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Chinese policy banks are boosting onshore dollar borrowing to help sop up excess liquidity in U.S. currency as the People's Bank of China avoids direct intervention in foreign exchange markets, policy advisors and analysts told MNI.

Banking system forex reserves hit a record USD1.01 trillion at the end of May, pumped up by a growing trade surplus and foreign inflows into bond and equity markets, and prompting the PBOC to hike foreign exchange reserve requirement ratios to 7% from 5% in order to head off upward pressure on the yuan. The PBOC move made the subsequent policy bank dollar bond sales more attractive, as other lenders snapped up the paper to limit their additional reserve requirements, said an official at a state-owned bank, asking to remain anonymous.

China Development Bank sold USD2 billion in onshore bonds, its largest such deal and its first in six years, before following up with another USD1 billion last Thursday. Export-Import Bank of China raised USD300 million last week, its first dollar issuance since 2016.

Authorities regard domestic dollar deposit levels as a risk, potentially pushing up the yuan or else threatening instability if rising overseas rates drive sudden outflows, the official said, though he added deposits might soon fall of their own accord if China's trade surplus narrows, the Federal Reserve tightens policy or if trade tensions flare again with the U.S.

Meanwhile, policy banks can play a positive role in assisting the PBOC to deal with dollar liquidity, Tu Yonghong, vice director of the International Monetary Institute at Renmin University of China, told MNI.

OFFSHORE ISSUANCE

Conditions are favourable for raising dollars given low interest rates in the U.S and the policy banks also need greenbacks for overseas investment projects such as those of the One Belt One Road initiative, Tu said. Authorities have also tried to take some heat out of the yuan by issuing quotas for up to USD10 billion in outflows under the Qualified Domestic Institutional Investor scheme, though Tu noted that the move to relax capital controls would have to be undertaken carefully in order to avoid excessive flows abroad of the Chinese private sector's large holdings of foreign currency.

While onshore dollar debt issuance jumps, offshore issuance is also recovering, with Jessie Tung from Moody's Investors Service predicting an increase over 2020 given large upcoming maturities.

But Chinese regulators are also increasing their scrutiny of mainland corporate bond sales as they crack down on shadow banks, which may put some less strategically important state-owned companies under pressure, or even lead to their default, Tung said.

Foreign investors now hold USD553 billion in domestic Chinese bonds, and their holdings will likely rise this year due to their attractive yields, Moody's said.

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