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Exclusive: China ramps up its defense of the yuan by directing bond limits

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SHANGHAI/BEIJING (Reuters) – China’s central bank has asked domestic lenders to reduce their investments in overseas bonds, according to two sources with direct knowledge of the matter, in the latest in a series of increasingly aggressive moves to prop up the yuan.

The sources said the directive, which was issued this week, is for banks to restrict southbound purchases under the Bond Connect scheme, and aims to limit the supply of offshore yuan.

The sources spoke on condition of anonymity because they are not authorized to speak to the media. The People’s Bank of China declined to comment on the content of the window’s guidelines.

The move is the latest in a host of recent efforts to make it harder to sell the yuan and support the currency against the US dollar.

With China’s financial markets suffering losses and large outflows, and investors impatient at the lack of more robust measures to address the ailing economy, the move also adds to the sense that policymakers view currency stabilization as an urgent task.

The currency weakness highlights one of the main challenges Beijing faces in its efforts to revive growth, as any major monetary policy easing could further fuel pressure to depreciate the yuan and accelerate capital outflows.

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Ken Cheung, chief Asian foreign exchange strategist at Mizuho Bank, said the directive “could reduce the flow of capital from the mainland through the bond market.” “It could also lead to a rise in offshore yuan yields to support the renminbi.”

The yuan, which has fallen more than 5% against the greenback this year, hit a 10-month low of 7.3180 per dollar last week, close to levels last seen during the 2008 global financial crisis. It has held steady since then. To trade flat at 7.2872 on Friday.

The offshore yuan also held steady, but the spread between onshore and offshore futures, a measure of the cost of borrowing the yuan, rose to its highest level in five years and indicated pressure on offshore short sellers.

Hong Kong’s one-month yuan borrowing costs – another measure of external liquidity, which rises when supply is tight – were near a five-year high earlier this week.

“The magnitude of the pressure remains very moderate, and may serve as a warning for speculative inflows on such CNY short positions,” said Qi Xiaojia, chief China economist at Credit Agricole.

Bears beware

Under the two-year Bond Connect plan, the subject of the central bank’s directive, mainland institutional investors can buy Hong Kong-traded bonds and, at the end of July, held about 426.98 billion yuan (60 billion U.S. dollars) in offshore securities.

It is not clear whether the request to reduce these holdings refers to the investments of banks or those owned on behalf of clients. However, July was the first month of the year in which the total declined, down 24.6 billion yuan from the previous month.

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The money flow isn’t massive, but since the move follows other efforts to stop short sellers, sources familiar with the guidance thought it would send a strong signal.

Meanwhile, the People’s Bank of China also urged banks to stop subscribing to negotiable certificates of deposit (NCDs) issued by offshore banks, two separate issues, earlier this week, another move aimed at cutting off offshore yuan trade.

“Restricting the flow of the yuan into overseas markets may lead to a narrowing of the yuan’s liquidity abroad to raise the cost of financing,” said one of the sources, who believes the central bank’s move is a blow to foreign yuan speculators.

A former central bank governor said the Chinese central bank’s increased sales in Hong Kong this week also helped tighten liquidity in the offshore market to help stabilize the yuan.

For weeks, the central bank has been setting the yuan’s trading range above market expectations, and state banks have been buying yuan in the onshore and offshore foreign exchange markets.

Earlier this week, China’s major state-owned banks withdrew external liquidity in yuan in London and New York trade, prompting a sudden surge in the yuan forward rate.

($1 = 7.2862 yuan)

Reporting from newsrooms in Beijing and Shanghai; Writing by Tom Westbrook. Edited by Shri Navaratnam

Our standards: Principles of Trust for Thomson Reuters.

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