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SHANGHAI: China's yuan inched up against a softer dollar on Tuesday, as investors cautiously returned to riskier assets after a heavy selloff on Omicron fears, although focus shifted to whether the currency could sustain its strength next year.

Prior to the market opening, the People's Bank of China (PBOC) set the midpoint rate at 6.3729 per dollar, 204 pips or 0.32% firmer than the previous fix of 6.3933.

In the spot market, the onshore yuan opened at 6.3750 per dollar and was changing hands at 6.3744 at midday, 14 pips firmer than the previous late session close.

Traders said the spot yuan benefited from a slight retreat in the dollar overnight, although prevailing worries about the fast spread of the Omicron coronavirus variant in other countries kept safe-haven demand intact, capping greenback losses.

They added yuan trading was largely tepid this week as many market participants have gone on their year-end holidays.

"The yuan was tracking the dollar's movements as holidays are looming," said a trader at a Chinese bank.

The Chinese yuan is on course for its second straight year of gains to be the best performing major emerging market currency.

However, its trade has been less tied to the dollar's prospects in recent months, prompting some debate over whether the yuan rally is sustainable.

Traders and analysts said a stronger dollar, a slowing domestic economy, monetary easing and policy divergence with other major economies could all pile downside pressure on the yuan.

Ming Ming, head of fixed income research at CITIC Securities, said rising expectations that the Federal Reserve will raise interest rates next year would support the dollar.

That is likely to come as domestic corporate demand for yuan conversion weakens following the Lunar New Year holiday.

"China's export growth is likely to fall in the second half of next year, foreign exchange settlement and demand will balance, and the dollar could again dominate the yuan's movements," he said in a note.

Guan Tao, a former official at the foreign exchange regulator, also warned that China should prepare for its currency to pull further away from recent highs if economic data continues to disappoint next year.

But Eugenia Fabon Victorino, head of Asia strategy at SEB, said the absence of outbound tourism should stem capital outflows, providing some support for the yuan.

"China will likely hold on to its tight border controls through end-2022, keeping the services deficit to a minimum," she said, expecting the yuan to steadily strengthen throughout 2022 to 6.3 per dollar.

"Thus, the sizeable current account surplus will provide sufficient buffer for the yuan even if the greenback strengthens hereon."

By midday, the broad dollar index fell to 96.478 from the previous close of 96.517, while the offshore yuan was trading at 6.3824 per dollar.

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