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China Money: Forwards trim outlook for yuan appreciation

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littlekracker



China Money: Forwards trim outlook for yuan appreciation


* Reuters, Friday March 5 2010


By Lu Jianxin and Edmund Klamann
SHANGHAI, March 5 (Reuters) - The dollar's global rebound and disputes between Beijing and Washington have spurred the forwards markets to scale back expectations for yuan strength, even as some researchers are now talking of renewed yuan appreciation.
The onshore dollar/yuan forwards, more attuned to domestic policy signals, have been the latest to trim their yuan appreciation bets, reopening a window for arbitrage with the more bullish offshore non-deliverable forwards (NDFs), which tend to take their cues from global currency trends.
"Market conditions have changed a lot since the fourth quarter of last year," said a senior dealer at a U.S. bank in Shanghai, citing a more than 8 percent rise in the U.S. Dollar Index since late November from its lowest in over a year.
"And with recent Sino-American disputes on issues such as U.S. arms sales to Taiwan possibly hardening China's stance on its stable yuan policy, the 2 to 3 percent yuan appreciation now implied in one-year NDFs may already be excessive."
Talk has resurfaced in recent weeks in global academic circles and among investment banks that China may allow the yuan to resume its climb in the near term, possibly even via a one-off revaluation, to counter renewed capital inflows.
Societe Generale's chief Asia economist, Glenn Maguire, said in February that China was likely to revalue the yuan by 5 to 10 percent in April or May, opting for a surprise one-time move to fend off speculators.
DEALERS DISAGREE
But dealers in the domestic market, the China Foreign Exchange Trade System, and many Chinese academics disagree, citing Beijing's typical style of gradualism in reforms.
"I don't agree with this opinion," said currency strategist Liu Dongliang at China Merchants Bank in Shenzhen.
"China has yet to see any signs suggesting an outlook for high inflation, so this is not the right time for the central bank to use foreign exchange policy to curb inflation."
China's central bank could let the yuan rise via adjustments to its daily mid-point, a reference rate from which the yuan can deviate by no more than 0.5 percent each day, without resorting to a one-off revaluation, dealers said.
That is how Beijing engineered a roughly 20 percent yuan rise against the dollar in the three years that followed its July 2005 revaluation.
Since July 2008, however, the currency has been effectively re-pegged to the dollar within a narrow 100 pip range, as the authorities seek to cushion exporters from the global financial crisis.
Expectations of yuan strength heightened late in the third quarter last year as China's capital inflows surged, but were dampened again as tensions between China and the United States heated up and the dollar regained strength overseas.
For some market players, however, the differing dynamics of the domestic and overseas forwards markets provide arbitrage opportunities.
Benchmark one-year dollar/yuan NDFs have been bid in a range of 6.64 to 6.68 since early February, implying 12-month yuan appreciation of 2.2 to 2.8 percent, down sharply from more than 4 percent implied last October and November.
The shift brought offshore forwards closer to the onshore one-year forwards, narrowing the spread to 500 pips by mid-December and making arbitrage unattractive.
WINDOW BACK OPEN
But signs that China would stick to its stable yuan policy emboldened the onshore market to push up one-year forwards, which have recently been bid in a range of 6.76 to 6.78, implying a 12-month yuan rise of 1.3 to 1.6 percent versus 2 percent in mid-October.
This moved the spread back out to 1,000 pips, enough for banks active in both markets to earn 1 million yuan ($150,000) in risk-free profit on a nominal position of $10 million, or a 1.5 percent annual return.
But the window may not stay open long, and Chinese rules restrict the scale of arbitrage business.
Foreign banks in China are constrained by quotas for long dollar and short yuan positions and are banned from shorting dollars entirely, so their financing for arbitrage is limited.
But within these constraints, eligible Chinese banks with foreign subsidiaries and foreign banks in China can sign a forward contract on the onshore market to buy dollars at the present exchange rate of 6.8300-plus yuan per dollar and agree to sell back the dollars one year later.
They can then do a reverse contract in the NDF market to sell dollars for yuan and agree to offset that position one year later, reaping the difference -- until the gap narrows again.
"Some major Chinese banks and their clients have noticed the return of the arbitrage opportunity, although the Spring Festival holiday in mid-February made it difficult for them to get funds to do the buiness," said a Chinese bank dealer in Beijing.
"Now they are back in the markets, and that may narrow the onshore and offshore spread and could close the arbitrage window again in a couple of months." (Editing by Tomasz Janowski) ($1=6.83 Yuan)

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