Why China's central bank is shoring up the yuan

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

For a second time this year, the People’s Bank of China announced Monday it would reduce the amount of foreign currency banks need to hold.

Such moves theoretically reduce the weakening pressure on the yuan, which has tumbled by more than 8% this year to two-year lows against the U.S. dollar.

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

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

They gave two reasons:

• “First, in a year of the once-in-a-decade leadership reshuffle and with elevated US-China tensions, Chinese leaders especially care about RMB’s bilateral exchange rate with USD because they believe RMB/USD somehow reflects relative economic and political strength.
• “Second, a big depreciation of RMB/USD could dent domestic sentiment and speed up capital flight.”

China’s ruling Communist Party is set in October to select a new group of leaders, while solidifying President Xi Jinping’s power.

Tensions between the U.S. and China have escalated in the last several years, resulting in tariffs and sanctions on Chinese tech companies.

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

That economic slowdown has contributed to the weakening yuan, which can help make Chinese exports cheaper to buyers in the U.S. and other countries.

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

In addition, the greenback — as measured by the U.S. dollar index — has benefited from 20-year lows in the euro and a similar plunge in the Japanese yen.

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

The analysts said they expect the yuan to depreciate to 7 against the dollar over the next three months. Nomura’s foreign exchange analysts forecast a 7.2 level 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 [7], certainly sort of beyond 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.”

“I think that’s the key threshold,” he said. “I think the reason they’re reluctant to allow that to happen is, if it goes beyond that level, then expectations for the currency risk becoming unanchored. You risk seeing much larger-scale 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 midpoint based on recent price levels.

The PBOC’s latest cut to the foreign currency reserve ratio — to 6% from 8% — is set to take effect Sept. 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.

For the long run, 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.