SHANGHAI The rare and dramatic slide in the yuan exchange rate that has shaken the outlook for the currency is unlikely to last long as trade rebounds and capital inflows resume.
While most foreign exchange traders have abandoned their original forecasts of a 3 percent appreciation in the Chinese currency against the U.S. dollar, they still expect the yuan to end 2014 up a net 1 percent, around 6.0 per dollar.
That would mark a nearly 4 percent strengthening from the nadir of 6.2370 hit on March 21.
A Reuters poll of 50 forex analysts on Thursday backed this view, noting the yuan would likely be the strongest emerging market currency in the next 12 months.
The People's Bank of China (PBOC) guided the yuan down by 2.54 percent over the course of a few weeks in February and March -- the biggest two-month fall since the establishment of the domestic foreign exchange market in 1994.
This was widely perceived as a swipe at speculators who had grown too comfortable betting on non-stop yuan appreciation.
Data suggests this campaign was largely successful, with the most overextended speculators forced to bail out of leveraged long-yuan positions as the currency weakened below 6.2 per dollar in recent weeks.
But traders aren't betting the currency will stay depressed. Indeed, the spot rate has flattened out in recent days.
"The first quarter is typically a weak season for China's foreign trade and exports, so it offers a good opportunity for the central bank to crack down," said Huang Yi, head of foreign exchange trading at Guangdong Development Bank in Shanghai.
"Foreign trade is expected to rebound in the second quarter and strengthen in the second half of the year, so the market expects the yuan to stabilize in the second quarter and regain strength toward the end of the year."
Thus, while traders see more volatility as likely this year after the central bank doubled the yuan/dollar trading band to 2 percent in either direction in mid-March, they see a resumption of the yuan's long rising trend.
"Interest rates on yuan deposits still enjoy large premiums versus dollar savings, among other factors," said Liu Dongliang, currency strategist at China Merchants Bank in Shanghai.
"So at least for the next six to 12 months, until the Federal Reserve starts raising the U.S. interest rates, hot money will continue pouring into China, putting the yuan back under appreciation pressure."
PBOC GOES SOLO
Traders say the yuan's fall this year was engineered by the PBOC, with market forces playing a minor role and fundamentals in China's foreign exchange market taking a back seat -- an oversupply of dollars was largely ignored.
"The central bank doesn't want non-stop yuan appreciation, but it certainly doesn't want non-stop depreciation either. You cannot expect PBOC to stand aside while the yuan goes into free fall," said a dealer at a major European bank in Shanghai.
Signs of a sharp slowdown in capital inflows into China in February can be seen in data, when the yuan began its dive.
The PBOC and commercial banks purchased 128.2 billion yuan ($21 billion) worth of foreign exchange on a net basis in February, the lowest amount of net purchases since September, the central bank's latest data showed.
That was down from 437.4 billion yuan in January and 295.4 billion yuan in February 2013.
Another reason that the PBOC would not guide expectations towards an established yuan depreciation trend is the quickly expanding offshore yuan market.
With $4 trillion in foreign exchange reserves, the PBOC can easily pull the yuan up or down in the onshore market, but is bound to have less influence in offshore markets, dealers say.
For instance, regulators in South Korea and Taiwan have recently flagged potential risks associated with a more volatile yuan by looking into the rapid rise of yuan deposits in their banking systems.
Yuan deposits globally outside mainland China now total more than a trillion yuan, up from just a few million yuan five years ago when China began earnestly to internationalize the yuan.
($1 = 6.2 Yuan)
(Editing by Jacqueline Wong)