China to play it safe on yuan

By Kevin Yao - Analyst

SINGAPORE (Reuters) - An abrupt drop in the Chinese yuan this week hurt battered Asian currencies and Beijing is expected to avoid sharp weakening out of concern that it may trigger a wave of competitive devaluations across the region.

China is Asia's dominant exporter and a sharp reversal of yuan's gradual climb would exert more pressure on several of the region's export-reliant nations that already grapple with a collapse in global demand for their goods.

If pushed against the wall, China's rivals could let their currencies weaken even further, undermining Beijing's efforts to help struggling exporters, some of which are shutting their doors as the global economy slides into a deep recession.

As a result, several analysts expect the authorities in China to attempt a fine balancing act -- nudging the yuan gradually lower over the months ahead, but not too rapidly in order to avoid a backlash from other Asian peers.

"It's likely that the Chinese authorities will start to push dollar/yuan slightly higher over the coming next months," said Thomas Harr, senior currency strategist at Standard Chartered Bank in Singapore.

"That will lead to the belief in the market that Asian currencies will weaken further," he said, predicting the yuan could weaken past 7 per dollar in the coming months.

While the yuan has been tightly managed by the central bank since its landmark revaluation in 2005, currencies of economies that have strong trade ties with China, such as the Taiwan dollar or the South Korean won, often take cue from yuan's movements.

For example, as the yuan fell, its daily correlation with the Taiwan dollar has strengthened.

The Singapore dollar and the Malaysian ringgit are also affected because their exchange rate regimes are similar to China's.

Analysts at ING changed their one-year forecast on the yuan to 7.22 per dollar from 7.03, which would represent a further 4.7 percent drop from current levels. One-year offshore forwards are pricing in a bigger drop to 7.275.

The yuan recovered a bit on Friday but has lost 0.7 percent this week, by far the biggest weekly drop since the revaluation. Gauges of implied volatility in the yuan options market have shot up.

CHANGING TACK?

The losses stirred speculation Beijing was changing tack to help exporters after it let the yuan to strengthen 18 percent since its revaluation in 2005 and kept it steady in the past five months even as other Asian currencies fell due to the darkening global outlook.

"Driving this new policy would seem to be the desire to put all the stops to prevent GDP growth falling below 8 percent in 2009 -- especially since exports are still around a third of GDP," said analysts at ING in a note to clients.

China's economic growth slowed to 9 percent in the third quarter after years of double-digit expansion and a threat of a deeper slowdown made the authorities adopt a nearly $600 million stimulus package and slash interest aggressively last month.