VINACHEM

This week's market turmoil stemming from Japan may have given China's central bank an unlikely assist in its battle to stimulate economic activity.

Like the Japanese yen, the Chinese yuan has been used to make carry trades -- borrowing in currencies of countries with low yields and investing in those with higher ones -- due to China's low interest rates and low volatility. Such trades had created downward pressure on the yuan. But the Bank of Japan's signal of faster-than-expected rate hikes and growing expectations for U.S. rate cuts sparked an unwinding.

The onshore yuan, which moves within a trading band of the exchange rate fixed by the People's Bank of China, jumped from 7.2446 per dollar last Thursday to 7.112 amid Monday's market plunge, hitting its strongest level since early January. It has since fallen back, marking 7.1820 as of Wednesday morning.

The offshore yuan, which moves more freely, surged at one point to 7.0836, the strongest since it touched 7.0748 on May 30. The offshore yuan was trading at around 7.1835 per dollar on Wednesday.

"The rally in the Japanese yen has triggered some unwinding of the carry positions, indirectly benefiting the yuan as well, which is also largely used as a funding currency," said Charu Chanana, head of FX strategy at Saxo, a Danish bank. Falling U.S. yields also fueled some unwinding in carry trades, she said.

Downward pressure on the yuan has been considered a key bottleneck for cutting interest rates, given Beijing's preference to maintain stability and boost its appeal as a global currency. A stronger yuan creates room for the PBOC to further ease monetary policy amid low inflation and a weak housing market.

China cut a string of interest rates in July after lower-than-expected economic growth figures in the second quarter.

"Chinese authorities could certainly take this shift in Fed narrative and strength of the yuan as a green flag for further rate cuts, having recently shifted their focus from supply-side reforms to demand-side stimulus in order to boost consumption," said Chanana.

On the other hand, additional rate cuts could further fuel a bond-buying frenzy that the PBOC has tried to cool. The yield on the 10-year government bond, which moves inversely to price, hit a low of 2.0913% on Monday, according to data provider Wind. In what one economist called a "contradictory" move, China's rate cuts came weeks after the PBOC announced that it had borrowed bonds from banks, sending a signal to markets that it can sell the bonds to keep rates high.

Toshifumi Umezawa, strategist at Pictet Asset Management (Japan), said a key concern was the risk of the yield curve flattening out, which could threaten the business model of banks that borrow in the short term and lend for the long term. That is why the PBOC appears to be shifting the focus of its policy to the short-term seven-day reverse repo rate, he added.

At a meeting last Thursday to lay out its plans for the second half of the year, the PBOC said it will "maintain the basic stability" of the exchange rate and "resolutely prevent the risk of overshooting."

Ju Wang, head of Greater China FX and rates strategy at BNP Paribas, said that "the one-way RMB depreciation view probably is coming to an end at least for this quarter," using the abbreviation for the yuan's other name, renminbi.

On Wednesday, the central bank adjusted the fixing to allow the yuan to weaken against the dollar. This is a reflection of the PBOC being more willing to let market forces work, as the dollar could soon lose steam as expectations build for a Fed rate cut next month, Wang said.

"We are not chasing at the current level," Wang said, as dollar moves could flip-flop amid rate speculation and recession concerns.

The European bank took profits on Monday, closing trades as the spread between the offshore and onshore currency closed.

BNP is in a "holding pattern" on Chinese government bonds, as the current yields of these debts are "complicated," Wang said. The PBOC on one hand needs to stimulate the economy more by cutting rates, but it doesn't want to risk financial instability, with smaller banks potentially booking losses on holdings of long-end bonds.

Wee Khoon Chong, Asia-Pacific macro strategist at BNY Mellon, said the bank is "seeing a neutral" yuan position, citing custodian data from long-term institutional investors. They have been selling China equities and buying China government bonds, he added.

Still, some analysts foresee yuan depreciation as Chinese economic fundamentals have not changed.

Kiyong Seong, lead Asia macro strategist at Societe Generale, said he fielded internal questions on Monday night from Asia, London and New York about when he would revise his forecast for the currency, as the yuan rose sharply. As the yuan has subsequently trended weaker, few have come to him.

Seong is keeping his year-end forecast of "slightly below 7.40" per dollar, a view he has held since July. In the short term, "even though we are seeing some further scope of the dollar-yen unwinding carry trade, it doesn't necessarily strengthen the Chinese yuan" in tandem with the yen, Seong said. He cited the weak Chinese economy and his projection that the U.S. is unlikely to enter into a recession.   – Source: Asian Nikkei –