The yuan is strengthening at the fastest pace in three months as Chinese bonds’ near-record yield premiums over U.S. Treasuries draw funds from abroad.
The currency rose 0.41 percent versus the dollar in the last two weeks, its best performance since the period ended May 1, according to the China Foreign Exchange Trade System. The difference in yields between China’s five-year notes and comparable U.S. government debt was at an all-time high of 258 basis points as of 12:11 p.m. in Shanghai, while the gap for 10- year bonds was a record 144 basis points, based on Bloomberg data going back to June 2005.
The People’s Bank of China raised interest rates three times this year and boosted lenders’ reserve-requirement ratios on six occasions, exacerbating a cash crunch that’s driving bond yields higher and making local assets more attractive to overseas investors. U.S. Treasury yields are falling amid signs the economic recovery is losing momentum. Gross domestic product rose 1.6 percent in the second quarter, compared with growth of 9.5 percent in China, official data show.
“U.S. Treasury yields have eased on growth concerns, while China remains characterized by a strong GDP outlook, still high inflation and a relatively tight monetary stance,” said Delphine Arrighi, a Hong Kong-based rates strategist at Standard Chartered Plc. “It is an incentive to bring funds into China, which is why the central bank monitors this very closely.”
China’s currency regulator reiterated a pledge last month to crack down on inflows of “hot money,” while official media cited central bank adviser Xia Bin as saying the nation should tax transfers of funds from abroad. A strengthening yuan and relatively high returns on local assets encourage investors to seek ways to circumvent capital controls and deter overseas companies from repatriating profits, complicating efforts to tame the fastest inflation in three years.
Chinese consumer prices rose 6.4 percent in June, while those in the U.S. increased 3.6 percent, the biggest gains since 2008.
“The two countries have extremely divergent growth cycles,” said Ju Wang, a fixed-income strategist for Asian emerging markets at Barclays Capital in Singapore. “The yield difference is one of the concerns of policy makers and has been officially cited by China as a reason for not hiking rates too aggressively because that would increase capital inflows.”
The gap between yields on China’s 10-year notes and Treasuries has more than doubled since April, while the spread between five-year notes widened 1.07 percentage points.
Ten-year bonds in Shanghai yield 4.03 percent, up 14 basis points, or 0.14 percentage point, from the end of April, according to data compiled by Bloomberg. The rate on similar- maturity U.S. Treasuries has dropped 70 basis points to 2.59 percent.
The yield on China’s 10-year notes will slip to 3.6 percent by the end of December, narrowing the gap with Treasuries, as growth and inflation cool in Asia’s biggest economy, according to Standard Chartered’s Arrighi. The rate reached 4.11 percent on July 22, the highest level since Feb. 14.
Barclays’ Wang expects the yield to climb to 4.3 percent by year-end as the authorities are unlikely to cut borrowing costs or loosen monetary policy anytime soon, she said. HSBC Holdings Plc also predicts a level of 4.3 percent that will keep China’s yield advantage over the U.S. intact.
“The big part of the widening was due to the money-market crunch in China that pushed 10-year government bond yields higher, while U.S. rates have been capped by weak growth momentum,” said Pin Ru Tan, an Asia-Pacific rates strategist at HSBC in Hong Kong. “The spread is unlikely to narrow in the near term as both dynamics will remain in play.”
China’s seven-day repurchase rate, a measure of the availability of interbank funding, averaged 5.26 percent in July and 5.90 percent in June, the highest levels in Bloomberg data going back to January 2004. The rate fell 79 basis points today to 4.11 percent, according to a daily fixing published by the National Interbank Funding Center.
Five-year contracts protecting Chinese government debt against default rose three basis points to 91 basis points yesterday, according to data provider CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.
Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent if a government or company fails to adhere to its debt agreements. A basis point equals $1,000 annually in a contract protecting $10 million of debt.
Basket of Currencies
The yuan weakened 0.03 percent to 6.4403 per dollar in Shanghai, retreating from a 17-year high of 6.4336 reached on Aug. 1, according to the China Foreign Exchange Trade System. It’s strengthened 2.3 percent this year and HSBC predicts a year-end exchange rate of 6.35. Barclays forecasts a 2.6 percent advance to 6.28, while Societe Generale SA said the currency will probably gain more than 3 percent.
“As long as the yuan continues its pace of appreciation, and as China’s economy is growing faster than others, then there are incentives for money to find ways into China,” said Wei Yao, China economist at Societe Generale in Hong Kong.
The yuan has strengthened against the dollar in all but one the last 11 months. The central bank said on Aug. 1 it will be more actively managed against a basket of currencies and market forces will play a greater role in determining the exchange rate.