SHANGHAI: China's central bank set its weakest fixing for the yuan in eight months after the euro hit a fresh two-year low overnight, pushing the Chinese currency to a new ten-month low.
The dollar/yuan rate has closely tracked the ailing euro in recent months, with the yuan weakening versus the safe haven greenback in line with euro weakening in global markets.
But in recent weeks many traders have questioned whether the People's Bank of China would allow the yuan to follow the euro lower as the region's debt crisis worsens.
On Wednesday the central bank set its midpoint at 6.3429, the weakest fixing since November 2011 and the first midpoint this year above the 6.34 mark.
Traders interpreted the fixing as a signal that the central bank is now prepared to accept further depreciation.
"It looks like (the central bank) will continue to maintain a strong link to the dollar index," said a trader at a major state-owned bank in Beijing.
Traders had earlier told Reuters that they believed the central bank would keep midpoint stronger than 6.34 in order to signal that it would not allow the spot rate to weaken beyond about 6.40.
The midpoint fixing is the base rate that the central bank uses to flag the government's intentions for the yuan's value, and from which the yuan is allowed rise or fall 1 percent in a single day.
"The psychological impact of fixing at its lowest this year will be strong," Dariusz Kowalczyk, economist at Credit Agricole CIB in Hong Kong, said in a note to clients.
"It creates an impression that Beijing is so focused on minimizing risks to growth ahead of the CPC Congress that it is ignoring any US pressure," he said referring to the Communist Party Congress due to occur later this year, when the Party will conduct a once-in-a-decade leadership transition.
The willingness to set weaker fixings could allow the yuan to depreciate further, since it has already been trading near the weak side limit of its daily band, he said.
But traders said that the magnitude of the midpoint's fall against dollar will continue to be less than the euro's corresponding weakness against the dollar.
Trading at 7.7150 per euro near midday on Wednesday, the yuan has now strengthened by 0.6 percent against the euro this year, compared to the yuan's 1.5 percent fall versus the dollar.
Traders widely believe the PBOC uses the dollar index - which tracks the greenback's value against a basket of currencies dominated by the euro - as a reference for setting its daily midpoint.
The yuan changed hands at 6.3891 per dollar late Wednesday morning, 33 pips weaker than Tuesday's close after touching an intraday high of 6.3967, its weakest level since late September last year.
While the yuan is weak against the dollar, it is at its strongest level against the euro since 2002, making Chinese goods more expensive in China's largest export market.
Traders believe the central bank is increasingly allowing the yuan to respond to market rather than using the midpoint to push back against such forces.
The International Monetary Fund appears to concur. It softened its stance on the Chinese yuan to "moderately undervalued" against a basket of currencies, and lowered its medium-term forecast for the current account surplus to between 4 percent and 4.5 percent of GDP, in an annual review released on Wednesday.
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