(Bloomberg) -- The yuan's calm is about to be put to the test.
After a six-week stretch of muted moves that pushed a volatility gauge to a three-month low, the currency is facing the twin pressures of a Federal Reserve interest-rate increase and the possibility of China's central bank allowing bigger swings once a key legislative meeting ends mid-March.
The key threat is a turnaround in the greenback, which is rebounding at the fastest pace in more than two months as the odds of a Fed hike this month surge. The People's Bank of China, which is seen wanting to keep the yuan stable ahead of the National People's Congress beginning this Sunday, can't maintain support permanently given that its foreign-exchange reserves have already slipped below $3 trillion, said Aidan Yao, a Hong Kong-based senior economist at AXA Investment Managers Asia Ltd.
“The PBOC will allow the yuan to swing more against the dollar,” said Fiona Lim, a senior currency strategist at Malayan Banking Bhd. in Singapore. She expects the yuan to weaken 0.5 percent the rest of this month. “Instead of accumulating depreciation pressure and falling suddenly as it did in August 2015, the monetary authority would rather release the pressure gradually and let the yuan be more volatile.”
The Bloomberg Dollar Spot Index has risen 1 percent in the past five days, the most since Dec. 20, to extend a February advance. The yuan's one-month implied volatility fell the most since 2005 last month amid muted dollar moves and tighter capital controls. The onshore spot rate was little changed Thursday at 6.8820 per dollar as of 5:28 p.m. in Shanghai, while the price in Hong Kong's overseas market retreated 0.09 percent to 6.8774.
China has stepped up efforts to choke capital outflows since December, asking banks to stop processing cross-border yuan payments until they balance flows and barring most offshore investments of $10 billion. The Chinese currency has been helped also by tightening liquidity onshore as the PBOC pushes money-market rates higher to reduce leverage in the financial system. The nation this week gave overseas investors access to its foreign-exchange derivatives market to allow hedging of bond positions.
“Instead of defending the yuan with foreign-exchange reserves and tighter capital controls, it would be more effective to attract inflows to the onshore bond market,” said AXA's Yao. “That's why China will not reverse the structural trend to liberalize its exchange rate. The recent opening up of the onshore currency derivatives market is another effort to make onshore bonds more appealing.”
--With assistance from Tian Chen and Richard Frost
To contact the reporters on this story: Robin Ganguly in Hong Kong at rganguly1@bloomberg.net, Emma Dai in Hong Kong at edai8@bloomberg.net.
To contact the editors responsible for this story: Richard Frost at rfrost4@bloomberg.net, Robin Ganguly, Chris Anstey
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