By Kevin Yao
BEIJING (Reuters) - China’s central bank is on guard against a sudden attack on the yuan in offshore markets, and is ready to intervene if the gap between offshore and onshore exchange rates becomes destabilizing, sources involved in policy discussions say.
Though the People's Bank of China (PBOC) wants to avoid a sharp depreciation in the currency, it is comfortable with further weakening of the yuan against the dollar, policy insiders said, especially as the U.S. Federal Reserve is expected to raise interest rates on Wednesday for the first time since 2006.
“An interest rate rise by the Fed could put big pressure on the yuan ... so it’s a good thing to allow the yuan to depreciate modestly to help release the pressure," said a senior economist at a top government think-tank.
But the bank, which devalued the yuan by an initial 2 percent in August when it introduced a market-based mechanism to determine the daily opening rate, was alive to the dangers of more abrupt falls, he added.
"A sharp yuan depreciation is not what the PBOC is happy to see ... If that happens, the PBOC will intervene ... because sharp yuan falls could fuel capital outflows and financial risks."
“The government still has various means to manage the yuan exchange rate," said another influential economist who advises policymakers. "The central bank may still intervene to prevent sharp fluctuations in the yuan exchange rate – on onshore and offshore markets."
The bank indicated late on Friday that it wanted markets to stop fixating on the dollar-yuan rate, which is at its lowest since July 2011, and launched a new index measuring the yuan, also known as the renminbi (RMB), against a basket of currencies.
“We should use the RMB index to show that the RMB has gained against most currencies, although it has depreciated against the dollar," said a policy insider at the Commerce Ministry.
"We should find the yuan's equilibrium exchange rate between the dollar, euro and yen," he added.
MIND THE GAP
A growing problem of the yuan's depreciation offshore - including a 2 percent fall this month alone - is that a wide gap is opening up with the onshore rate, which is partly sheltered from market forces by China's capital controls.
“The gap is not sustainable," said the think-tank insider, since it could lead to more capital outflows as trading companies sold dollars offshore to get a better rate.
With China's growth at its weakest in 25 years, it can ill afford further capital outflows, nor for its currency to keep pace with a rising dollar, which would suck money out of the slowing economy.
The growing spread could also disrupt corporate behavior, such as trade financing on commodities imports, which has benefited by arbitraging lower dollar interest rates offshore. Two senior oil traders said that was now on the decline because of the likely exchange rate loss.
"I believe the PBOC is still watching. It hopes the offshore rate could get closer to the onshore rate. If the big gap persists, we cannot rule out fresh interventions," the think-tank source said.
The gap between onshore and offshore rates also creates a diplomatic headache for China, less than a month since its currency was accepted by the International Monetary Fund into its Special Drawing Rights (SDR) basket of reserve currencies.
Before the IMF decision, the PBOC had intervened offshore to minimize the gap.
"If the onshore-offshore spread is too wide, China will lose credibility after joining the SDR; it will have two currencies," said Zhou Hao, China economist at Commerzbank in Singapore.
That would give ammunition to critics, especially in the United States, who complain that China keeps its currency low to support otherwise uncompetitive exporters.
With both the think-tank and Commerce Ministry source forecasting further currency weakness of at least 3 percent and perhaps as high as 6 percent against the dollar next year, it is little wonder that China is aiming to steer market attention away from the dollar rate and towards its new basket index.
"This could help avoid currency wars," said the latter.
(Reporting by Kevin Yao; Additional reporting by Pete Sweeney, Michelle Chen and Aizhu Chen; Editing by Will Waterman)