Why China’s central bank is propping up the yuan

The Chinese yuan has fallen to a two-year low against the US dollar in recent weeks.

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BEIJING — China’s central bank has sent a strong signal that it wants to prevent the Chinese yuan from weakening too quickly against the U.S. dollar, economists said.

For the second time this year, the People̵[ads1]7;s Bank of China announced on Monday that it would reduce the amount of foreign currency banks need to hold.

Such moves theoretically reduce weakening pressure on the yuan, which has fallen more than 8% this year to a two-year low against the US dollar.

Chinese authorities typically weigh the yuan’s level against a basket of currencies against which the yuan has strengthened by about 1% over the past three months.

However, Beijing’s latest actions show how important the yuan-dollar exchange rate remains, Nomura’s China chief economist Ting Lu and a team said in a report on Monday.

They gave two reasons:

  • “First, in a year of once-in-a-decade leadership change and with heightened tensions between the US and China, Chinese leaders are particularly concerned about the RMB’s bilateral exchange rate with the USD because they believe that RMB/USD somehow reflects relative economic and political strength.
  • “Secondly, a large RMB/USD depreciation could dampen domestic sentiment and accelerate capital flight.”

China’s ruling Communist Party is due to elect a new group of leaders in October, at the same time as President Xi Jinping’s power is being strengthened.

Why China’s central bank is propping up the yuan

Tensions between the US and China have escalated in recent years, resulting in tariffs and sanctions against Chinese technology companies.

Meanwhile, China’s economic growth has slowed over the past three years, especially with the shock of the pandemic in 2020. Tighter Covid controls this year, including a two-month shutdown of Shanghai, have prompted many economists to cut their GDP forecasts to close to 3 %.

The economic slowdown has contributed to a weakened yuan, which could help make Chinese exports cheaper for buyers in the United States and other countries.

The US dollar has strengthened significantly this year as the US Federal Reserve has tightened monetary policy aggressively.

In addition, the dollar – as measured by the US dollar index – has benefited from a 20-year low in the euro and a similar fall in the Japanese yen.

Levels to watch

“We think the PBOC may have tolerance for further CNY depreciation against the USD, especially as the broad USD continues to strengthen, although they may want to avoid continued and too rapid one-way depreciation if possible,” said Goldman Sachs analyst Maggie Wei and a team said in a report Monday.

The analysts said they expect the yuan to weaken to 7 against the dollar in the next three months. Nomura’s currency analysts predict a level of 7.2 by the end of the year.

The yuan last traded near 7.2 against the dollar around May 2020 and September 2019, according to Wind Information data.

“I don’t think it will go far beyond that [7]certainly more than the 7.2 that we saw during the trade war, Julian Evans-Pritchard, senior China economist at Capital Economics, said Tuesday on CNBC’s “Squawk Box Asia.”

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“I think that’s the key threshold,” he said. “I think the reason they’re reluctant to let that happen is that if it goes beyond that level, then expectations for the currency risk becoming unmoored. You risk seeing much larger capital outflows.”

The PBOC on Tuesday set the yuan’s midpoint against the dollar at 6.9096, the weakest since Aug. 25, 2020, according to Wind Information. China’s central bank loosely controls the yuan by setting its daily trading center based on recent price levels.

PBOC: Do not bet on a specific point

The PBOC’s latest cut in the foreign exchange reserve ratio – to 6% from 8% – is set to take effect on September 15, according to an announcement Monday on the central bank’s website.

Earlier on Monday, PBOC Deputy Governor Liu Guoqiang said that in the short term the currency should fluctuate in two directions and people “should not bet on a specific point”.

That’s according to a CNBC translation of a Chinese transcript of Liu’s remarks at a press event on economic policy.

In the long term, Liu maintained Beijing’s hopes for greater international use of the yuan. “In the future, the world’s recognition of the yuan will continue to increase,” he said.

— CNBC’s Abigail Ng contributed to this report.

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