Q+A: What is happening in the offshore yuan forwards market?

HONG KONG, June 14 (Reuters) - One year after China kicked off the offshore yuan market in Hong Kong to gradually internationalise its currency, trading has picked up in fledgling offshore spot and forwards.

As yuan deposits soared at banks in Hong Kong, spot trading in USD/CNH has increased and with it proper trading in USD/CNH forwards.

Still, with volumes at $300-500 million, they remain far below than that of yuan NDFs where daily volumes amount to about $2-$3 billion.

Even as trading volumes picked up, the USD/CNH forwards curve moved steadily higher in recent weeks, culminating in a sharp rise last Thursday, indicating the market may have finally disentangled from yuan NDFs.

Following are some questions and answers on what is happening in the offshore yuan forwards market.

WHAT TRIGGERED THE SPIKE IN USD/CNH FORWARDS?

Before June, offshore yuan forwards had a downward sloping curve as market players treated them as a similar product to the popular offshore non-deliverable forwards - a dollar-settled futures market used to bet on renminbi appreciation prospects.

But concerns that Beijing may be gradually easing cross-border yuan capital flows prompted market players to shift to the other model for pricing forward markets, i.e. in which interest rate differentials dominate.

Banks have steadily increased their purchases in USD/CNH forwards in recent weeks, betting that since Chinese rates are well above those in the United States, the forward curve should be upward sloping if mainland China's capital account was fully open.

That buying was exacerberated by a Wall Street Journal story last Thursday which said the Hong Kong unit of the Bank of China had received approval to remit yuan funds back into the mainland.

Traders latched on to the article as a capital account liberalisation of sorts as the Bank of China is the sole clearing authority for all yuan transactions in Hong Kong.

In volatile trade, six-month USD/CNH forwards moved as much as 150 points to its highest level since data became available since December as traders bet that interest rates between the mainland and Hong Kong would converge gradually.

The move was also amplified by broader weakness in regional markets and a higher USD/CNY fixing on the mainland on that day. Markets have subsided since then.

WHAT OTHER FACTORS ARE AT PLAY HERE?

A pick up in supply of offshore yuan bonds or "dim sum" bonds has also led to heavy buying of USD/CNH forwards. April and May have been record months of supply in offshore yuan bonds with year-to-date issuance of more than 50 billion yuan ($7.7 billion), surpassing the total issuance in all of 2010.

As USD/CNH forward points languished in negative territory, increased supplies have proved to be the icing on the yield cake for foreign investors.

A U.S. dollar investor could sell his dollars in the cash market for yuan , buy a dim sum bond <0#CNHBOND=> and then purchase dollars in the forward market at a discount, juicing up implied yields further.

This came at a time when according to some banks' trading desks, Bank of China has been a heavy buyer of dollars in the nascent USD/CNH forwards, stoking speculation that they knew something was up.

WHAT ARE THE CURRENT WAYS OF GETTING YUAN INTO THE MAINLAND?

Even though there has been a growing queue of issuers lining up to sell dim sum bonds since July 2010, regulations to repatriate yuan into the mainland remain cumbersome, though bankers say the process has gotten a bit easier of late.

Ironically, unlike U.S. dollars, yuan proceeds from each issuer in Hong Kong is approved on a case-by-case basis as authorities are wary about speculative flows flooding the mainland at a time when authorities are battling rising inflation.

For mainland banks and financial institutions, they are required to remit proceeds from raising yuan funds in Hong Kong within 30 days, according to current regulations.

Beijing periodically awards quotas to financial institutions in Hong Kong for investing in the mainland bond market. According to Deutsche Bank, 23 participating banks in Hong Kong have obtained such quotas so far with the total size of the quota estimated around 90 billion yuan.

HOW HIGH CAN USD/CNH FORWARD POINTS RISE?

At a difference of more than two percentage points between mainland and Hong Kong market interest rates, USD/CNH forwards have more room to rise, despite the latest surge.

But traders say the recent rise in both USD/CNH forwards and dollar/yuan NDFs may be done for now as markets are underpricing the prospects of more yuan appreciation in the near term.

Both Standard Chartered and Deutsche Bank recommend building long positions in yuan forwards in both these markets. For example one-year yuan NDFs are reflecting only a 1.4 percent appreciation compared to more than 3 percent at the start of May.

Beijing has allowed the yuan to gain 1.7 percent against the dollar so far this year. (Reporting by Saikat Chatterjee; Editing by Kim Coghill)