UPDATE 3-China raises banks' FX requirements to rein in yuan

* FX reserve requirement ratios raised for financial institutions

* Yuan pulls back after hitting three-year high vs dollar

* Set for strongest monthly gain since August

* Former forex official joins chorus cautioning on yuan gains (Recasts with FX reserve requirements)

SHANGHAI, May 31 (Reuters) - China’s central bank has directed financial institutions to hold more foreign exchange in reserve, a move that analysts say could help temper a rally in the yuan after the currency hit a three-year high against the dollar on Monday.

The People’s Bank of China (PBOC) said it will raise the FX reserve requirement ratio for financial institutions to 7% from 5%, from June 15. The increase will make it more expensive for banks to hold dollars.

Banks in China have about $1 trillion in foreign currency deposits, some of which are unconverted export receipts and investment flows. Analysts said the rise would force banks to freeze more of those dollars, slowing the yuan’s pace of appreciation by deterring dollar inflows in the longer term.

“The aim is to tighten foreign currency liquidity, raise foreign currency interest rates, so as to ease the yuan’s appreciationary pressure,” said Shuang Ding, head of Greater China economic research at Standard Chartered.

In response to questions, the PBOC referred Reuters to Guan Tao, a former senior official at China’s foreign exchange regulator.

Guan said the PBOC’s use of the FX reserve requirement ratio, a tool which it has used little in the past “shows that the PBOC still has many tools in its toolkit, and it has plenty of freedom to choose. In the future if speculative trading appears in the foreign exchange market, it has a steady supply of macro-prudential tools at its disposal.”

The announcement came after the yuan hit a three-year high against the dollar, and follows a chorus of warnings from Chinese officials against speculative bets on the currency.

Guan on Monday joined a slew of current and former officials cautioning against one-way bets on the yuan, which has seen a two-month long rally against the dollar. In a commentary in the official China Securities Journal, he warned against herd behaviour that could harm market order and weigh on China’s exporters.

Guan’s comments echoed those of a former central bank official, who said on the weekend that the yuan’s rise is not sustainable, and followed a warning by the central bank-backed Financial News. Regulators said last week they would crack down on forex market manipulation, while leaving currency policy unchanged.

A robust economic recovery and capital inflows have put the yuan on track to log its biggest monthly gain against the dollar since August, with traders interpreting the PBOC’s daily midpoint fixings as indicating implicit approval of a strong yuan.

On Monday, it lifted the yuan’s midpoint to its strongest since May 17, 2018. Spot yuan can trade 2% on either side of the daily fixing.

The firmer fixing also pushed the trade-weighted yuan basket index up to 98.22, its highest since March 29, 2016. Market players have widely viewed the 98 mark as the basket’s ceiling, as levels above that are seen to mean a loss of competitive advantage for China against its trading partners.

Spot yuan finished its domestic session at 6.3607 per dollar, its strongest such close since May 15, 2018.

Offshore yuan strengthened to a high of 6.3526 per dollar, also a three-year high, but turned weaker after the reserve requirement announcement. It last traded at 6.3700.

The chief trader at a foreign bank in Shanghai said the yuan could face resistance as overseas corporates buy dollars to make upcoming dividend payments.

“Some had purchased dollars mid-month, but these flows are not over yet,” he said.

But few expect a significant shift in structural factors behind the yuan’s rise, including strong inflows as the economy recovers. China’s factory activity continued to expand in May, despite surging raw materials prices weighing on small- and export-oriented firms.

Last week, heightened foreign interest led to record inflows into Chinese A-shares through the Stock Connect scheme linking the mainland with Hong Kong.

China’s major stock indexes slipped on Monday, but recorded their best monthly gain in six months. Flows into Chinese bonds have also been resilient.

Iris Pang, chief China economist at ING in Hong Kong, said in a note that yuan uncertainty presents a headache for companies, but that warnings from the PBOC about volatility should not be ignored.

“We believe that the PBOC is experimenting how much volatility the market can endure, and how behaviour of market participants can move the yuan,” Pang told Reuters.

Reporting by Winni Zhou, Samuel Shen and Andrew Galbraith in Shanghai; Additional reporting by Rong Ma in Beijing and Vidya Ranganathan and Tom Westbrook in Singapore; Editing by Jacqueline Wong