HONG KONG, Jan 5 (Reuters) - China's offshore yuan retreated in Hong Kong after making its biggest gain in a year in overnight trade, but it was still hovering around a one-month high as surging funding costs forced yuan short sellers to square positions and stop losses.
The offshore yuan changed hands at 6.8918 near midday. It rose 1.3 percent by the New York close to 6.8689 per dollar, its biggest gain since Jan. 11 last year, when it rose 1.5 percent.
"Short-term interest rate is too high now, with overnight borrowing cost of the yuan surpassing 40 percent," said Ngan Kim Man, deputy head of treasury at China Everbright Bank's Hong Kong branch.
The overnight yuan borrowing rate in Hong Kong has been elevated since Christmas holiday and the fixing hit one-year high on Thursday at 38.34 percent, and that compared to 4.82 percent at the beginning of December.
"If yuan short sellers do not square their positions, they will see losses immediately as the funding cost is really high," Ngan said.
The yuan is still under heavy depreciation pressure this year, and this expectation pushed investors, especially those in offshore markets, to build large short yuan positions to wait to collect profits.
In 2016, the yuan weakened 6.63 percent against the dollar, its biggest move since 1994.
China has been making great efforts to stabilise its currency ahead of U.S. President-elect Donald Trump's inauguration and the Chinese New Year later this month by taking actions that affect both onshore and offshore markets.
The People's Bank of China has set stronger than expected yuan daily midpoints for onshore trade and state banks were seen offering dollars in the past few days, in order to stop the yuan from falling too quickly and to stabilise market expectations.
On Thursday, with the global dollar index easing from a 14-year peak, the PBOC set a much stronger yuan midpoint at 6.9307, marking the biggest daily strengthening in percentage terms since Dec. 6.
"The movement yesterday was not triggered by an outright intervention from PBOC. Alternatively, it is more like a knee-jerk reaction as there were massive stop-loss flows in the market," said Zhou Hao, senior EM economist at Commerzbank.
"These wild movements of USD-CNH indicate that the market will remain volatile in the short term, but won't change the fact that yuan is under pressure to weaken," Zhou said.
Offshore market players say a shrinking yuan pool in Hong Kong, as fewer people are seeking yuan-denominated assets amid expectations the currency will weaken further, has also contributed to the volatility in offshore yuan rates.
Yuan deposits in the world's biggest offshore yuan hub fell by 5.3 percent from a month earlier to 627.6 billion yuan ($90.23 billion) in November, the lowest level since January 2013.
China's foreign exchange regulator said on Saturday that from the start of the year it would step up scrutiny on individual foreign currency purchases and strengthen punishment for illegal money outflows. The move reflects Beijing's concern over the high level of capital outflows in recent months, though individuals buying foreign currency was only a small part of the problem.
Reporting by Michelle Chen; Editing by Simon Cameron-Moore