Weakening yuan ahead

WSJ:

Pricing in the forwards market indicates the offshore yuan will decline 3.2% in the next year, to 7.12 to the dollar, according to Thomson Reuters. Depreciation expectations have picked up recently, though they remain less frenzied than at the start of this year when the forwards market pointed to one dollar buying 7.33 yuan in a year’s time.

The evidence from the past two years suggests that the PBOC can very easily squeeze investors out of their bearish bets in Hong Kong, market participants say.

One option would be to direct state-owned banks to buy up yuan offshore, driving up the borrowing costs for the currency and so making it much more costly to short the yuan. The pool of yuan floating around Hong Kong is shrinking—yuan deposits tumbled nearly 40% in the year through January, according to the Hong Kong Monetary Authority—making it less costly for the central bank to push up borrowing costs in this way.

The central bank wants to prevent the offshore yuan from falling significantly more than the onshore yuan because a divergence tends to increase pressure on capital outflows. If Individuals and companies believe the yuan will depreciate, they are more likely to swap it for foreign currencies like the dollar—weakening the yuan further.

Chinese authorities have clamped down on many of the channels through which money can leave its borders, which has lessened the pressure for now. But most investors still expect a decline in the yuan against the dollar this year, pointing to the divergence of interest rates and economic growth between the two countries. Bank of America Merrill Lynch analysts recommend betting on dollar strength against the offshore yuan through the options market.

A weakening yuan will generate all sorts of contortions. We’ll be watching what happens.

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