China’s state banks are walking a financial tightrope, exposing themselves to billions of dollars in potential losses while savvy investors quietly make easy profits. The culprit? A sneaky little financial manoeuvre called foreign exchange swaps.

These swaps have become the go-to tool for Chinese state banks, tasked with propping up the yuan during heavy selling pressure. According to insiders (who, unsurprisingly, prefer to remain anonymous), these banks have taken on short dollar positions worth over $100 billion since last year. The result? A market anomaly that handed traders on the other side of the deal virtually risk-free returns of around 6% in July. Not bad for doing the bare minimum.

While those returns have since dipped, there’s still a juicy potential payday for China’s banks if the yuan strengthens. But for now, losses are piling up—between $5 and $16 billion—thanks to the yuan’s drop earlier this year.

This is just the latest episode in China’s ongoing saga of currency management, a drama that began with a botched devaluation in 2015. That fiasco forced Beijing to burn through $650 billion of its precious foreign reserves to stop the yuan from freefalling and triggering capital flight. Fast-forward to today, and the state banks are bearing the brunt of the burden, sparing the reserves and keeping the central bank’s hands clean.
The benefits of using state banks for indirect intervention are pretty clear. It hides the state’s role in the market and avoids the scrutiny that comes with direct intervention by the People’s Bank of China.
While it’s all smoke and mirrors on the surface, beneath it all, these swaps are creating opportunities for international investors. Foreign banks, hedge funds, and even some offshore branches of Chinese banks are cashing in on the anomalies these deals create. For them, it’s like Christmas every day—an arbitrage play that’s just too good to pass up.

Here’s how it works: Foreign traders lend dollars to a Chinese bank and receive the yuan equivalent at the market rate. The bank has to pay back the dollars a year later, but here’s the kicker—it’s at a pre-agreed rate. Thanks to the higher US interest rates, traders pay back less than they borrowed, pocketing a profit.
In the meantime, traders can also use the yuan to buy Chinese bonds, adding a little extra on top of the already sweet deal. No wonder the demand for short-term Chinese certificates of deposit (NCDs) has shot up, pushing foreign ownership to its highest since at least 2015. With returns on these swaps combined with NCDs hitting a comfy 6%, why would anyone bother with boring old US Treasuries?

Of course, China’s banks have had a built-in loss from day one. They use dollars to buy up yuan in the spot market, supporting its value. If the exchange rate swings in their favour, they might eventually turn a profit. But if the yuan keeps sliding, their losses will only grow.

While no smoking gun links Beijing to these moves, the state banks’ support for the yuan conveniently shields the central bank from accusations of direct market meddling. Some insiders say the banks have had “verbal” chats with the PBOC about the currency market, though no one admits to hard-and-fast orders. Still, it’s a nifty way for China to keep its powder dry while letting the banks do the dirty work.

The bottom line? China’s opaque currency strategy may create risks for its banks, but it’s a goldmine for foreign investors. And while the yuan’s future is anyone’s guess, one thing’s for sure: this covert currency game isn’t going away anytime soon.