China's central bank is signaling it is abandoning its traditional role in the domestic currency market as the ready supplier of liquidity, forcing corporations to bear more risk so that they learn how to cope with a more volatile yuan.
One reason could be to prepare them for a further widening of the yuan's trading limit, which some economists predict will be doubled this year to 2 percent either side of a daily midpoint set by the central bank.
At the same time, forcing Chinese corporations to take on more currency risk implicitly makes invoicing and settling trade in yuan directly more attractive because doing so eliminates exposure to exchange rate risks. This advances another policy goal: increasing international use of the yuan in trade.
For years, the People's Bank of China (PBOC) worked to soak up the surplus currency earned by the corporations that make up the bulk of trading volumes and provide the backbone of the country's vast exports industry. Now, its behavior suggests it would rather let them take a loss than intervene.
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"If companies make bad trading decisions, why should the government pay the bill?" said a Chinese currency regulator, who requested anonymity because he is not authorized to speak to the media.
During years of export-led growth, the PBOC bought the dollars flooding into the economy as the country amassed trade and current account surpluses, leading to the world's biggest foreign exchange reserves of $3.3 trillion.
But now that China's current account surplus has narrowed to around 3 percent of GDP, down from double digit figures in the middle of the last decade, the central bank says the currency is near an equilibrium point, suggesting such a heavy central bank presence in currency markets is no longer needed.
"The central bank appears to be emphasizing what it has stated again and again: the yuan's value has reached a rough equilibrium," said a dealer at a European bank in Shanghai who declined to be identified because he is not authorized to speak to the media.
"It doesn't seem to have hard targets for the exchange rate like it appeared to have in the past, and it has abandoned its traditional role of the ultimate supplier of yuan or foreign exchange liquidity to the market."
The problem for the central bank is that corporations have been slow to get the message or see its implications, even after the central bank doubled the width of the yuan's trading band in 2012 to 1 percent, creating more room for the yuan to rise or fall on a given day.
However, market players and regulators quickly parted ways over how that new latitude should be used.
In the first part of the year, Chinese corporations stocked up on dollars, following a global trend as investors sought a safe haven in the face of the Greek debt crisis.
Later in the year, as data suggested the Chinese economy was getting over the worst of its slowdown in growth, companies began aggressively trying to sell their dollars and restock yuan.
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"Up until late July companies were building long dollar positions because some foreigners were talking how it's time to short China," said the currency regulator. "Then they began dumping those dollars all together when the dollar index slumped in the fourth quarter."
From Panic to Euphoria
Dariusz Kowalczyk, economist at Credit Agricole CIB in Hong Kong, said at the time Chinese companies' bullishness was eating into their foreign exchange reserves.
"They are bleeding hard currency. That is not sustainable."
At this point the central bank appeared to lose patience.
"We had repeatedly warned the companies not to panic about the yuan's value earlier in the year, but they didn't listen," said the regulator.
To get them to listen, the PBOC sent a message in two parts.
First, the central bank stood its previous strategy of buying up what corporations wanted to sell on its head, PBOC data shows.
Under its old regime, the central bank would have bought dollars in November when the value of the currency was falling to keep the yuan from appreciating too quickly.
Instead, the central bank and state-owned banks sold off $12 billion that month - as if they were trying to capitalist on the trend, not sterilize it.
In December, when the dollar began to rise again, the PBOC and state-owned banks again went with the trend, buying $22 billion, the data shows.
In the second part of the message, the central bank used its blunt administrative tool - setting the official midpoint - to prevent the market from pushing the yuan higher.
The decision to hold the yuan back without actually buying up the glut of dollars provoked a staring match between the central bank and corporations, each side expecting the other to blink first. On several days, the intraday trading graph flatlined.
"Traders tried creative ways to get around the deadlock, but the PBOC was quick to nip their initiatives in the bud," said a trader at a Chinese commercial bank in Shanghai, who did not want to be identified because he is not authorized to speak to the media.
Because Chinese corporation would not sell dollars to each other, and because the PBOC was unwilling to buy dollars either, transaction volumes sank, and the exchange rate glued itself to the strong side of the trading band for weeks on end.
Whether the message will require further reinforcement is unclear.
When the dollar index began rising again, the central bank began raising the midpoint in response, and some traders said that it also encouraged major state-owned banks to start buying up the dollar glut, restoring market liquidity by proxy.
This means corporates that held on to bets that the yuan would strengthen saw their gamble pay off when the yuan went on to set new record highs in January.
Since then the spot exchange rate has consistently remained near the strong side of the trading limit, indicating the market is more bullish than the central bank.
What is clear, traders say, is that the rules of the game have changed. Companies will be ill-advised to assume the PBOC will always intervene to preserve liquidity when it thinks it is endorsing moral hazard by doing so.
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"Obviously the intervention level has gone down," said Chia Woon Kien, head of Asia markets strategy at the Royal Bank of Scotland in Singapore.
She added that by making the market riskier for corporates, Beijing is also implicitly encouraging the internationalization of the yuan.
"Maybe this is their way of creating a bit of pressure on these guys and saying, 'look, watch out, we are going to bring more volatility, but you have the means to go out. If you invoice in yuan, you don't have to worry about forex risk anymore."'