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* Beijing targets "aggressive" trading to stem capital flows
* Also wants to narrow onshore-offshore yuan gap
* China-based banker says "easy-money" arbitrage days nowgone
By Engen Tham and Denny Thomas
SHANGHAI/HONG KONG, Dec 31 (Reuters) - Chinese authoritiesare starting to police the nation's foreign exchange market in away currency traders have rarely seen before, levying penaltypayments for aggressive trading and prompting some banks to turndown business.
Reuters reported on Wednesday that China's central bank hadsuspended at least three foreign banks from conducting some oftheir foreign exchange business until the end of March.
China's past willingness to tolerate some capital flight haspaved the way for locals to take billions from the country forfunnelling into assets such as French vineyards and luxuryproperties in the world's leading cities.
But with the country's growth at its weakest in 25 years andthe currency heading for a record fall this year,China is aiming to stem the capital outflows, which can beexacerbated by the widening gap between onshore and offshoreexchange rates for the yuan, or renminbi.
"China is essentially trying to close that gap and it's muchmore difficult to do that if you have these outsiders coming inand taking advantage of the arbitrage," said Jimmy Weng, HongKong-based fund manager at Genesis Capital Investment.
China-based forex market sources said Beijing had turned upthe pressure over the past few months following guidelinesreleased in September to strengthen regulation of the market andmake forex trades more expensive.
One foreign bank received a warning from the StateAdministration of Foreign Exchange (SAFE) regulator and wasforced to increase money set aside for trades as a penalty inNovember due to its "aggressive" business model for forexoperations, said a senior China-based banker in the FX team at aforeign bank. The person's own bank had shut down buy-side forextrades.
"It's possible that the foreign banks did everything right,that they put aside the 20 percent reserve, that they met the'know-your-client' (KYC) requirements, but are still tradingaggressively, which is clearly against what China wants," theperson told Reuters.
"We used to make so much money from arbitrage - easy moneyyou know? Now, none."
WE'VE BEEN ROBBED
The latest move comes just three months after the People'sBank of China (PBOC) ordered banks to scrutinise clients'foreign exchange transactions to prevent illicit cross-bordercurrency arbitrage between the offshore and onshore yuan.
On Wednesday, the country's foreign exchange regulator alsosaid it would improve its reserve position and contingency plansto curb risks from abnormal cross-border capitalflows.
"The main purpose is to crack down on excessive currencyspeculation and arbitrage, which may hurt the economy," said asenior economist at a think-tank linked to China's Cabinet.
"They are worried about falling FX reserves. The yuan facesobvious depreciation pressure as the Fed (U.S. Federal Reserve)may continue to raise interest rates, so policymakers areconcerned and intend to take effective measures to respond."
A source at one of the affected banks said China's centralbank asked them to disclose the names of their foreign exchangeclients buying spot and instructed any state-owned enterprisesamong them to stop trading.
"The PBOC is robbing us. They're not being reasonable; evenif we comply with everything, we provide all the documents, ourspot volume is too large," the person said.
The PBOC and SAFE did not immediately return requests forcomment.
The banks targeted were likely picked because of the largescale of their cross-border forex businesses, sources said.
MIND THE GAP
A surprise devaluation of the yuan by nearly 2 percent onAug. 11 fuelled a wave of capital outflows on fears the economymight be slowing more sharply than thought.
The spread between the onshore and offshore yuan has beengrowing since the devaluation, making it increasingly difficultfor the central bank to manage its currency and stem outflows.
China's central bank and commercial banks sold a net 2.19trillion yuan ($337 billion) of foreign exchange betweenJan-Nov, compared with a net purchase of 897 billion yuan in thesame period in 2014. Net sales indicate capital outflows.
Another government policy adviser said the direction ofChina's capital account liberalisation reforms was unlikely tochange, however, since they were key to greater globalacceptance of its currency.
"Capital flows depends on China's economic fundamentals; weshouldn't worry too much about short-term capital outflows if weare confident about our economic fundamentals. The direction ofcapital account reforms will not change," he said.
The yuan has come under renewed pressure since late Novemberamid speculation that Beijing would permit more depreciationafter the International Monetary Fund announced the currency'sadmission into the fund's basket of reserve currencies.
The onshore yuan traded in Shanghai has lost 1.48percent of its value since the end of November, and hasrepeatedly hit 4-1/2 year lows. The offshore market has traced asimilar pattern, hitting its weakest level since late September2011 this week. ($1 = 6.4935 Chinese yuan renminbi) (Reporting by Engen Tham in SHANGHAI, Kevin Yao in BEIJING,Denny Thomas in HONG KONG and Saeed Azhar in SINGAPORE; Writingby Adam Jourdan; Editing by Will Waterman)
