Finance

China Boosts FX Support as Yuan Nears Critical Policy Threshold

China ramps up FX support as the yuan nears its policy trading threshold. Explore PBOC's strategies and the impact on currency markets.

China Strengthens FX Support as Yuan Faces Mounting Pressure

China’s central bank has taken bold steps to enhance FX support measures as the yuan approaches its policy trading limit against the US dollar. The managed currency faces significant downward pressure due to external economic challenges, including the widening interest-rate gap between the US and China, looming tariff threats, and a sluggish domestic recovery.

The People’s Bank of China (PBOC) on Wednesday set a stronger-than-expected daily reference rate of 7.1887 per dollar—1,528 pips above the market consensus. This marks the widest deviation since April and is seen as a clear signal that Beijing is doubling down on its efforts to stabilize the currency and guide market expectations.

PBOC's Critical FX Support Measures

The PBOC has several tools at its disposal to maintain FX support and prevent market instability. The daily fixing mechanism remains its most prominent tool, capping yuan movements to 2% above or below the reference rate in onshore trading.

To complement this strategy, state-owned banks have scaled back yuan lending in Hong Kong, increasing the cost of borrowing the currency offshore. This has made it more expensive for traders to take short positions, discouraging speculation against the yuan.

Another measure under consideration involves increasing bill auctions in Hong Kong. These auctions would soak up excess yuan liquidity in the offshore market, further reinforcing Beijing’s strategy to bolster the currency.

Yuan Approaches Critical Trading Threshold

Despite these interventions, the yuan continues to weaken in the spot market. As of Wednesday, the currency traded at 7.3316 per dollar, nearing the bottom of its 2% trading band. This proximity raises concerns over potential market disruptions, including thin liquidity and pricing glitches in derivatives markets.

When the yuan last approached this threshold, the market experienced significant turmoil, highlighting the risks of maintaining a tight grip on the currency. Analysts warn that prolonged reliance on FX support could have unintended consequences, such as discouraging foreign investment or triggering a backlash in global financial markets.

Challenges of a Stronger Yuan

While the PBOC’s aggressive interventions have helped stabilize the yuan, they also come with trade-offs. The currency’s recent strength against a basket of peers—reaching a two-year high—has made Chinese exports less competitive globally. For an economy heavily reliant on trade, this could pose long-term challenges, especially as external demand weakens.

“The authorities are clearly unwilling to allow one-sided speculation to snowball at this point,” said Fiona Lim, a senior strategist at Malayan Banking Bhd. in Singapore. However, she cautioned that if new US tariffs materialize, Beijing might have to adjust its policy to mitigate additional economic pressures.

Impact of Liquidity Squeeze in Offshore Markets

In Hong Kong, the PBOC’s tightening measures have already led to a surge in yuan borrowing costs. The overnight interbank rate climbed to 8.1% on Tuesday, its highest level since 2021, before easing slightly on Wednesday. The one-month rate has also risen steadily, reflecting heightened demand for yuan liquidity as traders adjust to the new market conditions.

These elevated borrowing costs are part of the central bank’s broader strategy to deter bearish bets on the yuan. By making short positions less attractive, the PBOC aims to create a more stable trading environment, even as external pressures persist.

Market Expectations and Future Outlook

Analysts broadly expect the yuan to weaken further in 2025, given China’s economic fundamentals and external risks. US President-elect Donald Trump’s tariff policies remain a key concern, with additional levies on Chinese goods potentially exacerbating the downward pressure on the currency.

Nomura strategists, including Craig Chan, noted that fear of yuan depreciation often leads to increased FX hoarding and higher demand for dollars in the market. “Although some of the tariff risks are priced in, we believe additional measures could lead to a break higher in dollar-offshore yuan,” they wrote in a recent note.

Balancing FX Support and Economic Stability

The PBOC’s multi-faceted approach to FX support underscores its commitment to stabilizing the yuan. From stronger daily fixes to liquidity restrictions in offshore markets, the central bank has demonstrated a clear resolve to maintain market confidence.

However, these efforts come at a cost. Prolonged intervention could strain China’s foreign exchange reserves and limit its ability to respond to future economic challenges. Moreover, the risk of market disruptions increases as the yuan approaches its trading threshold.

To navigate these challenges, Beijing must carefully balance its short-term objectives of stabilizing the currency with its long-term goals of fostering economic growth and global financial integration.

Conclusion: Sustained FX Support Amid Mounting Challenges

China’s aggressive FX support measures highlight the central bank’s determination to shield the yuan from excessive depreciation. While these interventions have helped maintain market stability, they also underscore the complexities of managing a managed currency in an increasingly volatile global environment.

As external pressures mount, the PBOC’s ability to adapt its strategies will be critical in shaping the yuan’s trajectory and safeguarding China’s economic recovery.