* Arbitrage trade in yuan forwards seen staying open
* Trade on onshore forwards/NDFs can earn 1.5% annual yield
* Regulatory restrictions limit scale of arbitrage business
By Lu Jianxin and Jacqueline Wong
SHANGHAI, June 24 (Reuters) - An arbitrage opportunity between yuan onshore and offshore forwards has emerged since late May and is likely to stick around, providing an opportunity for banks in both markets as Beijing policymakers keep the currency on a tight leash.
The dollar has tumbled since early March, while the yuan has barely budged. This led to sharply contrasting views among investors on the yuan's outlook, which caused spreads between the two forward markets to diverge by the most in a year.
Ample liquidity in both the Chinese and foreign money markets, with banks more willing to lend cash as financial markets heal and hopes grow for a global recovery, also means that bank traders can finance arbitrage trades.
The spread between onshore dollar/yuan forwards and non-deliverable forwards has widened as far as 1,450 pips a month ago and remains unusually wide at near 780 pips.
For about a month through mid-June, the spread stayed above 1,000 pips -- a level at which dealers estimate that banks can make one million yuan ($150,000) in risk-free profit on a nominal position of $10 million, or a 1.5 percent annual return.
Because the forward contracts cover the same thing -- the yuan's rate against the dollar in a year's time -- the should not diverge so much. Thus a riskless profit can be scored by buying one forward and selling the other.
"With liquidity flows having accelerated in the past several weeks, arbitrage between the NDFs and onshore forwards has become a good choice as long as the spread between the two markets remains above 800 pips," said currency strategiest Liu Dongliang at China Merchants Bank in Shenzhen.
The main banks able to do such a trade -- Chinese banks with foreign subsidiaries and foreign banks in China -- can sign a forward contract on the onshore market to buy dollars at the present exchange rate of 6.8300-plus per dollar and agree to sell back the dollars one year later.
They can then do a reverse contract in the NDF market to sell dollars for yuan and agree to offset that position one year later.
"Recently, we have advised our corporate clients to do the arbitrage, which proves to be a lucrative business," said a dealer at big Chinese state-owned bank in Beijing.
"But Chinese rules ban firms from speculating in derivatives, so both we banks and our clients have tried more on the side of hedging. It will be difficult to distinguish speculation and hedging in many cases, but the ban has anyway capped volumes."
Because NDFs do not involve principal amounts changing hands, banks can earn the gap between the onshore and offshore markets and only need to commit principal on one side of the transaction, dealers said.
DIFFERENCES
Since late last year, the Chinese central bank has virtually pegged the yuan around 6.8300 to the dollar, reflecting China's cautious currency policy through the financial crisis and deep global recession battering exporters.
The dollar has been volatile all this time. The dollar index, a gauge of its performance against a basket of six big currencies, soared to a three-year peak in March only to tumble to its lowest since December this month.
As the dollar slid on worries about its status as a reserve currency and because investors shifted funds into riskier assets, one-year dollar/yuan NDFs hit a nine-month low of 6.6650 bid on June 1. That widened the spread against the onshore forwards to as much as 1,450 pips -- the most since July 2008.
Benchmark dollar/yuan NDFs have since risen back to around 6.7500, narrowing their spread versus the onshore market to around 800 pips, as the dollar index as stablised.
But the differences between the two forward markets are unlikely to change much for at least another few months and are expected to push the spread back over 1,000 pips, creating periodic arbitrage opportunities again and again, dealers said.
"One of the key differences between the two markets is that NDFs are largely propelled by global dollar movements, while the onshore market responds mostly to China's policy changes," said a senior dealer at a European bank in Shanghai, who trades on the China Foreign Exchange Trade System, the onshore Chinese market.
Another reason for the large spread to linger is that China's regulatory restrictions will cap a big expansion of the arbitrage business, making it difficult for traders betting on the arbitraged to narrow the gap easily, dealers said.
Foreign banks in China are only allowed to go long on dollars and short the yuan within regulatory approved quotas, and they are banned from shorting dollars, so financing for arbitrage will be limited.
The government also bans Chinese banks from quoting NDFs. Though domestic banks with networks abroad can continue limited NDF trade, they will not do that aggressively so as to attract regulatory attention and possible investigations, dealers said. (Editing by Eric Burroughs)