China Money: Forwards seen overpricing yuan vs dollar

SHANGHAI, March 12 (Reuters) - The forwards markets have been implying the yuan will appreciate an eye-popping 12 percent against the U.S. dollar over the next 12 months.

But few traders and analysts in Shanghai think that will happen. As the dollar has tumbled globally and Chinese inflation has risen in the past couple of weeks, they say forwards have begun seriously overpricing the currency.

"Markets have grown too pessimistic over the dollar's fall," Shi Lei, an analyst at Bank of China, the country's top foreign exchange bank, said in a research report this week.

"For the yuan, we forecast a trend of obvious slowdown in its appreciation in the third and fourth quarters, and maintain our forecast for the yuan to rise around 8 percent for all of this year," he said, adding appreciation would slow further in 2009.

The offshore non-deliverable forwards (NDFs) market on Monday implied a 12.40 percent rise of the yuan against the dollar over the next 12 months.

That was the highest implied appreciation since the yuan's CNY=CFXS peg to the dollar was abolished in July 2005, and up from levels below 9 percent as recently as February. On Wednesday afternoon, implied appreciation was 12.00 percent.

The yuan has also soared in the onshore forwards CNY1YOR= market. Implied 12-month appreciation there hit a record 11.95 percent on Monday. It was 10.94 percent on Wednesday.

The rise was especially dramatic because it occurred as the China-U.S. interest rate gap was widening, which in normal conditions would have tended to restrain the yuan in forwards markets. The spread of the one-year Chinese central bank bill yield CN1YNFIX=R above one-year dollar LIBOR LIUSD1YD= is now about 150 basis points.

The yuan appreciation implied by forwards would mark a big acceleration from 6.86 percent in 2007 and 3.40 percent in 2006.

BULLISH?

There are reasons to be bullish on the yuan: the dollar's slide to record lows versus other currencies, China's use of the exchange rate against inflation, and European diplomatic pressure on China to boost the yuan against the euro EURCNY=CFXS.

But with the exception of Goldman Sachs, which in late February raised its forecast for 12-month yuan appreciation against the dollar to 12 percent, few in Shanghai's markets think these factors justify recent forwards prices.

An informal Reuters poll of a dozen traders and analysts this week found all of them predicting appreciation of about 10 percent or slightly less this year.

Some believe foreign institutions' limited access to China's onshore spot forex market, which is in any case tightly controlled by the central bank, has fuelled excessive speculation in NDFs during a time of global dollar weakness.

"The recent steep fall of dollar NDFs is more propelled by dollar weakness in global markets than by increased anticipation of yuan appreciation," said a dealer at a U.S. bank in Shanghai.

Internationally traded one-year dollar/euro forwards EUR1Y= on Wednesday implied 12-month appreciation of the euro against the dollar of only about 1.63 percent.

If dollar/yuan forwards prices are reasonable, that suggests the yuan may rise some 10 percent against the euro in 12 months, which few think possible.

Meanwhile, onshore forwards may have been distorted by a shortage of dollars in the spot market, due to China's controls on short-term foreign currency debt. Banks say they have not yet been told their debt quotas for next quarter, making them particularly jittery about the shortage as April approaches.

The shortage has pushed costs of funding in dollars 500 or 600 bps above yuan financing. That has prompted some banks to obtain spot dollars by agreeing to pay them back through the onshore forwards and swap markets at big discounts.

POLICY CHANGE AHEAD?

Aggressive bets on the yuan's appreciation in the forwards market could prove ill-judged if Chinese forex policy changes.

For the past two weeks, the central bank has held the yuan's spot rate against the dollar essentially unchanged, one of the longest periods of stability in the past year.

Officials' remarks have suggested they might be reconsidering the policy of fast yuan appreciation to fight inflation.

Central bank chief Zhou Xiaochuan told a news conference last week that yuan appreciation would do little to curb inflation in a big country such as China, adding: "In my personal view, it is unnecessary to use the exchange rate to fight inflation."

Some traders think a policy review may have been prompted by news that direct foreign investment in China during January and February jumped 75 percent to $18.13 billion. This may have been caused by disguised inflows of speculative or "hot" money. If so, China may slow appreciation a bit to deter those inflows.

"Zhou's comments suggest the government may now feel the cost of relying almost entirely on yuan appreciation to curb inflation is too high," said a trader at a European bank in Shanghai. (Editing by Andrew Torchia)