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The yuan closed higher against the dollar on Tuesday, taking its cues from the US currency's decline on global markets, but dealers expected the yuan's gains to remain modest in the near term.
Rising inflation, among other factors, has recently helped to weaken market expectations of how quickly the yuan could rise in the coming weeks or months, dealers said.
The pace of the yuan's gains has slowed since the start of February, partly reflecting a steep two-day weakening last Friday and Monday, immediately following a visit to China by US Treasury Secretary Henry Paulson. "As China's inflation shows signs of an increase, upward pressure on the yuan is easing," said a dealer at a major Chinese commercial bank.
"Although the central bank may still have to allow the yuan to appreciate in the long run, the market believes it has more leeway to do it at a leisurely pace," he said.
Economic theory dictates that a rapidly growing economy would have an exchange rate that appreciates in real terms via a higher nominal exchange rate, faster inflation than the country's trading partners, or a mixture of the two.
The yuan closed at 7.7430 to the dollar, up slightly from Monday's close of 7.7520, after hitting an intraday high of 7.7400. The day's low was 7.7480. Dealers said they expected the yuan to move between 7.7300 and 7.7600 this week.
Before the start of trade, the central bank set a stronger daily mid-point for the yuan at 7.7397, up from Monday's mid-point of 7.7474, reflecting overnight dollar weakness on global markets, dealers said.
But the market failed to boost the yuan as far as the mid-point, particularly after February consumer price data was published in the morning, dealers said. Consumer price inflation was 2.7 percent in February, up from 2.2 percent in January but just below the market forecast of around 2.9 percent.
The data was distorted by the Chinese New Year holiday, but even combining January and February to iron out distortions by the timing of the holiday, inflation was 2.4 percent compared with a year earlier, while in the same two months of 2006 the increase was 1.4 percent.
The central bank auctioned 140 billion yuan ($18 billion) of one-year bills in its regular open market operation on Tuesday at 2.8701 percent, above market forecasts of 2.79 to 2.84 percent and against 2.8383 percent for such bills sold last week.
Traders said the central bank's willingness to let the one-year bill yield rise over the past two weeks, after keeping it almost flat for the previous several months, suggested it might be preparing to tighten monetary policy further, possibly with an official interest rate hike.
One-year NDFs quoted the yuan at 7.3190/7.3240, indicating appreciation between 5.68 and 5.75 percent from Tuesday's yuan mid-point. The NDFs showed appreciation between 5.49 and 5.56 percent on Monday.

Copyright Reuters, 2007

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