China Money: Risks limit room for yuan weakness

By Lu Jianxin

SHANGHAI, Dec 3 (Reuters) - China is apparently shifting currency policy to permit depreciation of the yuan , a step to aid its slowing economy. But the risks involved in the shift mean any weakening is likely to be small.

The threats of capital outflows, friction with major trading partners and competitive depreciations of other Asian currencies mean China will not let its tightly controlled currency slide far, analysts and traders say.

"The new trend is clearly to allow the yuan to move in either direction, including depreciation. This replaces the previous policy of one-way appreciation against the dollar," said economist Wang Haoyu at First Capital Securities in Shenzhen.

"But despite China's slowing export growth, the yuan is still the only major world currency that has the potential for its status to be upgraded in the long term, because of its economic potential. Fundamentals don't support steep yuan depreciation."

This week has seen the greatest turmoil in China's foreign exchange market since the yuan's peg to the dollar was abolished in July 2005.

After keeping its currency almost entirely in a tiny range of 6.82-6.85 against the dollar for four months, even as the global financial crisis caused most other currencies to plunge against the dollar, China's central bank let the yuan drop steeply.

On Monday, it set an unusually weak mid-point for the yuan and stood back without intervening as the currency fell to the bottom of its permitted daily trading band, which extends 0.5 percent on either side of the mid-point, for the first time.

The yuan hit the bottom of its band again on Tuesday and Wednesday. Trading almost ground to a halt on Wednesday morning because so few banks were willing to sell dollars, traders said.

They said the central bank may want to keep the yuan from sliding further this week, when U.S. Treasury Secretary Henry Paulson is due in Beijing and is expected to renew Washington's plea for yuan appreciation to help balance China-U.S. trade.

FORWARDS

Chinese authorities have not confirmed a policy change; a central bank official, commenting to Reuters on Monday, said only that China would continue reforms to its currency policy while maintaining the "basic stability" of the yuan.

But most traders are convinced that policy has shifted to some degree. Yuan depreciation against the dollar over the next 12 months implied by non-deliverable forwards , used to bet on future yuan moves, shot up to 6.64 percent on Tuesday, the highest in over five years, from near 2 percent last week.

One-year dollar/yuan volatilities , which reflect investors' demand to hedge against big swings of the exchange rate, were quoted at a multi-year high of 16.5 percent.

Domestic political pressure is believed to be a major factor behind the policy shift. Thousands of small factories in China's exporting regions, making labour-intensive goods such as shoes, clothes and toys, have closed in recent months, raising unemployment and sparking angry worker protests.

The yuan's appreciation of over 7 percent against the dollar earlier this year, to a peak of 6.8099 in September, pushed many of those factories into the red, analysts say.

Nevertheless, China looks unlikely to depreciate the yuan as much as the forwards market now implies.

Extended, sharp depreciation could prompt capital outflows from the country, complicating the central bank's efforts to bring interest rates down to help the economy. The central bank has declared it is determined to prevent large-scale outflows.

A big drop by the yuan could also set China up for a confrontation with the new administration of U.S. president-elect Barack Obama, who said in September that the yuan was "artificially low" and that he would press for appreciation.

"Steep yuan depreciation would not only promote growth in protectionist sentiment among China's trading partners, but also massive capital outflows," Ha Jiming, chief economist at China International Capital Corp, said in a research note.

ASIAN CRISIS

A third danger involved in yuan depreciation is that it could prompt competitive depreciations of other Asian currencies, worsening instability in global markets.

During the Asian crisis of 1997/98, China's decision to keep the yuan steady against the dollar, as other emerging market currencies tumbled, helped the region recover.

Although China may have concluded it can't adopt the same policy during the current crisis, it will try to avoid adding to financial instability in the region, analysts believe.

A dozen dealers and analysts informally polled by Reuters in Shanghai this week predicted China would probably not allow the yuan, at 6.8845 to the dollar on Wednesday morning, to fall below 6.90 before the end of this year.

The yuan could depreciate as much as 3 percent further in the first half of next year, to around 7.1 -- but only if the dollar continues to rise globally and if China's economic downturn continues to worsen, they said.

To deflect charges of currency manipulation from its trading partners, China could simultaneously announce reforms to its currency system, such as widening the yuan's trading band versus the dollar to 1.0 percent on either side of the daily mid-point, many traders think. (Additional reporting by Samuel Shen; Editing by Andrew Torchia)