Forex Investment and Currency Trading

Since early-April, the CNY/USD appreciation rate has slowed significantly to around 6.7% annualized rate in April-May, down from 17% in the first three months of the year. As a result, the non-deliverable forwards (NDF) market’s expectation for 12-month CNY/USD appreciation has also been scaled back to 6.6% from 11.7%. Is the slower CNY appreciation rate a change of course? Or is it just a normal China-style “stop” before the “go” again?

It is more likely to be the latter, and the current USD/CNY forecasts are 6.76, 6.60 and 6.30 on 3, 6 and 12-month horizons, implying 10% appreciation in 12 months’ time. Here is why market believes that China cannot afford to go slow, let alone to stop, on its long march to get the CNY right:

1. The People’s Bank of China needs to persistently buy large and rising amounts of USD, to hold the CNY at its current level. 

2. Yet, the official FX reserves number has still understated the true level of FX accumulation by the official sector. The total FX position of China’s banking system already reached US$2.1 trillion in April 2008, or over 56% of GDP

3. Interestingly, large FX inflows have continued to pour in, despite slower trade surplus growth and reduced global risk appetite. 

4. The size of China’s total balance of payments (BOP) surplus is unprecedented for any large economy, both in absolute levels terms and as a share of GDP. The estimate is that China’s BOP surplus had reached 15% of GDP in 2007, and is likely to rise further this year.

5. Will a 6%-7% CNY/USD appreciation in one year, in any meaningful way, help eliminate a US$700 billion BOP surplus (or US$262 billion trade surplus) and its associated distortions for China? The view, it is unlikely. China clearly prefers to move gradually; however, in the face of mounting economic costs and international pressures, “gradually” may also increasingly need to become “gradually faster” CNY appreciation.

The updated forecast implies 10% appreciation of the CNY in 12 months’ time, compared with 6.6% currently priced into the NDF market. The new 6-month CNY/USD forecast now implies 5% appreciation vs. 9% in the previous forecast made more than 3 months ago because of large realized appreciation in the past few months and the expectations of a more stable USD in 2H2008.