A Panicking China Triggers Biggest Offshore Liquidity Squeeze Since 2018 To Crush Yuan Shorts
It's not quite as bad as Jan 2016 when, with its currency in freefall, Beijing accused George Soros of orchestrating a campaign to crush the yuan (the senile billionaire was much more focused on sparking chaos in the US at the time with Trump about to become president)... but it's getting there.
With the yuan plumbing record lows in recent days...
... and China caught in the mercantilist trap where on one hand it needs a weak currency to boost its collapsing exports and reboot its flailing economy, hence last week's surprise rate cut by the PBOC...
... but on the other, terrified that another currency devaluation can spark huge capital flight similar to 2015-2016 when over $1 trillion in FX reserves fled the country (yet with rate differentials being where they are, it's not as if it has much of a choice), China has aggressively escalated its defense of the yuan, and pulled a page right out of the Erdogan playbook when overnight it sent funding costs in the offshore market to squeeze yuan shorts and set a new record with its stronger-than-expected reference rate for the currency.
Let's start with the fixing first: the People’s Bank of China set its daily fixing for the currency at 7.1992 per dollar Tuesday, compared with an average estimate of 7.3103 in a Bloomberg survey, a delta of 1,111 pips. That was the largest gap since the polls began in 2018.
The record bias for the fixing came a day after yuan one-month forward points, a measure of the cost to borrow the currency versus the dollar, jumped the most in offshore trading since 2017 when China's financial system was going though one of its patented turmoil phases which usually just precedes massive stabilizing intervention by the communist party.
Other parts of the forward curve are also rising. Tomorrow-next forward points climbed to the highest level since May 2022 on Monday, while the 12-month tenor rose to a three-month high. The spike up in forward points comes after some tenors slid to record lows in recent months, weighed down by the US-China yield divergence. US two-year Treasuries yield about 290 basis points more than similar-maturity Chinese government bonds, the widest spread since 2006.
Indeed, in another sign of a liquidity squeeze, Bloomberg reported that Hong Kong’s offshore yuan interbank rates climbed to the highest since 2018 on Tuesday.
“A CNH funding squeeze could be a tactical tool and a signaling device, but unlikely the go-to tool in isolation,” Citigroup Inc. strategists Philip Yin and Gaurav Garg wrote in a client note. “Overall, the combination of rate cut and other FX tools suggest that fundamental-driven yuan weakness is allowed but the pace is managed.”
Chinese funding costs surged in recent days as local banks refrained from providing more of the currency in the swap market, according to traders. That has made it more expensive for speculators to bet against the yuan, and forced a squeeze.
The PBOC sold 35 billion yuan ($4.8 billion) of bills in Hong Kong Tuesday, exceeding the 25 billion yuan of the securities coming due this month. That was the first time the central bank has refrained from a flat rollover in two years, according to data compiled by Bloomberg. The offering included 20 billion yuan of three-month bills which were sold at 3.2%, the highest yield since 2018.
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The above encapsulates Beijing's paradox rather well: on one hand, the yuan has been slumping for months as China’s economy struggles as a result of its collapsing housing market and relentless defaults among China's property developers, forcing the PBOC to cut interest rates and widen the yield differential with the US. But while the central bank is easing its monetary policy, it is also trying to slow the yuan’s decline with stronger-than-expected fixings, dollar sales by state banks, and measures such as tweaking rules on capital flows, afraid that public sentiment may tip beyond a breaking point which sees the country's tens of trillions in domestic savings take flight for offshore locations, a move which would send bitcon soaring.
Indeed, as Bloomberg adds, "For years, Chinese policymakers have been highly sensitive to any speculator-driven wild yuan swings as any disorderly depreciation may trigger a vicious cycle of excessive declines and capital outflows. In its latest monetary policy report released last week, the central bank said it will resolutely prevent “over-adjustment” in the yuan with an ample reserve of policy tools to manage the currency."
And while Beijing's strategy of draining offshore liquidity may squeeze short positions - if only briefly as Erdogan has learned in his many failed attempts to crush lira shorts - it will also undermine the long-term policy intention for yuan internationalization, said Xiaojia Zhi, chief China economist at Credit Agricole CIB in Hong Kong. This latest step shows “the PBOC is intolerant of rapid one-way moves and would consider various pool tools to discourage speculative flows on CNY depreciation and manage expectations." Then again, it's not as if it has much of a choice unless it wishes to see its economy collapse in a debt-deflationary vortex.
Indeed, the recent efforts to bolster the yuan are unlikely to be enough to prevent further losses given softening consumer spending, sliding home prices and debt repayment pressures facing the local government sector.
“Policy in China is proving to be more tolerant of weaker growth, and more resistant to abandoning its efforts to de-lever the pockets of debt,” strategists at Deutsche Bank AG led by Perry Kojodjojo wrote in a note. “We continue to believe that the natural corollary to this is weakness in the currency and the authorities don’t intend to draw a line in the sand.”
