CAUGHT SHORT AND HURTING ..... JUST AS THE PBoC WOULD HAVE WANTED IT

Tuesday 12th January 2016

CAUGHT SHORT AND HURTING ..... JUST AS THE PBoC WOULD HAVE WANTED IT.

ref :- "China opens new front in war on speculators" the FT Online Jan 11th, updated.

Remember last week, we had a look at the differential between the exchange rates of the official, onshore Chinese Yuan (CNY) and its offshore equivalent in Hong Kong (CNH). At the time US$ / CNY was trading at 6.5540 and US$ / CNH had been hammered out to 6.7100, a spread of over 1500 "pips", a record in itself and something of an embarrassment to the Chinese authorities. It would be fairly safe to assume that IMF officials who had only recently granted the Chinese currency Reserve status would have been unhappy at the state of affairs, and more than likely they would have discussed it with the People's Bank of China in the expectation that they would do something about it. Well, they did .... and in no uncertain terms. At the time of writing the spread is in to ..... zero. Both CNY and CNH are trading around 6.57 to the US Dollar.

Not that the PBoC would have needed much persuasion. Much of the impetus behind the Yuan's weakness has been led by speculative short-selling of the offshore CNH. The PBoC's aggressive buying has not only closed the unhealthy gap between the two (and therefore put a stop to the unwelcome arbitrage business whereby speculators make a turn by effectively buying cheaper CNH and selling less cheap CNY), but also brought some relief for the currency as a whole. The mechanics are fascinating, and as far as the PBoC are concerned they too bring their own rewards.

In global terms, and indeed when considered against China's arsenal of over $3.3 trn of foreign exchange reserves, CNH is a small market. Comparatively small interventions by the PBoC can have a very large effect on both exchange and interest rates. In purchasing large amounts of CNH which it will hang on to, the PBoC is draining liquidity (from a market already contracted in size since controls were relaxed on the onshore version in August), and effectively depleting the supply of CNH available for interbank lending. The obvious consequence of this is a spike in short-term interest rates. And when we say a spike ..... On Friday, overnight rates for CNY were 4%. Yesterday, they hit a record 13.4%. And today ? Try 66.82% on for size. Yes, that's 66.82%. The one week rate has gone from 7.1% to 11.2% to 33.75%. Even the 1 month rate is now at 15.74%.

This happy (for the PBoC) and entirely intentional consequence of buying and holding offshore Yuan is so effective because it puts a stop to one large element of the speculative selling ..... which is to say, the short-term carry trade. This involves borrowing CNH, selling the CNH for foreign currency, and repaying the loan once the CNH has fallen. In essence, you're borrowing a currency to sell it and that doesn't work if you've got to pay a stratospheric interest rate (which itself also supports the currency you're selling).

The PBoC will be content that it has got the offshore Yuan back in harness, but that has little effect on the overall prospects for the currency. Most still expect further weakness against the dollar, which would also be just fine so long as moves are gentle and controlled. And in answer to the accusation that it has embarked on a competitive devaluation, the authorities will point out that they are committed to maintaining the currency's value against a trade-weighted basket of currencies, rather than just the US dollar. By that measure, the yuan has barely moved recently. Actually, from a certain standpoint it's a view that makes a good deal of sense but unlikely to be one that protectionist politicians in the US and elsewhere will buy into.