China Makes Effort to Stabilize Yuan Amid Depreciation

China's central bank seems to have moved to stabilize the yuan despite mounting market sentiment that the currency has been toward the upper limit of its daily trading band for the past week.

The reference rate the People's Bank of China (PBoC) announces on the morning of each trading day to guide onshore trade of renminbi has risen 66 basis points since last Monday, while spot trading has been testing the limit to which the yuan is allowed to weaken daily.

Renminbi traded in the onshore market is allowed to rise and fall by 2 percent against the central parity rate each day. The spot trade's divergence from the official guidance suggests growing market pressure to see the yuan weaken to the greenback.

But economists have interpreted the reference rate's resilience as a move to prevent the yuan from a sharp decline that would exacerbate capital outflow and undercut financial stability.

The official gauge of China's manufacturing activity in January came in below the threshold separating expansion from contraction for the first time in more than two years, adding to concerns that the world's second-largest economy is losing momentum.

"The midpoint rate speaks very clearly to the central bank's stance -- a sharp fall in the yuan will not be tolerated," said Liu Dongliang, a Shanghai-based analyst with China Merchant Bank Co.

The U.S. dollar has undergone a sustained rally since late last year as the market is watching closely over whether February is going to see raised interest rates after the exit from quantitative easing in November.

Though China has removed the yuan's peg against the dollar since 2005 to consider its movement against a basket of currencies, economists say the Chinese currency's exchange rate with the dollar will not fluctuate markedly.

But pressure for the yuan to weaken is mounting, as more central banks around the world kicked off their own monetary easing programs.

Yet the yuan's reference rate has hardly budged. "The central bank is using the reference rate to stabilize the yuan," said Xu Gao, chief economist of China Everbright Securities Co., Ltd. "If such guidance is not in place, a sharply weakened yuan will accelerate capital outflow and complicate policy response."

"Some in the market have become too fixated over China's headline growth, and see a slowdown in growth rate as legitimate concern to justify the yuan's weakness," said Zhao Qingming, chief economist with the China Financial Futures Exchange.

China's economy expanded 7.4 percent last year, its lowest level in 24 years, but still managed to meet the 10 million job creation target set for the whole year as consumption contributes more to economic growth.

Proponents of the yuan's depreciation argue that a weaker yuan will add to the competitiveness of China's exports, but economists say that its impact is likely to be very limited.

"Large yuan depreciation will help exports, but in reality it will be difficult to implement given that China's trade surplus reached new historical highs in the second half last year, and the current account surplus widened. It may also lead to competitive devaluation from other countries, which will compromise the initial purpose of currency depreciation." said J.P. Morgan China Chief Economist Zhu Haibin in a research note.

Though the spread between the reference rate and spot trading has repeatedly widened to the daily limit of 2 percent, analysts say a further widening of the yuan's trading band is also unlikely in the near term.

"If the central bank does so, the market will misinterpret it as allowing the yuan to weaken further," according to China Merchant Bank's Liu.

China widened the yuan's trading band to 2 percent on either side of the reference rate in March, a move that snapped the yuan's rising trend against the dollar and changed the perception that the currency is a one-way bet.

"Given the scale of China's economy and its trading volume, the yuan's fluctuation shouldn't be too dramatic and the existing trading band is already wide enough," said Zhao of the China Financial Futures Exchange.

It is the reference rate, Zhao said, that authorities should work on going forward to bring more transparency and better reflect the market's opinion on the currency.

China has been promoting the yuan's global use and a stable yuan would gain more acceptance in global trade.

"After all, you don't want to use a currency that goes up and down too hard," as Zhao said.