China’s Covert Currency Strategy Exposes Banks to Losses While Boosting Investor Profits

China’s covert approach to managing its currency has exposed domestic banks to potential multi-billion-dollar losses, while providing substantial profits for hedge funds and other investors, according to a Bloomberg report.

The central component of this strategy involves the use of foreign-exchange swaps, which Chinese state-run banks have increasingly turned to in a bid to stabilise the yuan amid significant selling pressure. Sources familiar with the matter confirmed that these swaps have allowed Chinese banks to accumulate short positions against the US dollar, with the total reaching over $100 billion since last year.

However, these trades have distorted the foreign-exchange swap market, resulting in near risk-free returns of up to 6% for traders on the opposite side of these deals. Although these returns have recently decreased, estimates indicate that Chinese banks have incurred paper losses ranging from $5 billion to $16 billion during the yuan’s sharp decline earlier this year.

This strategy represents a shift in China’s approach to currency management, particularly after a problematic 2015 devaluation that forced the government to spend $650 billion in foreign reserves. By leveraging state-run banks instead of direct intervention by the central bank, China has been able to support the yuan without depleting its reserves, which has allowed the country to avoid international scrutiny.

Brad Setser, a senior fellow at the Council on Foreign Relations, remarked, “The benefit of using state banks for indirect intervention is clear. It hides the government’s role and avoids the public and international scrutiny that would arise from direct action by the People’s Bank of China (PBOC).”

While this indirect intervention has shielded China’s reserves from being exhausted, it has also created opportunities for global investors. Foreign banks, hedge funds, and even offshore Chinese entities have capitalised on the market inefficiencies created by these foreign-exchange swaps. By leveraging these trades, these investors have been able to generate significant profits, attracting multinational corporations and financial institutions alike.

The People’s Bank of China (PBOC) and the National Financial Regulatory Administration have declined to comment on the situation, leaving the full extent of the risks and opportunities surrounding these currency management tactics largely shrouded in secrecy.