China Money: Dlr funding costs jolted by outlook for yuan rise
* Banks unwilling to keep dollars on hand
* Firms borrow dollars to buy yuan for speculation, arbitrage
* Key six-month dollar funding costs triple in two months
* Further rises could jeopardise dlr funding activity
* Market move poses new challenge for stable yuan policy
By Lu Jianxin and Edmund Klamann
SHANGHAI, Nov 5 - Resurging expectations of yuan appreciation have made dollars more scarce in China's foreign exchange market, tripling six-month dollar funding costs and creating new complications for Beijing's stable yuan policy.
Over the past two months, Chinese banks have become eager to sell extra dollars to the central bank, fearing the U.S. currency could fall in value, while their corporate clients are increasingly keen to borrow dollars to buy yuan <CNY=CFXS>, to speculate on yuan appreciation or for arbitrage.
With expectations of yuan strength unlikely to die down any time soon, Chinese dollar funding costs are set to keep rising in coming months and could climb prohibitively high, jeopardising banks' foreign exchange business as well as corporate dollar funding for purposes such as trade and investment, dealers said.
"There is an acute dollar shortage on the market," said a dealer at a Chinese commercial bank in Shenzhen. "The situation is likely to worsen in coming months as banks don't want to retain dollars and some of their clients are borrowing dollars to conduct arbitrage trading."
The People's Bank of China has kept the yuan at a virtual peg against the dollar since July 2008, confined to a range of only about 100 pips, partly to help insulate China's exports from the turmoil of the global financial crisis.
Confounding market expectations, the central bank has shown no signs that it will soon abandon that policy and revert to the steady appreciation seen from July 2005 to July 2008.
But with the worst of the crisis now likely over, and China's economy recovering faster than its major trader partners, Western policymakers have renewed calls for Beijing to allow the yuan to appreciate to help address trade imbalances.
MARKETS ROIL
The various pressures for yuan appreciation have generated volatility and uncertainty in the market, [ID:nSHA92604] and the rise in dollar funding costs in China's currency exchange market is turning up that pressure a bit further.
The benchmark six-month dollar lending rate <CNY6MFIX=R> on the Shanghai-based CFETS was 122 basis points above the six-month dollar London Interbank Offered Rate <USD6MFSR=> on Thursday, against a negative 5 bps on Sept. 1.
The jump means six-month dollar funding costs have risen to an annual rate of 1.79 percent from only 0.68 percent on Sept. 1.
The six-month funding cost hit a one-year high of 2.30 percent on Oct. 20, when the offshore non-deliverable yuan/dollar forwards market was implying 4.55 percent yuan appreciation over the next 12 months, a 14-month high.
"Dollar funding costs have become the latest victim of yuan appreciation expectations," said a European bank dealer trading on the market, China Foreign Exchange Trade System .
"And rises in these costs could in turn become another source of pressure for China to eventually permit its currency to resume appreciating."
Six-month dollar costs are still far below the official benchmark rate for yuan loans of the same duration, now at 4.86 percent, with speculation capped by China's strict controls on foreign exchange holdings.
Banks must sell dollars in excess of their official quotas to the central bank, and cannot borrow dollars beyond amounts set by regulators or sell dollars short in the spot market.
Dollar funding costs have at times, however, surged to levels that hinder normal business.
In March 2008, the six-month funding cost rose to an annual rate of 14 percent, 7 percentage points above the official benchmark rate for yuan loans at that time and effectively cutting off dollar fund-raising lines to corporations.
Dealers said a return to such levels could push the central bank to act, especially following a wave of overseas acquisitions that has boosted Chinese banks' and corporations' dollar needs.
With China's huge foreign exchange reserves of $2.27 trillion, the central bank could easily pump more dollars into the market to push down funding costs, dealers said, but this could end up simply fuelling further speculation on yuan gains given the strength of market expectations.
"The solution may lie only in the PBOC allowing the yuan to resume appreciating, although we believe dollar funding costs will not be the key factor leading them in that direction," said a dealer at a North American bank in Shanghai.
After a revaluation in 2005, the yuan rose 19 percent against the dollar before coming to a grinding halt three years later.
Dealers now believe China may not necessarily be resisting yuan appreciation but simply awaiting an appropriate catalyst, such as imported inflation, to spark a renewed rise. [ID:nSHA214323]