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A lower reference rate set by the Chinese central bank caused the yuan to close down against the dollar on Monday, extending last week's slide and erasing gains that followed Sino-US trade talks in May. The yuan's 0.36 percent drop over the past three trading days was its second biggest fall since its revaluation in 2005.
The central bank fixed its daily mid-point lower for the third straight day on Monday, apparently in order to control the pace of appreciation while testing the market's response to increased volatility, dealers said. The yuan closed at 7.6632, down from Friday's finish of 7.6550.
It was the lowest close since 7.6673 on May 21, when China widened the yuan's daily trading band to 0.5 percent on either side of the mid-point from 0.3 percent in an apparent conciliatory gesture to Washington just before the trade talks.
"The yuan's recent steep fall was guided by the central bank's mid-point," said a Shanghai dealer at a European bank. "The central bank wants to kill two birds with one stone: curbing the yuan's appreciation, while testing the market's reaction to the yuan's sharper volatility."
Before trading started on Monday, the central bank set the yuan's mid-point at 7.6785 to the dollar, weaker than Friday's 7.6656 and sharply lower than last Wednesday's 7.6398.
Monday's mid-point, the lowest since 7.6804 on May 18, was down an unusually steep 0.51 percent from Wednesday - the biggest three-day drop in the mid-point since the yuan's peg to the dollar was abolished in July 2005. Traders believe the central bank wants to dampen speculation that it will permit faster long-term appreciation of the yuan in the wake of the trade talks in Washington.
It may also be preparing the market for greater two-way volatility in coming months, since creating a more active currency market is one of its policy goals.
However, traders noted that the yuan traded stronger than its mid-point throughout Monday, and closed well above the mid-point. This suggested the market still expected yuan appreciation to resume before long.
They expect the currency to rebound and test the psychologically important level of 7.6300 for the first time as soon as next week. Monday's offshore non-deliverable forwards showed no signs of weakening expectations for yuan appreciation.
One-year NDFs quoted the yuan at 7.2990/7.3040, indicating appreciation of 5.13 to 5.19 percent in one year's time from Monday's mid-point. That was up from 4.99-5.09 percent on Friday, though below 6.55-6.62 percent in late March.

Copyright Reuters, 2007

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