Update for Recent Development in Chinese Yuan

Update for Recent development in Chinese Yuan

1. The expectation or speculation about a Chinese Yuan revaluation started from the beginning of 2003.

2. Why we say 2003? Because the Non-deliverable forward of USD against Chinese Yuan started to fall into discount from premium at the beginning of 2003.

3. Non-deliverable forward is a type of derivative in the foreign exchange market where by the home currency is not delivered (or settled, transferred) at maturity, instead the difference of market rate against the contract rate is settled with a reference currency (usually USD).

4. China has a very restricted money market and therefore commercial loans are not readily accessible in short tenor such as overnight or 1 week, the most common interest rate benchmark in China is a 1-year bank lending rate, which currently stands at 5.31%, if we compare the Chinese interest rate with the US rate of the same tenor (1 Year US rate is approximately 2.35%), in foreign exchange market, assumed that Chinese Yuan is convertible, the USD should be at a premium against the Chinese Yuan. In the non-deliverable market, however, the USD is trading at a discount against Chinese Yuan after January 2003, which obviously is not logical from an interest arbitrage point of view. The reason is that the assumption that Chinese Yuan is freely convertible is void, the USD discount ( for instance 1-year non-deliverable forward discount of USD is 2400 pips or 0.24 Yuan) is an implied expectation of Chinese Yuan revaluation in one year's time as perceived by the market.

5. The expectation that Chinese Yuan would appreciate and happen in foreseeable future was advocated by major US Investment Bank such as Goldman Sachs and Morgan Stanley. International organizations such as IMF started to talk more about the issue ever since 2 years ago. In the recent years, there was a very fast expansion of Chinese export into the United State. The most recent number of US July trade deficit announced last Friday was $50.1 billion, though lower than the June historical record of $55.8, still formed as a threat for financing of these huge deficit through capital account surplus by the US. Furthermore, the July US trade deficit with China set another monthly record at $14.9 billion as imports increased 3.7% from June and exports fell 2.6%. US manufacturers and politician still blamed China's policy of pegging its currency against the US dollar for the soaring bilateral deficit.

6. Now that we know that the USD discount of Chinese Yuan NDF reflects the market's expectation about Chinese Yuan revaluation percentage, we can look at the current market discount which stands at 0.24 Yuan, working it against the current exchange rate of 1USD= 8.2766CNY, it is reflecting a revaluation of 0.24/8.2766, a 2.9% revaluation of Chinese Yuan against USD in one year's time if the Chinese Yuan is made freely floating and convertible now.

7. The speculation about China's readiness to give in to international pressure, particularly from the United States, to either un-peg its currency, or let the Yuan trade in a wider trading band reached its peak in September and October last year after the Group of 7 meeting in Dubai last year ended with a communiquй which called for more flexibility in exchange rate globally with particular focus on Asian countries. China