Investor appetite for Dim Sum bonds is cooling as options contracts suggest prospects for yuan gains are the worst since China ended a peg in July 2005.

The average yield on yuan-denominated sovereign debt in Hong Kong reached 2.72 percent last week, more than double the all-time low of 1.14 percent in June last year, according to HSBC Holdings Plc data. The yuan's one-year implied volatility, a measure of expected exchange-rate swings used to price options, sank to a post-peg low of 2.25 percent on Aug 15 and forwards contracts are at the biggest discount to the onshore exchange rate since December.

The yuan weakened 1.1 percent so far this year in Shanghai as the slowest economic growth since 2009 spurred capital outflows and Europe's debt crisis battered exports. The People's Bank of China, which set its yuan reference rate on Thursday at the weakest level since November, said this month it plans to keep the exchange rate "basically stable." China's sovereign Dim Sum bonds yield 2.72 percent on average, more than double the 1.03 percent for US Treasuries.

"The trading range of the yuan has been quite narrow," said Richard Li, a senior Asia foreign-exchange strategist at Banco Bilbao Vizcaya Argentaria SA in Hong Kong. "For the yuan to resume a notable appreciation trend, Chinese growth has to bottom out and export growth should pick up. Capital outflows should come to a halt as well. The absence of these factors thus far has made the PBOC cautious."

The yuan is allowed to trade as much as 1 percent on either side of the central bank's reference rate. It gained 0.12 percent to 6.3584 per dollar as of 4:01 pm in Shanghai, a 0.2 percent discount to the daily fixing of 6.3449. Twelve-month non-deliverable forwards for the currency advanced 0.05 percent to 6.4463 in Hong Kong, 1.3 percent weaker than the spot rate. The contracts, which are settled in dollars, allow investors to buy or sell the currency at a set price on a specified date.

Among 23 emerging-market currencies that Bloomberg tracks the volatility of, only Hong Kong's dollar, which is pegged to the greenback, is expected to be more stable than the yuan. One-year implied volatility for the Hong Kong dollar is 0.95 percent and that for the yuan is 2.38 percent. The Argentine peso is projected to be the most volatile with a reading of 20.01 percent.

China allowed the yuan to strengthen 21 percent against the dollar in the three years after a peg ended in July 2005, before halting gains for almost two years to help sustain exports amid a global recession. The currency has since risen 7.3 percent.

Exports climbed 1 percent in July from a year earlier, following an 11.3 percent increase in June, data showed on Aug 10. The trade surplus was $25.15 billion, less than June's $31.7 billion. Gross domestic product rose 7.6 percent in the second quarter, the least in three years.

Mainland financial institutions sold a net 3.8 billion yuan ($600 million) of foreign currency last month, and the nation had a deficit on its capital and financial account of $71.4 billion in the second quarter, official figures show. Foreign direct investment on the mainland declined 8.7 percent in July, the biggest drop this year, the government reported on Thursday. The data suggest "sizable" outflows, BBVA's Li said.

Analysts have scrapped projections for yuan gains this year, with the median end-2012 estimate in a Bloomberg survey having dropped 3.2 percent to 6.32 per dollar since December. The currency finished 2011 at 6.2940 and the median prediction for end-2012 at that time was 6.12. Andy Ji, a Singapore-based foreign-exchange strategist at Commonwealth Bank of Australia, cut his prediction in July to 6.3 from 6.07.

"We made our forecasts a tad weaker because we expect the PBOC to maintain its weakening bias on the lackluster economic data in the short-term," said Ji, whose yuan estimates were the most accurate over the last six quarters, according to Bloomberg Rankings. "We continue to pencil in an appreciation path in our yuan forecasts on the 12-month horizon" because an expected improvement in the global economy will likely boost capital inflows to developing nations, he said.

US presidential elections may also drive "modest appreciation" in the yuan, BBVA's Li said.

"China will try to refrain from setting the yuan too weak to avoid the accusation of protectionism," said Li.

(HK Edition 08/18/2012 page2)