Just because China is burning through its reportedforeign-exchange reserves more slowly doesn't mean it's losing itscommitment to prop up the yuan.

The People's Bank of China and local lenders increased theirholdings in onshore forwards to $67.9 billion in August, positionsthat would boost China's currency against the dollar. The amount isfive times more than the average in the first seven months, PBOCdata show. The positions are part of a three-stage process tosupport the currency without immediately draining reserves,according to China Merchants Bank Co. and Goldman Sachs GroupInc.

Standard central bank intervention to support a currencygenerally involves selling dollars and buying the home tender.In this case, China's large state banks borrowed dollars in theswap market, sold the U.S. currency in the cash spot market andused forward contracts with the central bank to hedge thosepositions.

“If you can intervene without actually diminishing yourreserves, it's somehow viewed as better,” said Steven Englander,global head of Group-of-10 foreign exchange-strategy in New York atCitigroup Inc. Such central bank activity “may not look quite asdramatic as the sale of reserves, and they may prefer thatoptically,” he said.

Using derivatives for intervention had the benefit of delayingany decline in the PBOC's $3.5 trillion trove of foreign-exchangereserves, helping calm investors rattled by an economic slowdownand a slumping stock market. It was also faster as the monetaryauthority's managers didn't have to liquidate assets such as U.S.Treasuries to raise the dollars needed for direct yuanpurchases.

The lack of a more detailed account of the PBOC's operationskeeps investors guessing the extent of capital outflows anddepreciation pressure. The authority has succeeded in containingthe yuan selloff after unexpectedly devaluing the currency by 2.8percent on Aug. 11 and 12.

The currency weakened to 6.45 per dollar on Aug. 12 beforestrengthening to 6.36 as of Tuesday in Shanghai, according to ChinaForeign Exchange Trade System prices.

The PBOC directed questions on forwards trading to itsreserves-management arm, the State Administration of ForeignExchange, which didn't reply to a fax seeking comment. Calls to themedia offices of Industrial & Commercial Bank of China Ltd. andBank of China Ltd. — two of the nation's three largest banks — wentunanswered. Forward contracts are agreements to buy or sell anasset at a specific price on a future date.

Gains in China's currency would be welcome, U.S. TreasurySecretary Jacob J. Lew said, adding that the world's second-largesteconomy must abide by commitments not to weaken the yuan.

The U.S. Treasury dropped its view that the yuan is“significantly undervalued” while saying that forces drivingappreciation in the longer term remain and China needs to allowsuch strengthening eventually, according to a semi-annual reportreleased Monday. It said China intervened “heavily” in the pastthree months, spending an estimated $229 billion to support theexchange rate.

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

“The scale of decline in this data is significantly larger thanthat in PBOC's foreign-exchange reserves and its foreign assets,suggesting that banks have resorted to their own spotforeign-exchange positions to help absorb outflow pressure,” MKTang, a senior economist at Goldman Sachs in Hong Kong, wrote in aresearch report.

Swap Market

Major Chinese banks borrowed dollars in the onshore swap marketin late August and September, and then undertook “heavy dollarselling” in the spot market, said Frank Zhang, head offoreign-exchange trading at Shenzhen-based China MerchantsBank.

The PBOC then came in to offset, or “square”, the positions withthe banks, essentially taking on their trades onto its own balancesheet, according to Goldman Sachs.

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

As the rout in emerging assets spread across Asia, central banksfrom South Korea, Singapore, India, Philippines, Malaysia andThailand increased the use of forwards to $22.5 billion in August,compared with $6.5 billion the month before, according to officialdata calculated by Goldman Sachs.

The PBOC doesn't report its financial instruments to theInternational Monetary Fund. Hiding its footprints in the financialmarket may just be a convenient side effect of using thederivatives market.

On a practical level, buying yuan forwards means the PBOCwouldn't drain yuan liquidity out of the system as it wouldotherwise by buying its own currency in the spot market. Policymakers cut interest rates and the reserve-requirement ratio inAugust, partly to replenish the funds drained duringintervention.

“If you have a transaction that settles down the road, theactual liquidity impact in the short term may not be asdramatic,” said Citigroup's Englander. “Down the road youcan't avoid it.”

Selling dollars in the forward market may be more effective inreversing bearish yuan trades that global investors put on at atime of risk aversion, according to Jose Wynne, head offoreign-exchange research at Barclays Plc.

Instead of rushing for the exits, some foreign investors maystay put and buy dollar contracts to cover their yuan exposure, hesaid. China's benchmark 10-year sovereign yield has dropped about0.4 percentage point to 3.1 percent since the Aug. 11 devaluation,rewarding those who held their nerve.

“The central bank shouldn't be selling spot, becauseinternational investors aren't looking to sell their bonds and taketheir dollars back home,” Wynne said.

Bloomberg News

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