China is propping up the yuan even more than drain on reserves show - by using derivatives

A customer holding a 100 yuan note at a market in Beijing.
A customer holding a 100 yuan note at a market in Beijing. PHOTO: REUTERS

BEIJING (BLOOMBERG) - Just because China is burning through its reported foreign-exchange reserves more slowly doesn't mean it's losing its commitment to support the yuan.

The People's Bank of China and local lenders increased their holdings in onshore forward contracts to US$67.9 billion in August, positions that would boost China's currency against the US dollar. The amount is five times more than the average in the first seven months, PBOC data show. The positions are part of a three-stage process to support the currency without immediately draining reserves, according to China Merchants Bank Co. and Goldman Sachs.

Forward contracts are agreements to buy or sell an asset at a specific price on a future date.

Standard central-bank intervention to support a currency generally involves selling US dollars and buying the home tender. In this case, China's large state banks borrowed US dollars in the swap market, sold the US currency in the cash spot market and used forward contracts with the central bank to hedge those positions.

"If you can intervene without actually diminishing your reserves, it's somehow viewed as better," said Steven Englander, global head of Group-of-10 foreign exchange-strategy in New York at Citigroup. Such central-bank activity "may not look quite as dramatic as the sale of reserves, and they may prefer that optically," he said.

Using derivatives for intervention had the benefit of delaying any decline in the PBOC's US$3.5 trillion trove of foreign-exchange reserves, helping calm investors rattled by an economic slowdown and a slumping stock market. It was also faster as the monetary authority's managers didn't have to liquidate assets such as US Treasuries to raise the dollars needed for direct yuan purchases.

China, which owns one-third of the world's US$11.3 trillion of foreign-exchange holdings, isn't alone in ramping up the use of derivatives to prop up currencies against the dollar.

As the rout in emerging assets spread across Asia, central banks from South Korea, Singapore, India, Philippines, Malaysia and Thailand increased the use of forwards to US$22.5 billion in August, compared with US$6.5 billion the month before, according to official data calculated by Goldman Sachs.

The lack of a more detailed account of the PBOC's operations keeps investors guessing the extent of capital outflows and depreciation pressure.

The authority has succeeded in containing the yuan selloff after unexpectedly devaluing the currency by 2.8 per cent on Aug 11 and 12.  The currency weakened to 6.45 per US dollar on Aug 12 before strengthening to 6.35 in Shanghai, according to China Foreign Exchange Trade System prices. In the offshore market, the yuan gained 0.2 per cent to 6.3750, the first advance in four days.

Gains in China's currency would be welcome, US Treasury Secretary Jacob J Lew said, adding that the world's second- largest economy must abide by commitments not to weaken the yuan.  The US Treasury dropped its view that the yuan is "significantly undervalued" while saying that forces driving appreciation in the longer term remain and China needs to allow such strengthening eventually, according to a semi-annual report released on Monday. It said China intervened "heavily" in the past three months, spending an estimated US$229 billion to support the exchange rate.

China's reserves fell by US$43.3 billion last month, half of the record US$93.9 billion decline in August, and well below the record US$120 billion decline in foreign-currency assets held by all Chinese financial institutions, including the PBOC. Historically, the numbers have broadly matched each other as policy makers buy or sell reserves to partially offset capital flowing in and out of the nation.

"The scale of decline in this data is significantly larger than that in PBOC's foreign-exchange reserves and its foreign assets, suggesting that banks have resorted to their own spot foreign-exchange positions to help absorb outflow pressure," MK Tang, a senior economist at Goldman Sachs in Hong Kong, wrote in a research report.

Major Chinese banks borrowed dollars in the onshore swap market in late August and September, and then undertook "heavy dollar selling" in the spot market, said Frank Zhang, head of foreign-exchange trading at Shenzhen-based China Merchants Bank.

The PBOC then came in to offset, or "square", the positions with the banks, essentially taking on their trades onto its own balance sheet, according to Goldman Sachs.

The PBOC doesn't report its financial instruments to the International Monetary Fund. Hiding its footprints in the financial market may just be a convenient side effect of using the derivatives market.  On a practical level, buying yuan forwards means the PBOC wouldn't drain yuan liquidity out of the system as it would otherwise by buying its own currency in the spot market. Policy makers cut interest rates and the reserve-requirement ratio in August, partly to replenish the funds drained during intervention.

"If you have a transaction that settles down the road, the actual liquidity impact in the short term may not be as dramatic," said Citigroup's Englander. "Down the road you can't avoid it."