HONG KONG and other investors in China face an official ban on the use of foreign exchange deposits in Chinese banks as collateral for loans in yuan. As part of a drive to cool the economy, the People's Bank of China has ordered banks to stop granting yuan loans to investors who use foreign currency as collateral. The move makes official the growing practice among Chinese banks in the past two years. 'The PBOC directive means that the investor who needs local currency will have to exchange his US or Hong Kong dollars for yuan in swap centres or through the interbank network,' said an official with the PBOC's Shanghai branch. He said the move was aimed at controlling indiscriminate yuan loans especially when the central authorities were trying to implement an austerity drive to rein in inflation hovering at 20 per cent. 'Also, the PBOC can ensure that priority for loans will be given to key infrastructure projects,' he said. The official target is to bring retail price inflation to within 15 per cent and consumer price inflation to about 18 per cent, goals which some private sector economists believe are unrealistic. Shanghai Securities News yesterday reported that the PBOC's Shanghai branch was complying with the directive from headquarters with immediate effect. Analysts said the decision was prompted by the PBOC's need to have better control of money supply and by the appreciation of the yuan against the US dollar, which is traded at about 8.3 yuan. 'By forcing all investors to change their hard currencies for yuan through official channels, the PBOC can control money supply - and thus inflation - more effectively,' said Norman Sze, Arthur Andersen's general manager in business advisory. He said with a more accurate picture of the volume of foreign currency the PBOC could then better estimate the impact of aggregate money supply on the economy especially on inflation. Government statistics show that China's foreign reserves jumped to US$51.6 billion at the end of last year, from $21.2 billion at the beginning of the year and by March of this year had ballooned to more than $58 billion. Until the latest move, a mainland and foreign investor could easily borrow an equivalent amount in yuan for working capital in exchange for foreign currencies he placed with Chinese banks as a pledge. The scheme was advantageous to foreign investors in the face of the declining value of the yuan in 1992 and 1993, which made investors nervous about falling profits from operations. That led to a rush for foreign currencies to hedge against the yuan by mainland and foreign investors, pushing down the yuan even further. 'Before the single-tier exchange rate was enforced last year, there were fears that the yuan would drop further against the US dollar. So there was an element of foreign exchange risks for investors,' Mr Sze said. Although placed as collateral the foreign currencies could still be drawn by the investor if he did not buy enough of them in the swap centres to remit profit home or to use them for unexpected additional expenses. The foreign currencies placed as collateral generally did not earn any interest but an astute investor could make a foreign exchange gain if he chose to exchange them into yuan at the right time to repay his loans. The days of the weak yuan and shortage of foreign reserves appear to be over for now.