China's central bank has halted offshore yuan borrowing by domestic companies, official media reported, a move seen as an attempt to clamp down on hot money flows at a time when the authorities are still tightening policy to battle inflation.

The move is unlikely to slow the growth of the offshore yuan or CNH market in Hong Kong as Beijing still encourages the outward flow of yuan via trade settlements and foreign direct investment and has recently tweaked rules to encourage trade.

Citing unidentified sources, the official Shanghai Securities News reported on Tuesday that the People's Bank of China had told banks in mid-July that it would stop accepting applications for direct offshore yuan borrowing from mainland companies.

The step is expected to hit a growing trend among mainland companies of borrowing relatively cheap offshore yuan in Hong Kong and remitting it home for business purposes to circumvent tight domestic cash conditions in the mainland.

Borrowing rates in the offshore market are much lower compared with onshore because of a shortage of investable yuan-linked assets and due to strict barriers to cross-border capital flows.

At a time when the authorities are tightening policy, it seems odd that mainland companies can borrow cheap funds in Hong Kong and remit them onshore, so this seems like an extension of the tightening, said a strategist at a European Bank in Hong Kong.

The Hong Kong Monetary Authority, the territory's de-facto central bank, denied such a policy move had taken place.

The HKMA has checked with the People's Bank of China, and understand that offshore yuan borrowing by domestic companies was never allowed in the first place, it said in a statement.

As such, reports that such a service has been stopped are incorrect. This is the PBOC's response to media queries, and does not represent a change in policy, it said.

CRACKS IN THE GREAT WALL

On Monday, China's central bank reiterated that fighting inflation remained its policy priority. Since October, it has raised interest rates five times and bank required reserves nine times to prevent rising prices from fuelling social unrest.

But even with the steady tightening, China's inflation hit a three-year high of 6.4 percent in June.

Tightening monetary conditions have forced small to medium-sized mainland companies to tap the shadow banking system, where anecdotal evidence shows lending rates are as high as 18 to 25 percent, and of late the international debt and CNH markets.

At $14.3 billion year-to-date, high-yield issuances in the international bond markets have already eclipsed the 2010 numbers with China accounting for a nearly 70 percent market share.

Closer to home, HSBC estimates bonds of sub-investment-grade quality make up roughly a seventh of the 138 billion yuan in total outstanding offshore yuan debt. In the second half of 2010, such issuances were virtually non-existent.

With the cash squeeze showing no signs of abating, mainland companies have also resorted to raising cheap yuan funds from offshore banks via Hong Kong subsidiaries and remitting it back to the mainland disguising it as trade flows.

Month-on-month growth in renminbi deposits in Hong Kong decelerated in June to 4.8 billion yuan ($746 million), less than a tenth of the average monthly increase of 46 billion yuan during the first five months of this year, underscoring the rising trend of more Beijing-directed corporate flows.

GLOBAL EXPANSION

While the latest measures show China is intent on clamping down on inflows of speculative funds disguised as trade, authorities have taken steps to boost trade-related activity.

Last week, the HKMA tweaked market regulations by allowing banks participating in offshore yuan business to consolidate their positions by including their trades in the foreign exchange market.

We think the regulation change to enable intra-group consolidation of trade-related yuan positions will help to facilitate the global expansion of yuan trade settlement, Deutsche Bank strategists said in a note.

Since landmark reforms last July allowed banks in Hong Kong to freely trade renminbi, trade settled in China's currency has grown six-fold.

Yuan-settled trade accounted for 7 percent of China's total trade in the March quarter compared with less than 1 percent in the prior year.

(Reporting by Kazunori Takada, Chen Yixin and Kelvin Soh; Writing by Saikat Chatterjee; Editing by Kim Coghill)

China Inflation