Yuan Funding Crunch Shows Risks in Reserve Currency Ranking

  • Overnight funding cost in Hong Kong soared to 23.7% on Monday
  • Yuan will join IMF’s Special Drawing Rights next month

China’s desire to stabilize the yuan risks undermining its future as a global reserve currency.

QuickTake The People’s Currency

For the second time this year, the overnight cost to borrow the offshore currency in Hong Kong surged above 20 percent amid speculation the People’s Bank of China is mopping up liquidity to boost the exchange rate. The volatility comes less than two weeks before the yuan’s inclusion in the International Monetary Fund’s Special Drawing Rights -- an event seen as a validation of President Xi Jinping’s efforts to promote its standing on the world stage. The PBOC said on Monday that the speculation wasn’t accurate.

"This is not the sort of behavior you would expect from an SDR currency," said Sue Trinh, Royal Bank of Canada’s head of Asian foreign-exchange strategy in Hong Kong. "You can’t have funding for a reserve currency blowing up or moving in such a volatile fashion; it would be a nightmare for short-term portfolio management."

Any use of borrowing rates to shake down bears risks eroding authorities’ pledges to give markets more sway in the world’s second-largest economy and undercutting Hong Kong’s position as the biggest offshore yuan trading center. The yuan’s funding costs at home and abroad have been more volatile than the four existing currencies in the IMF’s reserve basket over the past three years, data compiled by Bloomberg show.

The offshore yuan funding cost, known as Hibor, jumped 15.7 percentage points to 23.7 percent on Monday, the second-largest increase on record, before falling to 12.4 percent on Tuesday. The rate previously surged to a high of 66.8 percent in January as China’s policy makers battled to restore control over the currency after a series of weaker fixings. Central bank officials can influence funding costs in Hong Kong by encouraging state-owned banks to hold back from loaning their excess yuan. A higher yuan Hibor increases the cost to borrow the currency and sell it.

Asked about speculation that the funding costs have risen because the PBOC is supporting the yuan against the dollar, and about concern that the volatility could impact its role as a global reserve currency, the central bank said Monday that such opinions and analysis are “untrue.”

Compared with January, when fears of a sharper depreciation in China’s currency spurred turmoil in global markets, there’s no sign now of panic. A gauge of mainland stocks traded in Hong Kong rallied the most in five weeks on Monday, while the yuan was little changed in Shanghai. The currency traded at 6.6712 per dollar at 4:13 p.m. local time on Tuesday.

Greater Volatility

Traders are growing used to China’s policy makers intervening before key events, said Hao Hong, chief China strategist at Bocom International Holdings Co. in Hong Kong. "The central bank has done this before."

Still, the move is underscoring the greater volatility in China’s money markets compared with other reserve currencies. While the overnight Shanghai Interbank Offered Rate surged to 13 percent during a credit crunch in 2013, similar funding costs for the dollar, yen, euro and pound all traded within a 100 basis-point range in the past three years, according to data compiled by Bloomberg.

"The rapid rise in offshore yuan funding creates uncertainty about the cost of hedging," said Rajeev de Mello, Singapore-based head of Asian fixed income at Schroder Investment Management Ltd., which oversaw $460 billion of assets globally as of June 30. "While there is always some volatility in currency forward hedging, in major currencies it is substantially lower and usually more stable."

For QuickTake explainer on the drive to free the yuan, click here

After the authorities shifted the yuan to a more market-determined exchange rate system last year, the PBOC has burnt through foreign reserves and tightened capital controls to stem losses in the currency. The yuan has fallen 4.6 percent over the past 12 months in Shanghai versus the dollar, Asia’s biggest loss, and trades half a percent away from a six-year low.

A decision from the PBOC to not extend swap contracts that it entered last year to prop up the yuan could have drained the offshore currency supply, CIMB Securities Ltd. analysts Ben Bei and Edith Qian wrote in a note. The Chinese government is prioritizing currency stabilization over internationalization in the near term, they said.

“China wants to retain control of its currency despite having increased the flexibility of the exchange rate," said Dennis Tan, foreign-exchange strategist at Barclays Plc in Singapore. "High interest rates discourages offshore yuan bond issuances and loans, and erratic spikes hinder money market development."

Losing Interest

Yuan deposits in Hong Kong slumped to a three-year low in July, while the city’s Dim Sum bond market risks irrelevance with the number of corporate issuances of yuan debt in the offshore market dwindling this year.

While the yuan will resume its decline against the dollar once SDR inclusion and a weeklong holiday at the start of October have passed, China’s policy makers will choose the timing and speed of the descent, according to Michael Every, Hong Kong-based head of financial markets research for Asia-Pacific at Rabobank Group.

“Everyone knows the PBOC is a very tough operator," Every said. "You can control a currency as much as you want; but you can’t then complain if people don’t want to use it.”

— With assistance by Justina Lee, Tian Chen, and Kyoungwha Kim

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