China's yuan posts strongest close against dollar since May

SHANGHAI Mon Sep 10, 2012 6:53am EDT

SHANGHAI (Reuters) - The central bank fixed a stronger yuan midpoint against the dollar for the third straight trading day, with spot prices posting their strongest close since late May following a dramatic overnight plunge in the dollar index.

The People's Bank of China set the yuan midpoint at 6.3375 before the market opened after the dollar index .DXY tanked in overnight trade, dropping nearly 100 basis points in global markets as disappointing U.S. economic data led traders to bet that more quantitative easing -- which puts downward pressure on currency values -- is on the way.

Spot prices opened stronger than the midpoint at 6.3370 and closed negligibly weaker at 6.3376, the strongest closing for the currency since May 23.

The close marks a continuation of a new trend that began last week, when spot yuan began to consistently trade stronger than the midpoint for the first time since March.

The trading band for spot prices was widened in April to 1 percent from 0.5 percent, but exploration of the new range was mainly confined to the weak side until recently as the dollar explored new highs against a plunging euro.

Traders said the PBOC was initially concerned at the rate of yuan depreciation that ensued after the band was widened. It deliberately set higher midpoints than the market was comfortable with, they said, to signal it would not allow depreciation to become so abrupt as to destabilize markets.

However, as corporates successfully unwound short-dollar positions by the end of the first half, market-driven depreciation pressure on the yuan eased, leading to the current equilibrium in which the spot price remains in a narrow range between 6.33 and 6.35.

Chinese leaders, facing intensified concern that the domestic economy is having difficulty weathering sustained weakness in its exports markets, have said that Beijing will take steps to support exporters, which many interpreted as an official endorsement of a weakening trend in the yuan.

However, Guo Jianwei, deputy director of the central bank's monetary policy department, said the yuan's current equilibrium suggested that the trading band could be widened again to allow the yuan to better reflect market forces.

Speaking on the sidelines of an investment forum in Xiamen, Guo said the yuan's new-found volatility had reduced the incentive for speculators to go long on the yuan on the assumption the only direction it could go was up.

Guo also said it was a good time for Chinese firms to make overseas investments in yuan to hedge against exchange rate conversion risks. Such investment would also help increase the global status of the Chinese currency.

"Our dream of developing the yuan into a more commonly used global currency is taking shape and I think we have the conditions to realize it eventually," he said.

Traders told Reuters that they see limited upside room for the yuan to appreciate against the dollar this year, given the state of the domestic economy, in particular weakness in exports, which would be aggravated by strengthening movements in the yuan.

OFFSHORE AND FORWARDS

Forwards contracts continue to trade at a discount to spot prices.

The offshore 1-year non-deliverable forward (NDF) contract changed hands at 6.4195 at the market close, softer than the spot price but narrowing the previous trading day's spread by over a basis point.

Onshore 1-year deliverable contracts also strengthened but not as strongly as the NDFs, closing at 6.4625.

While many read the discounted prices as expressions of depreciation expectations, interest rate differentials have begun to play a more important role in forwards pricing as money begins to flow more freely across Chinese borders.

(Editing by Jacqueline Wong)