China signaled its intention on Tuesday to drain excess cash from its financial system by unexpectedly raising the yield on bills at a central bank auction and announcing new rules to curb hot money inflows.
One of the measures directed against inflows — requiring banks to hold a minimum amount of dollars overnight — sparked a day of unprecedented yuan volatility, with the Chinese currency ending sharply up against the dollar.
Taken together, the moves flagged China's increasing concern about a surge in liquidity after the U.S. Federal Reserve launched another round of quantitative easing, prompting some analysts to say monetary tightening may be closer than thought.
The expectations were fuelled by comments from two central bank deputy governors that the Fed's easing could lead to asset bubbles and inflation and that Chinese authorities were keeping a close eye on the situation.
"China still has a strong momentum of rapid credit expansion," said Du Jinfu, one of the deputy governors, in summing up the challenges facing the central bank.
"There is obviously an increase in cyclical macro-economic risks such as excessive liquidity, inflation, bad debts and asset bubbles," Du told a financial conference.
Shortly before Du's comments, the central bank surprised markets by ramping up the yield on one-year bills to draw cash out of the financial system.
It sold the bills at a yield of 2.3437 percent, more than 5 basis points higher than levels at auctions since just after the central bank raised its benchmark interest rates in mid-October.
Markets were even more surprised by the yuan's moves on the day. The Chinese currency registered its largest intraday price movement since its July 2005 revaluation after the foreign exchange regulator imposed a minimum on forex positions that banks must hold overnight.
This caused a scramble for dollars, weighing on the yuan. But it soon rebounded to score its biggest daily post-revaluation gain amid rumors of central bank intervention to push it higher.
Several market participants said that they saw no evidence of such an intervention by the central bank, however.
RATE RISE ON WAY?
Analysts and traders took the yield increase as a sign that the central bank could raise rates again, or increase banks' required reserves.
"The auction yield itself already suggests a possible rate hike is coming soon," said a senior trader at a Chinese bank in Shanghai. "Previously, rises in the auction yield of one-year bills often pointed to a quick follow-through rate hike."
Analysts said the central bank wants to prevent a flood of cash from generating runaway inflation and price bubbles in asset markets, particularly stocks and property.
Annual consumer inflation rose to a 23-month high of 3.6 percent in September and analysts polled by Reuters expect data on Thursday to show it climbed to 4 percent in October.
Complicating matters is an apparent surge in cash seeking a home in China, as evidenced by sharp fall in short-term money market rates last week.
Not only are funds being shifted from bank deposits and property into the stock market, helping the main Shanghai index rise around 18 percent since the start of September, but there are signs speculative capital inflows are on the rise.
MORE CRITICISM FOR QE2
While Beijing maintains strict capital controls, some hot money finds its way into the country disguised as trade or foreign direct investment, which the State Administration of Foreign Exchange (SAFE) said it would address further.
SAFE published rules on its website on Tuesday aimed at strictly managing firms' short-term foreign debt quotas as part of efforts to curb speculative capital inflows.
"The rules out this morning are a clear attempt to crack down on hot money inflows and outflows, as well as to cut down on the ability of onshore corporates to take short USD positions through the onshore forwards market," Stephen Green, China economist with Standard Chartered in Shanghai, said of SAFE's announcement.
"China has already done a lot in terms of controlling access to onshore asset markets, particularly real estate, so that's a positive as it makes it harder to hold CNY (yuan). But given CNY has been weakening against most Asian currencies, the temptation of many will be to bring in funds."
Still, SAFE's deputy chief, Deng Xianhong, was quoted by the China Securities Journal as saying so far China has not seen large inflows of speculative funds betting on the yuan rising.
Keeping up a drumbeat of comments critical of the Fed's quantitative easing ahead of the G-20 leaders' summit in Seoul, Ma Delun, deputy governor of the PBOC, told a financial forum in Beijing that the Fed's steps could have a negative impact on the global economy in part by encouraging such capital flows.
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