It was not too long ago that everyone was asking ‘when will China finally let the yuan go?’ [i.e. appreciate rapidly]. Indeed, back in March, when consumer price inflation was at 8.3% y-o-y, non-deliverable forwards (NDFs – a basic measure of investors’ expectations) were pricing in 13% appreciation for the yuan over the following 12 months. Now, however, I’m beginning to ask myself if yuan appreciation really is the one-way bet everyone once assumed it was.

Bear in mind that the yuan has barely moved against the greenback over the past two months. In fact, it has actually depreciated slightly, with the unit shedding 0.20% in September to compound the 0.05% decline in August. That period was the only consecutive months in which the yuan has fallen since its revaluation against the dollar in July 2005. Ok, you can hardly call this a dramatic fall, but any such fall in China is nonetheless significant.

Importantly, further depreciation is becoming an increasingly likely prospect. Beijing is showing real nerves over the health of the economy, with the central bank cutting interest rates by 0.27% on September 15, only to repeat the act less than four weeks later. In addition, Vice Premier Li Keqiang has moved to cool fears by saying that the authorities will ‘forcefully boost domestic demand, especially consumer spending, to sustain sound and fast economic growth’. Given that second quarter growth was still above 10% (even though it did mark a fourth consecutive quarter of slowing economic expansion), this may well suggest that the Q3 figure – released on Monday – is set to be very disappointing. Indeed, Fan Caiyue, a government researcher, suggested recently that economic growth in the first nine months of 2008 may have dipped to 9.8%. Following real expansion of 10.6% and 10.1%, respectively, in the first two quarters of the year, this would imply that Q3 growth slowed to just 8.7% – the first time growth would have fallen below 9% since the second quarter of 2003.

If the Q3 figure does live up to the hype, and significantly disappoints, I would expect the authorities to further loosen monetary policy to prop up growth. By my reckoning, this would mean Beijing steering the yuan even lower to help support exports.

This scenario is already being priced into NDF markets, with the spread of spot yuan over 12-month yuan NDFs having dipped into negative territory for the first time ever. This marks a sharp narrowing from the all-time high of CNY0.819 reached on March 13, and implies that investors are now anticipating yuan depreciation over the coming 12 months; with the one-year NDF currently trading at CNY6.9259/US$, the market expects a 1.4% decline over the next year.

This likely spells bad news for the rest of Asia, as a weaker yuan raises concerns over export competitiveness among China’s neighbours. Indeed, I have increasingly been looking at the spread of spot yuan over 12-month yuan NDFs to get a handle on the direction of the Malaysian ringgit. The spread and the ringgit spot rate have moved virtually in tandem throughout 2008, and with the spread having now dipped below zero, it appears that further declines for the ringgit are now likely. And this is without factoring in the ongoing political uncertainty in Malaysia, the fact that inflation is still lingering around 27-year highs, economic growth looking increasingly shaky, and that risk aversion remains very much the call of the day.

I’m rather hesitant to end on a bearish note – the world is, after all, a little light on positives in the current climate – and so I point to the fact that with economic woes persisting across the eurozone, I continue to expect further gains for the yuan against the euro. The yuan has raced to a five-year high, smashing through the all-important CNY9.40/EUR level in the process. Although it has come a long way in a very short space of time, given my bearish view of the euro (which could conceivably fall back below US$1.20/EUR over the coming months), I fully expect the yuan to continue heading higher against the battered euro, and am hungrily eyeing a move to the strong side of CNY9.00/EUR for the cross-rate. The downside for China is that this will make its goods more expensive to European consumers this Christmas.