SHANGHAI China's foreign exchange regulator is considering cutting short-term foreign debt quotas for some commercial banks, three sources familiar with the situation said on Friday, as it seeks to curb speculation over yuan appreciation.
Onshore dollar funding costs have risen steadily over the past weeks to the highest levels since mid-2008, reflecting increasing demand to borrow dollars to swap for yuan as expectations mount that Beijing could soon let its currency start strengthening again.
The planned steps by the State Administration of Foreign Exchange (SAFE) underline authorities' determination to keep speculative flows of capital from creating instability in the world's third-largest economy.
SAFE is also conducting nationwide checks on illegal "hot money" inflows, the sources said.
But analysts said the moves did not necessarily indicate that Beijing was laying the groundwork for any immediate change in currency policy.
"The interest rate spread between U.S. dollars and yuan has spurred hot money for the purpose of arbitrage to look for any way it can to get into China, so the cut in the foreign debt quotas is meant to stop that," said one of the sources.
Authorities have plenty of reason to be concerned about speculative money flowing into China from overseas.
The economy grew 11.9 percent in the first quarter from a year earlier, and the central bank said in a report on Friday that the outlook for exports and imports in the second quarter was bright.
China's foreign debt is modest compared with its official foreign exchange reserves, which totaled $2.4 trillion at the end of 2009.
However, the government is also grappling with red-hot property prices, and last week launched a concerted campaign to contain speculation in that market to curb inflationary pressures.
Central bank adviser Li Daokui underlined such risks on Friday, saying the economy was showing signs of overheating.
It would not be the first time China's foreign exchange agency has moved to rein in holdings of foreign debt.
It imposed similar restrictions in 2007, when Chinese companies were actively borrowing overseas funds on the assumption the yuan, which was in the process of strengthening at the time, would keep going up.
China began repegging the yuan to the dollar in the middle of 2008 to help its economy fight the global financial crisis, but in recent weeks expectations have been growing that it may soon allow the yuan to start rising again amid an easing of Sino-U.S. tensions over the currency and signs of robust economic growth.
Most economists expect Beijing to allow a gradual appreciation of the currency as opposed to making a big-one off revaluation.
The yuan rose against the dollar in onshore forwards on Friday as Chinese firms rushed to shift dollars into the Chinese currency.
Offshore, one-year dollar/yuan non-deliverable forwards (NDFs) slipped to a three-month low of 6.5820 from Thursday's close of 6.6040, implying markets are expecting 12-month appreciation of 3.71 percent, up from 3.37 percent.
Spot yuan dropped to 6.8275 to the dollar from Thursday's close of 6.8263.
Gradual dollar selling by Chinese companies over the past few weeks has accumulated, causing a dollar squeeze on the onshore market this week, traders said.
The more companies sell dollars, the less there is available onshore as foreign exchange is concentrated in the hands of the central bank.
A dollar liquidity crunch pushed up dollar funding costs implied by one-year onshore dollar/yuan swaps to 4.1682 percent on Friday from Thursday's 4.0725 percent, hitting their highest since October 2008 for the third straight day.
"There's a sort of panic as expectations on a resumption of yuan appreciation grow every day," said a senior dealer at a major Chinese commercial bank in Shanghai.
The move by SAFE could weigh down dollar/yuan non-deliverable forwards (NDFs).
"If Chinese authorities were to tighten controls over this type of capital inflows ... it would result in an onshore U.S. dollar shortage and drive up onshore U.S. dollar interest rates," Morgan Stanley's Qing Wang said in a note to clients in response to the Reuters news.
"This would discourage demand for long dollar/yuan trade on the offshore NDF markets, as was the case during 2005-2007."
Banks had previously been told that their short-term currency quotas were to remain unchanged at $32.9 billion for the year ending March 31, 2011, after a 12 percent rise in the previous year that effectively loosened controls to help China's financial sector grapple with the global financial crisis.
Still, some observers interpreted SAFE's move as potentially meaning yuan appreciation could be on its way sometime soon.
"This new policy may indicate that Beijing would resume a modest yuan rise very soon," said Nie Wen, an economist at Fortune Trust Co in Shanghai.
Callum Henderson, head of FX strategy at Standard Chartered in Singapore, noted that Beijing had also taken steps to reduce speculation before the landmark 2005 revaluation.
"China has a very good history of making incremental but important steps to micromanage the economy," he said.
"The very fact that Chinese exporters are starting to hedge more...it would seem that locals are expecting a move."
(Additional reporting by Aileen Wang and Langi Chiang in Beijing and Eric Burroughs in Hong Kong; Writing by Jason Subler; Editing by Kim Coghill)