Forex Investment and Currency Trading

10% CNY appreciation expected in 2008. The authorities are increasingly targeting gains against the Euro as well as the USD.

The CNY has appreciated 4% since the start of the year, its largest three-month gain since revaluation in 2005. The annualized pace of appreciation is likewise running around 15%. Rising inflation pressures are a popularly cited reason for the recently large gains. The authorities have also talked of targeting CNY gains against a trade-weighted basket, rather than just the USD. The Euro area is currently China’s most important trading partner, yet the EUR has risen 1% against the CNY this year. Market revises its CNY call to 6.400, from 6.600, by end-2008, to take into account recent gains.

However, this assumes appreciation slows modestly in H2 from its current rate. Most importantly, inflation is expected to stabilize in the coming months as disruptions related to the snowstorm ease. Base comparisons also drag down the YoY inflation rates from June 2008. Moreover, while the PBOC Q4 report released February 27 noted that the currency can be used to target inflation, the PBOC Governor later qualified the statement on March 7 by saying the impact of a stronger currency on inflation is limited.

Further, export growth is expected to slow in Q2 mainly as a result of weaker US demand. A stronger CNY versus the USD is also anecdotally hurting profit margins, as reflected by reports of a growing number of firms now invoicing in non-USD in order to hedge against their currency risks. The Ministry of Commerce has already warned on export growth in H2 and officials is expected to grow more cautious of strong CNY gains in H2 thus slowing the pace of appreciation.

The CNY NDF curve is likewise pricing in greater appreciation in the short-end relative to the long-end. Specifically, 3M NDFs are pricing 12% annualized appreciation, whereas 12M NDFs are pricing in a smaller 10% appreciation. There is little value in selling USD/CNY at these levels with the NDF curve broadly pricing in the current CNY forecast.