China's central bank said it was tweaking the mechanism for setting the yuan's daily fix to smooth out fluctuations against the dollar, an acknowledgment that the country is hitching the yuan's value closer to the U.S. currency.
The People's Bank of China said it was adding a "countercyclical" component to its model to prevent big swings. In the process, the bank is reasserting the use of a heavier hand on the currency's value, backtracking on efforts to make the yuan more market-oriented as worries about the Chinese economy mount.
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Since Moody's Investors Service downgraded China's sovereign-debt rating this week, the first such cut since 1989, activity in the market has also indicated the central bank is trying to send a message to investors to prevent bets against the yuan.
The purpose of the tweak to the model guiding the yuan's fix, already in effect on a trial basis, is to counter a "herd mentality" in the market that in the past year has pressured the yuan against the dollar, the currency-trading arm of the PBOC said in a statement Friday. It didn't elaborate on how the new countercyclical component will work.
The central bank had already taken steps to keep the yuan relatively steady. Since late last year, it has tightened restrictions on money leaving China's shores and pushed up short-term interest rates, which discourages bets against the yuan with borrowed money.
In recent weeks, it became clear that the central bank was effectively re-anchoring the currency to the dollar, a shift from its tactics over the past year of trying to guide it gradually lower against the U.S. currency. Behind the reversal is a Chinese leadership whose priority is economic and political stability ahead of a power shuffle later this year. Beijing also wants to avoid increased trade frictions with Washington. President Donald Trump has accused China of exploiting the yuan's value to gain advantages over its trading partners.
Only two years ago, China's central bank said it was adjusting the mechanism to align the yuan more closely with market forces. That ambition has since given way to heavy market interventions aimed at propping up the currency.
Keeping the yuan closely aligned with the dollar makes it less alluring for companies and ordinary Chinese to swap their yuan for the U.S. currency, slowing capital outflows. But the strategy gets trickier if the dollar starts to rally, for example in response to rising U.S. interest rates.
The PBOC rarely discusses the shifts in its exchange-rate approach in detail, which has increased market uncertainty over its policy intentions.
"Because of the lack of disclosure, the fixing mechanism likely will become less transparent," said China economist Zhu Chaoping at UOB Kay Hian Holdings Ltd., a Singapore-based brokerage firm.
Traders said sudden drops in dollar against the yuan Thursday and again Friday shortly after the market opened suggested the central bank was directing big Chinese banks to sell dollars and buy yuan.
"The buy orders from these banks were quite huge," said a Shanghai-based senior trader at a midsize domestic bank Friday. "People are really in a panic right now because we all suspect that it's our government trying to teach Moody's a lesson but nobody knows how far the PBOC will go," he said.
The yuan strengthened 0.1% to 6.8610 to the dollar Friday, at one point trading at its strongest level against the U.S. currency in more than three months. The gains were roughly mirrored in the offshore market.
Meanwhile, the cost for banks to borrow yuan from each other overnight surged to 7.76% on Friday in Hong Kong's offshore market, the highest since Jan. 9, according to the Treasury Markets Association. That rate was 4.17% on Thursday.
The rise appeared to be aimed at deterring "short" bets against the yuan, which are done with borrowed funds, by making such strategies costlier.
"They want to give a warning that any investor who shorts [the yuan] after the downgrade will suffer," said Ken Cheung, Asia currency strategist at Mizuho Bank in Hong Kong.
China's hand was evident in the stock market, as well. Sharp rallies in Chinese financial blue chips have buoyed the country's main index back above the psychological threshold of 3100.
"Clearly, state funds intervened on Thursday to give the market a dose of confidence and counter recent blows from negative news," said Deng Wenyuan, an analyst at Soochow Securities. "The authority won't allow the index to drop further."
Some investors are already positioning for a stronger yuan. "There is a fair chance that [the yuan] would end this year by appreciating to less than 6.9 a dollar," predicts Chi Lo, China economist at BNP Paribas Investment Partners, the asset-management arm of the Paris-based bank. "This would make Chinese assets more attractive."
Shen Hong and Yifan Xie in Shanghai contributed to this article.
Write to Lingling Wei at firstname.lastname@example.org and Saumya Vaishampayan at email@example.com
(END) Dow Jones Newswires
May 26, 2017 07:50 ET (11:50 GMT)