China-based banks have reportedly taken short positions amounting to over $100 billion against the US dollar, using complex currency strategies to gain the upper hand, which has significant implications for the global economy.
China using foreign exchange swaps to short DXY
According to a report by Bloomberg, foreign exchange swaps have become a key tool in China's currency management. State-run banks are using these swaps to short the US dollar to support the yuan during periods of heavy selling pressure. These positions have exceeded $100 billion since last year. It is expected that this strategy might help China to stabilize the yuan without burning through its foreign reserves. However, it has also put banks at risk. Reports estimate that banks have incurred potential mark-to-market losses ranging from $5 billion to $16 billion when the yuan dropped earlier this year. Investors involved in these swaps have enjoyed nearly risk-free returns of up to 6%. Since July, returns have decreased, showing that it was a golden opportunity for those quick enough to act.
A repeat of 2015’s currency fiasco?
China wants to avoid another currency fiasco like the 2015 episode when it burned through $650 billion in foreign reserves. At that time, the burden was shifted onto banks, avoiding the risky optics of depleted reserves. This strategy has its own downsides. Currently, banks are shouldering the burden, and if the yuan weakens further, the losses are expected to skyrocket. So far, the strategy has helped stabilize the yuan, but the question remains: How long can they sustain this?
Conclusion
The growing gap in borrowing costs between the USA and China is pushing investors away from the yuan. The People's Bank of China has maintained a strong yuan policy by keeping its daily reference rate tightly around 7.09 to 7.11 against the US dollar this year. Meanwhile, the yuan has recently traded around 2% below that rate for the first time in 8 years. This signals increased selling pressure in the market. The push for a weaker yuan stems from the gap in bond yields, with 10-year US Treasury yields at 4.57% while Chinese government bonds offer just 2.3%.
China continues to use its currency tools to maintain yuan stability, which has broad implications for the global economy. The question of the sustainability of such a strategy remains open given the current economic conditions.
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