China-based banks are reportedly taking massive short positions against the US dollar, amounting to over $100 billion. The East Asian nation is quietly using this complex currency strategy to gain the upper hand, and the implications seem to be massive for the global economy.

This strategy has led to billions in potential losses for the banks involved, while savvy investors pocket easy profits.

This development comes at a time when Chinese stocks are teetering on the edge of a five-year low with the CSI 300 Index down over 13% since its peak in May. Market players are now putting pressure on the People’s Bank of China (PBoC) as traders expect the yuan to weaken further.

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. The state run banks are using these swaps to short the US dollar in an attempt to prop up 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.

The report mentioned that it has been an easy win for investors. They enjoyed nearly risk-free returns of up to 6% by taking the opposite side of these swaps. Since July, returns have decreased, and it turns out 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 the time, it offloaded this burden onto banks and avoided the risky optics of depleted reserves.

This strategy has its own downsides. As of now, banks are shouldering the burden. If the yuan weakens any 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?

The growing gap in borrowing costs between the United States of America and China is pushing investors away from the yuan.

Traders are now looking towards PBoC to act on it. China’s central bank 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 an increased selling pressure in the market. The push for a weaker yuan stems from the gap in bond yields. 10-year US Treasury yields are at 4.57%, while Chinese government bonds offer just 2.3%.

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