SHANGHAI: China's yuan strengthened moderately on Thursday, tracking overnight gains in the euro and other non-dollar currencies, as traders say they expect the yuan's recent strong link to the euro to persist.
The euro rose on Wednesday after European Central Bank Governing Council member Ewald Nowotny said he could see grounds for giving the euro zone bailout fund a banking license that would increase its crisis-fighting firepower.
Spot yuan gained 35 pips to 6.3850 per dollar at midday after the central bank set its daily midpoint at 6.3381, 48 pips stronger than Wednesday's fix.
The yuan has closely tracked the euro in recent months, but the euro gave back a chunk of its gains in early Asian trade on Thursday, and Chinese traders remain focused on the question of whether - if the euro continues its slide - China's central bank will allow the yuan to follow it down.
In a shift from conventional wisdom early this month, many traders now believe the central bank would tolerate further yuan weakness, if market forces push it that way.
Wednesday's setting of the mid-point was the weakest of the year and the first above the psychologically important 6.34 level, after the euro hit a two-year low the previous night.
Traders say the central bank is likely to weaken the midpoint in order to shift it closer to where spot transactions are actually occurring. That would amount to a license for further depreciation.
The central bank has long used the dollar index as a reference for setting its daily midpoint, which is the base rate from which the yuan is allowed to rise or fall by one percent in a single day. The index tracks the greenback's value against a basket of currencies heavily weighted towards the euro.
But while the direction of the daily fixing is reliably in sync with the direction of non-dollar currencies, the central bank also tries to keep the yuan exchange rate broadly stable.
That means that the magnitude of the daily fluctuations in the midpoint are often smaller than corresponding movements in both the dollar index.
Yet the yuan spot market has become ever more sensitive to global markets in recent months. Traders say the combination of global dollar strength and robust demand for dollars from onshore corporate clients has driven the yuan's weakness in recent months.
As a result, the spot price has edged progressively further from the midpoint.
"The recent situation is a bit extreme," said a trader at a foreign bank in Shanghai.
"The yuan's transaction price is continuously above (i.e., weaker than) the midpoint price, even to the point of approaching the weak-end limit. The central bank definitely doesn't want this phenomenon to persist indefinitely. They'd prefer that it stay within about 200 pips."
Indeed, since early June, the yuan has consistently traded farther from the midpoint than would have been allowed prior to mid-April, when the central bank widened the currency's daily trading band from 0.5 percent to 1 percent.
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