NDF discount reflects tighter yuan liquidity

Updated: 2011-12-08 07:41

By Dariusz Kowalczyk (HK Edition)

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NDF discount reflects tighter yuan liquidity

The yuan (CNY) has been trading at a discount in the non-deliverable forward (NDF) market versus the spot market since late September, begging the question whether this is a trading opportunity for believers in appreciation of CNY spot, or the beginning of downward pressure on the Chinese currency.

There are six main reasons for the discount, of which risk aversion in global markets is the easiest to explain. It has led to the closure of short US dollar (USD)/Asia positions, including against the CNY, with players exiting the trade without specific attention to the level of implied premium or discount.

The second factor is related to weakening fundamentals of the Chinese economy. China's poor November PMI releases are pointing to a clear slowdown in the economy. Export growth slowed in October to a relatively low level of 6.9 percent YoY in volume terms and the trade surplus narrowed. As a result, the overall balance of payments is already under pressure.

September saw a $61 billion drop in foreign exchange (FX) reserves, although this probably largely reflects valuation changes. However, October brought the smallest net selling of FX by clients to mainland banks in a decade, at just $3 billion. It seems that China is barely running a balance of payments surplus, perhaps as hot money is leaving the real estate market where prices have begun to fall.

Thirdly, the change in the balance of payments can be seen in the spot market, where the CNY has been languishing in the lower half of the daily trading band. Not infrequently, it has traded at the very bottom, and the People's Bank of China had to intervene to support its own currency. As a result, since early October the CNY has stopped appreciating in the spot market.

Perhaps the most important reason for weakness in the NDF market is related to developments in the offshore market (CNH). CNH forward points have been rising and the one-year forward point hit a record high of 635 pips on Wednesday. Because both the CNH and NDF markets are accessible to the same group of offshore players, arbitrage activity keeps spreads between CNH and NDF forward points in a range. This means that when USD/CNH forwards are moving up, USD/CNY NDFs are being pulled higher as well.

Why are USD/CNH forwards rising? There are a number of reasons, but primarily they fall into three categories: tightening of liquidity conditions in the CNH market, convergence of dim sum bond yields towards their onshore counterparts and closing of bets on CNY appreciation.

The CNH market is experiencing liquidity tightening due to supply and demand factors. CNY internationalization in trade has recently stalled, leading to an outflow of CNH funds from Hong Kong into the mainland as a result of CNY-settled trade. At the same time, demand for the CNH is rising due to higher dim sum bond yields and the fact that some banks have overextended their CNH loan books.

Convergence of dim sum bond yields with onshore yields is proceeding quite fast. It is being fuelled primarily by China's announcement of the mini QFII program, under which offshore investors in the CNH market will be able to buy onshore bonds. While the size of the program will initially be small at 20 billion yuan, primary market yields are already rising as investors are unwilling to buy at yields well below mainland levels given future opportunity to invest at higher, onshore yields.

Lastly, short USD/CNH positions in the forward market, based on bets that the CNY will keep on gradually appreciating and that the CNH spot is a good proxy for the CNY spot, are being unwound. This is because the outlook for CNY appreciation is less certain and the recent volatility in the CNH-CNY basis makes the proxy argument less appealing. Many investors used to prefer buying the CNH in the forward rather than the spot market. As a result of the unwinding, USD/CNH rates are moving higher.

The above trends pushing up USD/CNH forwards are likely to continue, exerting upward pressure on USD/CNY NDFs. Chinese data is likely to weaken further, leading to more doubts over CNY spot gains and to additional buying of USD/CNY NDFs. As a result, NDFs are likely to price in even deeper depreciation of the CNY spot.

The author is senior economist/strategist - Asia ex-Japan at Credit Agricole CIB. The views expressed here are entirely his own.

(HK Edition 12/08/2011 page2)