The People's Bank of China crushed short positions in the 'offshore' Yuan market, forcing the Hong Kong traded version of the mainland currency higher and close to a match with its official Shanghai traded cousin.
At the close of trading last Wednesday the spread between the 'offshore' Yuan (CNH) and the 'onshore' Yuan (CNY) had widened to a record 1409 points. The Hong Kong version ended at 6.6964 to the U.S. Dollar 2.1 percent weaker than the official Shanghai traded pair at 6.5559. Today the two pairs have been realigned, the CNH at 6.5787 and the CNY at 6.5729, 6:25 pm New York.
Overnight, the People's Bank of China (PBOC), in a move reminiscent of the European Rate Mechanism crisis in 1992, raised the borrowing cost of overnight CNH to over 60 percent, forcing virtually all short positions to cover and initiating the biggest short squeeze in recent markets.
The PBOC accomplished this by restricting access to CNH by draining liquidity from the market, buying dollars and selling CNH and then denying any new CNH for banks to lend. The central bank is the sole originator of CNH, it is not traded or held elsewhere. The bank also ordered commercial banks not to lend any of their remaining CNH stocks to short sellers. By removing this much liquidity from the market, the CNH, for a spell at least, became unusable, so presumably it will be short-lived.
The immediate priority of the Chinese authorities was to fulfill one of the stipulations of the Yuan inclusion in the SDR basket of the International Monetary Fund, that the freely traded CNH would track the managed CNY.
The CNY is restricted to a daily 2 percent move on either side of its fixed reference rate. The PBOC has used the fixing rate to guide the Yuan lower, starting with a surprise devaluation on August 11th. The bank has said that the fixing rate is determined by the Yuan's last closing level, its value against a basket of currencies and by considerations of supply and demand, but it has acted with considerable freedom and limited transparency in its currency policy.
The PBOC cut the ‘onshore’ CNY reference rate 1.1 percent in the first four days of last week, prompting a global equity rout and the sharpest drop in the offshore Yuan's value since the August shock. After last week’s move the reference rate was held relatively steady for three days.
The bank has used the reference rate and currency intervention to manage the Yuan. Intervention in the Hong Kong market cost China $513 billion of its almost $4 trillion currency reserves last year, the first draw in the history of the People's Republic.
The direction of the Yuan has been generally lower since January 2014 when the CNH reached 6.0161. From then until the August devaluation the CNH traded roughly between 6.1000 and 6.3000. But with the August surprise the meandering nature of the CNH altered dramatically. Since the close on August 10th at 6.2147 the Yuan has lost 5.9 percent of its value against the U.S. Dollar. Markets around the world from equities and commodities to debt yields have followed the Chinese currency lower.
The fear ricocheting through world markets from the Yuan devaluation is basic. The Chinese economy has been the growth engine and the hope engine for world GDP for most of the recovery. If it is faltering or crashing what will replace it?
If Beijing sees the need for a surprise and clumsy devaluation of its currency in pursuit of a mercantilist rescue of its overbuilt manufacturing and housing sectors, one can only ask, What are the Party mandarins hiding?
Chief Market Strategist
WorldWideMarkets Online Trading