China Money: Banks count cost of dollar shortage

Banks in China are struggling with a curious result of the authorities' tight grip on the foreign exchange market: a severe shortage of U.S. dollars. And the shortage may get worse before it gets better.

The squeeze is dampening activity in the market and threatening to hinder some corporate customers' use of dollars for purposes such as trade and investment, dealers say.

For a country with $1.65 trillion in foreign reserves, much of it in dollars, the shortage may seem surprising.

But the vast bulk of those dollars is in the hands of the central bank, not commercial banks, which sell most of their U.S. currency on to the central bank as soon as they obtain it in order to avoid losses due to appreciation of the yuan .

Contributing to the shortage are rules designed to restrict onshore supplies of dollars and thus limit inflows of speculative money betting on yuan appreciation. For example, there is a ban on selling dollars short in the spot market, and the central bank requires many banks to settle reserve ratio increases in dollars.

And last year, the State Administration of Foreign Exchange (SAFE) slashed banks' quotas for short-term foreign currency debt below one year. Foreign banks were told to cut holdings to 60 percent of 2006 levels, and domestic banks to 30 percent.

The result is a doubling of dollar funding costs within China over the past few months.

The foreign currency debt quotas are due to expire at the end of this month but the market fears they could be rolled over or even cut further, worsening the dollar squeeze.

"Many believe the 2008 quota for domestic banks could be cut by half from the 2007 level, so that the authorities can have complete control of dollar supply on the domestic market," said a dealer at a state-owned Chinese bank in Beijing.

Gene Ma, an economist at China Economic Monitor in Beijing, said: "As authorities fight to reduce excessive liquidity, they're unlikely to loosen their grip on money in the banking system, even if the money is foreign currency."

The six-month dollar lending rate in China's onshore currency market was 1,134 basis points above the six-month dollar London Interbank Offered Rate last week, against 900 bps a week earlier.

A month ago, the spread was 450 bps, and it was only a dozen bps before the clampdown on foreign currency debt, dealers said.

The jump means six-month dollar funding costs have risen to an annual rate of about 14 percent, over seven percentage points above the official benchmark rate for yuan loans at 6.57 percent.

DOLLAR FINANCING HIT

"This shortage is so acute it's hurting dollar financing at Chinese companies and limiting the size of banks' foreign exchange business," said a dealer at a North American bank.

SAFE declined to comment. But one source close to the regulators, who doesn't set policy but is aware of regulators' thinking, said a further tightening was more likely than a relaxation.

"Some banks complain that a dollar shortfall is hindering their business, but I think they made their bed and must lie on it," the source said, speaking on condition of anonymity because he is not authorised to talk publicly about policy.

"In their battle for market share, they have agreed to help corporate clients settle large dollar forwards positions, and this aggravates a dollar squeeze in the market."

Such comments alarm Chinese bankers, who say they face a no-win situation: if they keep dollars on hand to meet the shortage, they risk those dollars losing value. The yuan has risen 11 percent against the dollar since the start of 2007.

"Regulators have urged us to retain some dollars to meet any shortage. That's OK if we know how much the yuan will rise in a certain period of time and can hedge the risk," said a dealer at a major Chinese commercial bank in Shenzhen.

"But with the pace of yuan appreciation completely in the hands of regulators, should banks or their clients pay the bill for risking a possible exchange loss of 10 percent or more?"

The dollar shortage has rocked China's onshore forwards market, where fears of continued tight quotas after March have caused banks to scramble to obtain dollars by agreeing to pay them back through forwards and swaps at big discounts.

A dealer at a European bank said regulators apparently think the current costs of the dollar squeeze are worth living with in order to limit speculation. But he believes the authorities may feel compelled to ease the shortage later this year.

"If foreign currency debt quotas are cut by another half this year from last year, dollar funding costs will be pushed well over 10 percentage points above the yuan loan rate," he said.

"That level may prevent banks and companies from making any speculative gains at all from selling their extra dollars -- and that could be the time for regulators to pump dollars into the market through their agents, the biggest state-owned banks."