Country seeks to stabilise yuan, stocks still fragile

China set another firm fix for its currency on Tuesday and stepped up a verbal campaign, backed by what dealers said was aggressive buying, to convince sceptical investors that they were in control of events.

Analysts said offshore buying by state-owned banks, under the direction of the People's Bank of China (PBOC), dried up yuan liquidity to such an extent that overnight yuan borrowing rates in Hong Kong (HIBOR) hit a record 66.8 percent, and the spread between onshore and offshore yuan exchange rates briefly evaporated.

Last week, the spread had exceeded 2 percent, making it harder for Beijing to stem the flow of capital from its slowing economy.

"The strength of its (the PBOC's) actions appears to have reached the 'nuclear-weapon' level, and is comparable to that of the steps taken by other central banks when they previously fought against international speculators, such as George Soros," said a senior dealer at a European bank in Shanghai.

China's equity markets, which tumbled 10 percent last week and a further 5 percent on Monday, remained volatile, going from black to red and back again. At the end of the morning session the Shanghai Composite Index was up 0.4 percent, and the CSI300 index had added 1 percent.

The PBOC set the mid-point for the yuan at 6.5628 per dollar, just two pips weaker than the previous strong fix and firmer than its spot levels late on Monday.

The spot yuan weakened from its overnight close to 6.5733 to the dollar, but offshore it strengthened as much as 180 pips to 6.5660, reversing a spread that had threatened last week to become unmanageable.

SHARPENING DILEMMA

Perceived mis-steps by the authorities have stoked concerns in global markets that Beijing might be losing its grip on economic policy, just as the country looks set to post its slowest growth in 25 years.

Fitch Ratings said the government was grappling with a "sharpening dilemma between a perceived need to keep interest rates low to help the economy manage its debt burden, and downward pressure on the Chinese yuan and foreign reserves".

Sources suggested there were moves afoot for China's cabinet to take a bigger role in overseeing financial markets.

The State Council has set up a working group to prepare for upgrading the cabinet's financial department to bureau level, said a source close to the country's leadership.

Officials were doing their best to talk up the currency.

The PBOC plans to keep the yuan basically stable against a basket of currencies, and fluctuations against the U.S. dollar will increase, Ma Jun, the central bank's chief economist, said on Monday.

Han Jun, deputy director of the office of the Chinese Communist Party's Leading Group on Financial and Economic Affairs, said a more substantial decline in the yuan was "ridiculous" and "impossible".

He was speaking at a briefing held at the Chinese consulate in New York, suggesting the authorities were broadening their verbal campaign to deter yuan sellers.

"With export growth deeply in negative territory, and exports likely to remain weak in coming months, it is likely easier to reach a policy consensus to allow some depreciation," Goldman analysts wrote in a note.

Figures for China's December trade accounts are due on Wednesday and are expected to show further falls in both exports and imports.