Yuan Forwards Underestimate China's Currency Gain, Goldman Says

By Kim Kyoungwha and Judy Chen
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Aug. 6 (Bloomberg) -- China's yuan is likely to appreciate against the dollar ``almost three times as fast'' as traders predict because money flowing into the country is still increasing, according to Goldman Sachs Group Inc.

The rate of yuan gains has slowed over the past month and non-deliverable forwards show traders have pared expectations for the speed of the advance on speculation China is reducing the pace to protect exporters as economic growth cools. China last month set up an electronic network to monitor export income to stop currency speculators using bogus contracts to bypass investment rules.

China's record trade surplus and so-called `hot money' inflows betting on yuan appreciation have pushed the nation's foreign-currency reserves to $1.8 trillion, driving inflation to a 12-year high in February.

``We remain confident that it would be the wrong decision to close long yuan exposure at these levels,'' Thomas Stolper, a London-based strategist at the world's biggest securities firm by market value, wrote in a research note yesterday. ``The pace of reserve accumulation remains a serious issue.''

Cash inflows from the trade surplus and foreign direct investment suggests reserve accumulation runs at about $30 billion per month before additional speculative capital, according to the report. This year's monthly increase in reserves amounted to $46.8 billion on average, hindering the People's Bank of China from conducting ``effective'' monetary policy and added ever more dollars to the ``staggering'' reserves, Goldman said.

Forward Bets

The yuan traded at 6.8506 per dollar as of 12 p.m. in Shanghai, from 6.8556 yesterday, according to China Foreign Exchange Trade System. The currency is more than 20 percent higher than the 8.3 level it was pegged at until July 2005.

Non-deliverable forwards show an implied rate for the yuan of 6.6115 in the next 12 months, a gain of 3.2 percent from today's spot rate and compared with bets for a level of 6.4650 at the start of July. Forwards are agreements in which assets are bought and sold at current prices for future delivery. Yuan forwards are non-deliverable because they are settled in dollars.

China's Politburo, the Communist Party's top decision-making body, dropped mention of ``tight'' monetary policy in a report on July 25 and said growth and inflation were both top priorities.

China's crackdown on ``hot money'' seems to be curbing inflows of speculative capital, enabling policy makers to slow the pace of yuan appreciation, Yu Yongding, a former adviser to the central bank, said in an interview last week.

More rigorous checks by the State Administration of Foreign Exchange, China's currency regulator, have started to control ``unwanted money'' flows, reducing the need for rapid yuan gains to quell inflation, Yu said.

`Unfortunate Development'

Any slowdown in the yuan would be ``a rather unfortunate development as it would create incentives to worsen the imbalances'' in the economy, sacrificing domestic demand to further boost exports when the exact opposite is needed,'' Stolper said.

The market's perception that growth without exports is difficult to achieve in China is unfounded, Stolper said.

The People's Bank of China guides the exchange rate against a basket of five currencies that includes the Japanese yen and euro. The yuan is allowed to trade 0.5 percent against the dollar either side of a reference rate set each day by the central bank. China set the reference rate weaker for a sixth day today at 6.8525.

On Goldman Sach's trade-weighted index the yuan ``is clearly still appreciating,'' Stolper said, strengthening 1 percent of a two-week period.

China's decision to raise tax rebates for textile exporters last week is seen as a measure to ``offset the worst side effects of an otherwise unchanged foreign-exchange stance,'' he said.

``By giving in to some pressures from the industries hardest hit, the overall currency policy of gradual yuan appreciation may actually be maintained more easily,'' Stolper wrote.

To contact the reporters on this story: Kim Kyoungwha in Beijing at kkim19@bloomberg.net; Judy Chen in Shanghai at xchen45@bloomberg.net;