the city’s credentials as a level playing field for market participants, according to Commonwealth Bank of Australia. Aberdeen Asset Management Plc said the severity of China’s actions was a surprise, while Natixis SA judged it a setback for the yuan’s internationalization.

“While the central bank holds the traditional view that confidence derives from stability, financial markets believe confidence lies in transparency and predictability," said Andy Ji, a Singapore-based foreign-exchange strategist and economist at CBA. "Investors won’t hand over their confidence to a central bank; that’s the irony as China internationalizes the yuan."

Mainland authorities’ heavy-handed intervention in Hong Kong raises questions about the role the city can play in China’s push for its currency to be used more widely in global trade and finance. The world’s second-biggest economy is giving international funds greater access to onshore capital markets at the same time as it allows more bond sales by foreign issuers in Shanghai. Yuan deposits in Hong Kong posted their first annual decline last year, while issuance of Dim Sum bonds fell for the first time since the market’s inception in 2007.

Issuance of Offshore Yuan-Denominated Debt

The PBOC intervened in Hong Kong last month after the yuan’s offshore exchange rate sank to a record 2.9 percent discount to the onshore rate, which can be more easily controlled as China’s biggest banks and companies are all state-owned. In addition to buying the currency, it gave guidance to some Chinese lenders in the city to suspend yuan lending to curb short selling, a policy that contributed to the overnight interbank lending rate surging to an all-time high of 66.8 percent on Jan. 12.

The gap between the yuan’s exchange rates at home and abroad expanded to the biggest in three weeks on Wednesday, a sign that international traders are reviving bets against the currency. There will be a "very intense" confrontation between short-sellers and the PBOC in the near term, said Kenix Lai, a foreign-exchange analyst at Bank of East Asia Ltd. in Hong Kong.

The central bank raised its reference rate for the currency by 0.16 percent on Thursday, the most in two months. The move sends a "strong signal" to speculators that it won’t tolerate depreciation, said Irene Cheung, a foreign-exchange strategist at Australia & New Zealand Banking Group Ltd. in Singapore.

‘Quite Drastic’

While monetary authorities in other emerging markets do intervene when volatility is high and outflows are severe, the PBOC’s actions were still "quite drastic" and surprising, said Edmund Goh, a Kuala Lumpur-based investment manager at Aberdeen Asset. The company reduced its holdings of offshore yuan-denominated notes, or Dim Sum bonds, during the past six months in anticipation that capital outflows from emerging markets would pick up.

"We were caught off-guard because of how aggressively things went, and the development probably damped some investors’ confidence," Goh said. "When the expectations for the yuan to appreciate were no longer there, we expected the demand for the currency to be weaker. But we didn’t expect the doors of the capital account to close so quickly. We knew the liquidity would be poorer, we just didn’t expect it to be that bad."

Record Outflows

The yuan has retreated 2.7 percent since policy makers secured reserve-currency status from the International Monetary Fund in late November, even though the PBOC burnt through an unprecedented $108 billion of foreign reserves in December as it supported the exchange rate. Outflows from China increased to $158.7 billion that month, the most since September, according to a Bloomberg Intelligence estimate.

Companies sold 3.1 billion yuan of Dim Sum bonds in January, down from last year’s monthly average of 23.9 billion yuan, according to data compiled by Bloomberg. Only September -- the month after a surprise yuan devaluation -- saw less issuance over the past five years. The amount of Chinese currency deposited in Hong Kong dropped to a two-year low of 851 billion yuan in December, the city’s monetary authority said on Jan. 29.

The PBOC’s recent moves are reversing China’s efforts to build up the yuan’s global prestige and are detrimental to Hong Kong as a major offshore center, said Alicia Garcia Herrero, Asia Pacific economist at Natixis in Hong Kong. The former British colony cannot be too dependent on China, which it is replicating, and should operate in a freer and different regulatory environment, she said.

"For foreign investors with no real business on the mainland, the offshore yuan has become too unpredictable so they are simply retrenching," said Herrero. "And investors who operate in China and need the yuan may as well borrow onshore."

— With assistance by Tian Chen

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