By Winni Zhou and John Ruwitch
SHANGHAI (Reuters) - China's central bank will sell yuan-denominated bills in Hong Kong in late June, in a move some market analysts believe is aimed at preventing the yuan currency from declining further.
The yuan slumped by about 2.5 percent between mid-April and mid-May, with May becoming its worst month in nearly a year after a major escalation in the U.S.-China trade dispute.
The People's Bank of China (PBOC) said in a statement on its website on Tuesday the bill auction in Hong Kong was aimed at "improving the yuan bond yield curve" in the financial hub.
Markets widely interpreted the move as a clear signal the central bank was intent on maintaining its tight grip on the currency.
A bill sale like this will theoretically freeze yuan funds in Hong Kong and push up borrowing costs for the Chinese currency. By soaking up yuan liquidity offshore, the auction will make it more expensive for speculators to bet on a weakening yuan.
"The central bank is defending the exchange rate by stabilising expectations onshore and fighting against the yuan bears offshore through the bill auction," said a trader at a Chinese bank. She said the auction was a warning shot across the bow of yuan short-sellers.
The auction will be the fourth sale of offshore yuan bills in Hong Kong in seven months. Like the first, last November, the latest sale will be an "off-cycle" issuance as there are no bonds due to expire this month. The last two sales were roll-overs.
The move comes days after the offshore yuan tested near seven-month lows over the weekend after central bank Governor Yi Gang suggested in an interview that there was no hard and fast line in the sand for the exchange rate.
The currency rebounded, but with lingering uncertainty about the China-U.S. trade war and onshore and offshore yuan both trading weaker than 6.9 per dollar, the psychologically important 7 yuan-per-dollar level looms. Last time the yuan hit that level was during the global financial crisis.
In recent weeks the official midpoint fixing set by the central bank has hovered in a tight range persistently firmer than market consensus. Market participants believe the central bank hopes to dampen volatility and counteract depreciation expectations.
Separately, some market participants said state-owned Chinese banks were draining yuan liquidity in Hong Kong last week, which also pushed up the cost of borrowing in the city.
Reflecting the tightness, Hong Kong's overnight yuan borrowing rate was fixed at 2.56578% on Tuesday, up 47 basis points from 2.09600% at the end of May.
State-owned banks used similar tactics in 2016 and 2017 to raise yuan borrowing costs, helping prop up the offshore yuan. A firmer offshore yuan can partially alleviate depreciation pressure on its onshore counterpart.
Looking ahead, the market will take its cues from the U.S. Federal Reserve's June meeting and expected China-U.S. trade war discussions at the G20 meeting in Japan on June 28-29.
"If the Fed doesn't sound as dovish as the market expects at the June 18-19 policy meeting, EM Asian currencies and the yuan are likely to drop sharply," said Gao Qi, FX strategist for Asia at Scotiabank in Singapore.
"Under this scenario, the PBOC could squeeze offshore yuan liquidity conditions to defend the yuan ahead of the G20 Osaka Summit."
Ken Cheung, senior Asian FX strategist at Mizuho Bank in Hong Kong, said the PBOC was sending mixed signals. Governor Yi Gang said last Friday no "numerical number" for the exchange rate was more important than another.
"Having refrained from drawing a line in the sand, the PBOC could mitigate bearish RMB speculation around a particular level and contain RMB deprecation overshooting after breaking above the 7-per-dollar level," Cheung said.
Additional downside pressure on the yuan could emerge if trade negotiations fall through during the G20 summit, he said.
Following the recent stabilising measures, many economists believe the yuan is unlikely to breach 7-per-dollar ahead of the G20.
The PBOC did not elaborate on the bill auction plan.
"The timing is interesting," said Tommy Xie, head of Greater China research at OCBC Bank in Singapore.
He said the central bank may be stockpiling "ammunition to prevent excessive volatility" in case there is no China-U.S. trade deal at the G20 summit.
(Additional reporting by David Stanway and Wang Jing; Editing by Simon Cameron-Moore and Jacqueline Wong)