Yuan Faces Appreciation Pressure on Rates, SAFE Says (Update3)

By Bloomberg News
March 9 (Bloomberg) -- The yuan is facing increased pressure to appreciate as a widening interest-rate differential spurs inflows of funds through "underground money shops,"
China’s top currency regulator said.
The funds are disguised as foreign direct investment and trade accounts, Yi Gang, head of the State Administration of Foreign Exchange, said at a briefing in Beijing today. The yuan’s exchange rate will be kept stable at a "reasonable and balanced level," he reiterated.
China has pegged its currency to the dollar since July 2008 to help exporters weather a global recession. A recovery in overseas sales has intensified bets among traders that policy makers will resume gains to reduce import costs and contain inflation amid a surge in property and stocks prices.
"You can’t win," said Stephen Green, head of China research at Standard Chartered Bank Plc in Shanghai. "You have speculative inflows now because people expect appreciation and you will have speculative inflows if you gradually appreciate the currency. Speculative inflows are the price you pay for having waited so long to allow the yuan to appreciate."
The spread between China’s one-year deposit rate and its U.S. equivalent reached 1.43 percentage points today, compared with parity on May 6 last year. Non-deliverable yuan forwards show traders are predicting a 2.7 percent gain in the currency in a year.

Capital Inflows

"China’s relatively high interest rates and some yuan appreciation expectations may attract some cross-border arbitrage capital," according to a statement issued by SAFE before Yi’s press conference. "Companies increasingly prefer to hold yuan assets while borrowing in foreign currencies."
China’s foreign-exchange reserves of $2.4 trillion are the largest in the world, a sum approaching the size of the U.K.
economy. The increase in holdings and rising export earnings force the central bank to buy dollars to keep the yuan stable, with a proportion of the funds invested in U.S. Treasuries.
Yi said China will keep the yuan "basically stable,"
while the government continues to improve the currency’s mechanism. Green estimated China may resume appreciation at the end of the second quarter or the beginning of the third quarter, and allow "very slow" gains in the currency.

U.S. Treasuries

The Asian nation is the largest creditor to the U.S., with
$895 billion of the debt as of December. China has previously expressed concern that a drop in the dollar will erode its investments, while President Barack Obama and European officials have said the mainland keeps the yuan artificially weak to boost exports to the detriment of its overseas counterparts.
Treasuries are a "market investment" that seeks "a win- win situation with the U.S.," Yi said. "The U.S. Treasuries market is very important for China. China is a responsible investor, and we don’t want to politicize the issue."
The foreign-exchange reserves are "appropriately diversified," SAFE said in a statement today. They include dollars, euro and yen, and the investments were "generally safe" in 2008 and 2009, the administration said.
China is the world’s fastest-growing major economy and this year is projected to overtake Japan as No. 2 in global gross domestic product rankings. GDP expanded 10.7 percent in the fourth quarter, the quickest pace in two years.

Inflation Risk

Record loan growth is threatening to stoke inflation and prompted the central bank to raise the amount of cash banks must set aside as reserves for a second time this year last month.
Investors may use inflation data due this week as a chance to "add to appreciation bets" on the yuan, according to Sebastien Barbe, head of emerging-market research at Credit Agricole CIB in Hong Kong.
Consumer prices probably climbed 2.5 percent in February from a year earlier, up from 1.5 percent in January in the biggest increase since October 2008, according to the median estimate from 23 economists in a Bloomberg News survey before the March 11 report.
Central bank Governor Zhou Xiaochuan said on March 6 that China will exit its crisis stance "sooner or later." He also said China must be very cautious about the timing of normalizing policies, and this includes the yuan’s exchange rate.
Twelve-month non-deliverable yuan forwards traded at 6.6482 per dollar as of 12:33 p.m. in Hong Kong, according to data compiled by Bloomberg. The contracts touched 6.6260 yesterday, the highest level since Feb. 1. The spot rate was 6.8264, according to the China Foreign Exchange Trade System.
The central bank may allow the currency to strengthen 3.4 percent to 6.6 by the end of this year, according to the median estimate in a Bloomberg News survey of 25 analysts. Credit Agricole’s Barbe predicts appreciation will resume by the end of the second quarter and forecasts a year-end rate of 6.5.
Yi said he was unable to comment on when the government would adjust its exchange-rate policy. Policy makers plan to remove the remaining barriers preventing the currency being used for trade settlement, he added.