10/09/2017 06:09 AST

A stunning rally by the yuan is prompting speculation that Chinese policymakers are loosening their iron grip on the currency.

After spending much of the year trading in a narrow range, the yuan has surprised market watchers by leaping 5 per cent this quarter, in what is set to be its biggest gain in at least a decade. With the exchange rate moving by a daily average of 0.2 per cent in the past month, compared with 0.1 per cent last quarter, the question now is whether the People’s Bank of China will continue to allow such swings to the downside if the dollar began to appreciate.

Earlier weakness in the yuan had spurred drastic steps to limit declines, including stricter capital controls as well as a change to the daily fixing regime to allow for enhanced control by policymakers. For UBS Wealth Management, allowing greater flexibility risks the return of bearish bets which have all but evaporated.

“The PBOC may loosen its grip on the dollar-yuan rate, and allow the exchange rate to be more market-driven,” Teck Leng Tan, an analyst at UBS Wealth Management, wrote in a note. “This should be seen in the context of economic growth slowing toward the year-end and into 2018. Less PBOC support for the yuan should raise the dollar-yuan volatility profile and cause yuan depreciation expectations to shift higher again.”

The yuan surged as much as 0.8 per cent on Friday, the biggest intraday advance since January, to 6.4350 against the greenback. That’s the strongest level since December 2015. It later pared gains to trade at 6.4460 as of 2:31pm in Shanghai.

The risks to the yuan include a potential rally in the Bloomberg Dollar Spot Index — which has fallen for six months in a row — weaker economic data, escalating tensions in North Korea and the end of a key Chinese Communist Party congress in October. Analysts have speculated that the meeting beginning October 18 is one of the main reasons why the PBOC has tolerated the yuan’s recent gains.

“It is prudent for investors to hedge against the risk of renewed yuan weakness after the 19th Party Congress,” UBS’s Tan said. Here’s a QuickTake on China’s market meddling.

State media have signalled support for widening the yuan’s trading band in recent months. The China Securities Journal, which is sponsored by the state-run Xinhua News Agency, said in early August that it’s time for China to boost exchange rate flexibility, while a newspaper run by the central bank laid out the steps needed for further reforms in a July 12 report that included potentially widening the trading range.

There’s still plenty of room for swings in the currency to increase before such a step is taken. While the onshore spot rate is allowed to deviate as much as 2 per cent daily on either side of the reference rate, it has rarely moved more than a quarter of that range since the fixing reform enacted in August 2015. The spot rate was last trading at a 0.8 per cent premium to the fixing, near the biggest spread since May. The PBOC didn’t immediately respond to a fax seeking comment.

The PBOC strengthened the reference rate for the 10th day in a row on Friday. The fixing has been set more consistently in line with Credit Suisse Group AG’s model based on the rate’s stated mechanism, enabling the yuan to jump versus its official trade-weighted basket of currencies, according to the bank.

“Our best guess is that this regime shift reflects a desire for a strong yuan ahead of the October 18 Party Congress and perhaps as a response to tension with the US and North Korea,” Credit Suisse strategists Ray Farris and Trang Thuy Le wrote in a note Wednesday. “We tend to expect it to retrace weaker later in the year or early next year. However, we admit to being uncertain.”


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