All the warning signs were there, especially the backup in the CNY exchange rate. Chinese stocks had stood for a good run while the PBOC had flooded internal channels, but how much of that was real liquidity versus the appearance of stuffing funding into the narrow coffers of the largest state run banks? Increasingly it seemed far more the latter as the first shots of volatility appeared last week and only grew from there. That was expected on both artificiality and the regular hangover after the Lunar New Year fades.

What was interesting and much more significant was the eurodollar market trading in almost perfect concert to CNY yesterday. It suggested once more this overall global funding environment that is and has been the PBOC’s most dangerous financial enemy. As I wrote yesterday (subscription required):

Before this morning’s sharp reversal, it was clear that the Chinese/”dollar” connection was the driving force in the selloff. The CNY exchange rate has struggled to maintain closer to 6.50 and this morning it finally moved sharply lower; trading at almost 6.54 at one point before staging a modest recovery. Almost everything else seemed to move in tandem, including eurodollar futures.

The CNY middle rate was set at almost 6.54 this morning, with the selling rate nearly 6.55 and the lowest since President’s Day. In addition, O/N SHIBOR jumped over 2%, which seems something of an obsession with the PBOC in maintaining the overnight rate a few pips below that level; perhaps with very good reason.

Stocks in China plunged Thursday amid heightened worries about market liquidity, just as leaders of the world’s largest economies are preparing to meet in Shanghai.

The Shanghai Composite Index SHCOMP, -6.41% tumbled throughout the trading session to finish down 6.4% at 2,741.25. That was the worst percentage drop for China’s leading benchmark since Jan. 26 and took the benchmark down to a 47% loss since last summer.

  The sudden selloff appeared to be due to several reasons, from worries about tighter liquidity in the market to withdrawal of money by investors who have been hammered by months of volatile trading in China…
  By the close, the Shenzhen Composite Index 399106, -7.34% had dropped 7.3%, and China’s Nasdaq-style ChiNext board was down 7.6%. More than 1,300 stocks in Shanghai and Shenzhen fell by 10% — the maximum level that Chinese authorities allow an individual stock to fall in one day.