Renminbi Bulls Start to Cool Their Heels

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In the race between the tortoise and the hare, the slow plodder has finally edged in front.

China's renminbi – never the swiftest mover in the currency market – is a standout performer this year, thanks to its small but notable gain against the resurgent U.S. dollar.

The Chinese currency has risen 1.7 percent this year and is up 3.6 percent in the past 12 months. Though the gain appears unexciting, comparisons with other emerging market currencies are much more flattering.

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Since late May when Ben Bernanke, U.S. Federal Reserve chairman, first referred to the Fed's determination to start easing asset purchases, most emerging market currencies have dropped sharply to their lowest levels in years.

The Philippines peso is down 5.3 percent, the Indian rupee has lost 8 percent, while the Brazilian real has tumbled 11 percent.

Year to date, the renminbi is the only emerging market currency to rise against the dollar. And thanks to its tightly-controlled daily trading band, its appreciation has been accompanied by little of the volatility typical in other emerging market currencies, making risk-adjusted returns particularly attractive for some investors.

A number of Asia-based hedge funds have described their long renminbi positions as among the most profitable trades of the year, while private banks say clients have been rewarded for their bullish views.

Driving the renminbi's rise has been a flood of capital into China, keen to tap a rising stock market and resurgent property prices. That the authorities – who have the ability to temper appreciation by lowering the daily fixing around which it can trade – have been willing to tolerate continued strength also suggests a change of mindset in Beijing.

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"During this period of economic transition, growth momentum slowdown and high financial market volatility, the last thing the Chinese are going to want to do is give the financial market the impression that they're going to pursue a policy of depreciation," says Sacha Tihanyi, Asia currency strategist at Scotia Bank. "That can then spur financial market outflows . . . and potentially be destabilizing for the banking system."

But many analysts say time is running out for further renminbi gains. Some of the supportive trends are beginning to reverse amid more worrying economic news in China, and as the authorities crack down on fake trade invoicing – a common method for avoiding strict capital controls designed to limit "hot money" inflows.

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Standard Chartered forecasts just a 0.25 percent further rise this year, while Deutsche Bank recently recommended a long dollar position against the renminbi.

Nick Verdi, head of Asia currency research at Barclays, says the renminbi is likely to weaken.

"Through May, China was still getting strong inflows. Since then, there is evidence that some of these hot money inflows are starting to recede," says Mr Verdi.

The switch in sentiment is partly due to the economic signs coming out of China, which have clearly worsened in recent weeks. Trade, manufacturing and industrial production have all come in weaker than expected, prompting fresh downgrades to growth forecasts.

"It is possible that [the renminbi] has already overshot fundamentals," says Paul Mackel, foreign exchange strategist for Asia Pacific at HSBC, which recently cut its growth projections for both this year and next to 7.4 percent.

Portfolio investors have certainly been given pause for thought. An equity market tumble in June erased the year's gains, pushed Chinese stocks into bear market territory, and brought the Shanghai Composite back down to 4½-year lows.

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Brokers in Hong Kong say that earlier in the year, when Chinese stocks were soaring, there was a waiting line for investors looking to borrow the investment quotas needed to tap mainland markets. That interest has almost completely dried up.

The recent liquidity crunch in the mainland banking system has also played its part. In early June, interbank lending rates soared to record levels, at one point topping 25 percent, as the People's Bank of China refrained from adding money to the market in a bid to stem rampant credit growth. The impasse stoked fear in the market, and sparked a major sell-off in Chinese bank stocks.

But despite all the bad news, even short-term bears believe the renminbi will ultimately return to its path of appreciation, although the gains are likely to become smaller and slower over time.

"Longer term, the currency will have to revert to fundamentals – that would mean a stronger currency," says Mr Verdi.