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In spite of noticeable efforts to liberalize the capital account and internationalize the CNY, offshore and onshore CNY markets are still segmented. However, they can provide good insight on the expected pace of China's economy, and on commodity and FX markets.

1. Onshore: The rediscount rate is charged to banks by the People's Bank of China or PBOC - which sets the time deposit and lending rates, as well as the Reserve Ratio. The most traded market rates are the 7-day repo rate and the Shibor (Shanghai Interbank Offer Rate).

2. Offshore: The USD/CNH (H is for Offshore Non-deliverable - basically Hong-Kong) is Chinese Yuan delivered in HK where the outstanding of CNH deposits is growing sharply. There is also an offshore interbank market and a growing amount of CNH bonds are being issued (Ministry of Finance Bonds, in order to build a benchmark curve). The PBoC determines the interest rate offered to Hong Kong banks on their CNY deposits.

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The onshore and offshore interest rate swap market is based on many references, but the benchmark and most liquid reference rate is the 7-day repo rate (followed by the 3-month Shibor). On the contrary, the CNH IR swap market is much less developed.

The Shibor is the rate at which banks lend unsecured funds to each other for a given maturity. The Shibor swap rate is the fixed cost to receive the benchmark interest rate: 7-day repo or 3-month Shibor.

Both charts below use those rates to gauge interest rate expectations and their link with the forward premium for the USD/CNH.

1. The left chart shows the spread between the 1-year lending rate of the PBoC and the 1-year IRS swap based on 7-day repo rate (in each case the reference is the Central Bank).

2. The right chart is based on the spread between the 1-year Shibor and the 1-year IRS swap based on the 3-month Shibor.

The recent hike in interest rate spreads reflects expectations of easier monetary policy in the short run. The higher liquidity of the 7-day repo based IR swap does not seem to provide any comparative advantage in terms of tracking the expectations of appreciation/depreciation for the USD/CNH. In both cases, a significant disconnect occurred in February 2012.

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The FX market was clearly driving the expectations of a monetary easing. So far, only RRR adjustments have been carried out. Going forward, PBoC will likely reduce RRR further to support the market liquidity but a lending rate cut remains unlikely in 2012, on inflation concerns.

Reserve Requirements are the main instrument of the PBoC to withdraw liquidity (preferred to Central Bank bills for instance). Their recent decline cannot be detached from the stagnation of FX reserve accumulation and the decline in the trade balance surplus.

The chart below shows my rate expectation metrics: they are close or above their historical highs. If the PBoC does not cut repo rates, a reversal should occur within the next few weeks.

As a result, for those willing to play copper or AUD/USD based on China's monetary policy, we recommend caution as their downside potential is, at least temporarily, limited (see chart below for AUD and Copper).

(click to enlarge)

Source: Red China Blues: Monetary Policy Expectations And FX/Commodity Signals