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The Yuan’s Descent Brings on Opposite Reaction

“SHANGHAI—China’s sudden move to engineer a weaker yuan to curb heavy inflows from abroad has led to an unexpected and undesirable upshot: a sharp increase in cash flowing into its financial system.

Investors have been buying up U.S. dollars and selling yuan over the past two weeks, leading to local currency flooding China’s money markets and sending short-term interest rates plummeting. That has concerned economists, however, as it contradicts Beijing’s campaign since June to keep borrowing costs high to rebalance a credit-driven economy and rein in risky financing such as the loosely regulated “shadow-banking” sector.

The policy makers’ dilemma also shows how complex it is to manage the vast state-controlled economy and how interlinked the entire financial system is.

“If you want to deleverage the economy, you have to keep interest rates high and liquidity tight. If you weaken the currency, liquidity will increase. The two objectives are conflicting. So what is it that the central bank wants to achieve?” said Teck Kin Suan, an economist atUnited Overseas Bank U11.SG -0.87% in Singapore.

The problem has arisen as the People’s Bank of China has been guiding the yuan weaker, seeking to discourage speculative foreign funds that profit from high interest rates and gains in the currency. Those flows are a problem as they add excess cash to the economy and contribute to soaring property prices.

The central bank’s moves to guide the yuan appear to have worked. The currency Friday suffered its biggest one-day fall since its revaluation in 2005. The yuan is down 1.7% since reaching a record high in January.

But while it is seeking to block cash from abroad entering China, the increased supply of the Chinese currency in the financial system because of its foreign-exchange intervention is still adding liquidity to the banking system.

As a result, money-market interest rates are falling with the benchmark cost of short-term loans among banks–the weighted average of the seven-day repurchase agreement rate–down to 2.83%, from 3.84% two weeks ago and a high of 8.94% on Dec. 23.

The rate is now at levels seen before an unprecedented cash crunch that Beijing engineered in June to help curb explosive growth of shadow banking activities. Since the summer credit crisis, the Chinese central bank has allowed three more cash squeezes to occur in October, December and January, pushing the benchmark borrowing cost to average around 4%-5%.

Now with easy-money rates back though, worries are resurfacing that banks will feel emboldened again to take on the riskiest forms of lending, economists said.

“To me, deleveraging is still a more critical task for the central bank right now because the risks associated with shadow banking and local government debt are much higher. They will have to make a choice,” said Mr. Suan.

Some economists say managing the world’s second-largest economy, ranging from ensuring growth doesn’t slow too much to tackling rising financial risks and deterring speculative so-called hot money inflows, means the authorities can sometimes adopt short-term measures at the expense of achieving long-term goals….”

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