NEW YORK (Dec 31): China has a message for currency speculators: the free lunch is over.

The People’s Bank of China has suspended at least two foreign banks from conducting some cross-border yuan business until late March, according to people with direct knowledge of the matter. The clampdown comes as the growing offshore-onshore spread makes it profitable for those who skirt capital controls to buy the currency at a discount in Hong Kong and sell it in Shanghai.

By closing loopholes in its regulations, China is trying to stabilize the yuan after a surprising revamp of its currency- valuation system in August led to capital outflows and prompted policy makers to tap US$213 billion ($300.3 billion) of foreign reserves to support the yuan. The risk is that discouraging arbitrage will cause the exchange rates to diverge further, undermining the goal of unifying the two markets.

“The market should see this as a warning shot across the bow,” said Douglas Borthwick, the New York-based head of currencies at Chapdelaine & Co., a unit of the British inter- dealer brokerage Tullet Prebon Plc. Chinese regulators don’t want onshore trades to be speculative in nature and “in the short term this will likely lead to further widening of the spread,” he said.

A three-month ban on settling offshore clients’ yuan transactions in the onshore market was imposed Tuesday, the people said, asking not to be identified because they aren’t authorized to speak publicly on the matter. The central bank didn’t immediately respond to questions on the matter, and it was unclear how widely the ban has applied among foreign banks or which institutions are suspended.

Spokespeople for Citigroup Inc., HSBC Holdings Plc. and Standard Chartered Plc., which are among the largest foreign dealers allowed in China’s interbank foreign-exchange markets, declined to comment on the ban and whether their operations were affected.

The offshore yuan, which is freely traded overseas, touched a five-year low earlier Wednesday before erasing losses on speculation the government was intervening to support the currency. It traded at 6.5673 per dollar in New York, leaving it at about 1.2% cheaper than the rate in mainland China.

The gap between two rates has widened since August when China’s devaluation, part of the move to a more market- determined currency regime, fueled expectations among overseas investors for further yuan weakness. The divergence is undesirable because it means companies cannot use hedging tools tied to overseas rates to protect their onshore exposure.

By imposing the ban, China seeks to prevent speculators from bring money in illegally to arbitrage, even though it helps narrow the differences.

Currency policy

“Some banks were supposed to be penalized for engaging in arbitrage between the offshore and onshore markets,” said Suan Teck Kin, an economist at United Overseas Bank Ltd. in Singapore. “If the PBOC sees it’s a genuine trade, they’ll probably let you proceed. If they suspect you are manipulating, they want to clamp down. What they want to see is a natural convergence of the two yuan rates.”

Chinese authorities, who won their case to make the yuan part of the reserve-currency basket at the International Monetary Fund last month, are walking a fine line between opening capital markets and cracking down on shoddy transactions. The new currency policy aims to give markets more sway in determining its exchange rate and interest rates, while retaining certain controls to ensure stability.

Since August, regulators have limited some banks’ capacities for foreign-currency transactions and raised costs for lenders to settle trades. The State Administration of Foreign Exchange said Wednesday it will prevent risks associated with abnormal cross-border capital flows.

‘Right Thing’

The central bank last week said it would allow more foreign institutions with significant volumes to trade in the onshore foreign-exchange market and extend onshore trading hours. It said the moves will help narrow the onshore and offshore difference.

“They are doing the right thing,” former Morgan Stanley Chief Executive Officer John Mack said in an interview on Bloomberg Television Wednesday. “The Chinese want to minimize volatility. When you have the arbitrage set up where it’s an absolute money maker and more people come into that trade, it creates a lot of volatility.”

David Loevinger, a former China specialist at the U.S. Treasury, doubts the ban will be enough to discourage speculators. Chinese companies with overseas affiliates, for example, often find ways to circumvent capital controls, he said.

“It’s a bit like sticking your fingers in two holes of a leaky dam,” said Loevinger, now an analyst at fund manager TCW Group Inc. in Los Angeles.