The People’s Bank of China announced on Sept. 5 that it would reduce financial institutions’ foreign exchange deposit reserve ratio by two percentage points from Sept. 15, from 8% to 6%.

It’s the second time such measures have been announced this year, and the two percentage point reduction is the largest since 2004. The move could theoretically reduce downward pressure on the yuan, which has fallen to two-year lows against the dollar in the past few weeks.

Economists say China’s central bank has sent a strong signal that it wants to keep the yuan from depreciating rapidly against the dollar.

According to CNBC, Lu Ting, chief China economist at Nomura Securities, said in a report on Monday that the Chinese authorities attach importance to the yuan exchange rate against the U.S. dollar for two reasons.

For one, CCP leaders are particularly concerned about the bilateral exchange rate between the renminbi and the U.S. dollar amid the 10-year reshuffle of the CCP leadership and rising Sino-U.S. tensions. They argue that the yuan’s exchange rate against the dollar reflects relative economic and political strength to some extent.

Second, a sharp yuan depreciation against the dollar could shake domestic sentiment and accelerate capital flight.

CNBC noted that tensions between the U.S. and China have escalated over the past few years, prompting Washington to impose tariffs and sanctions on Chinese technology companies.

At the same time, China’s economy has slowed down in the past three years, especially under the influence of the pandemic. In addition, the Chinese regime has implemented a strict “Zero-Covid policy,” which has caused several major cities across the country to be locked down one after another. As a result, many economists have forecast that China’s GDP growth will reduce to around 3%.

The economic slowdown has pushed the yuan lower, making Chinese products cheaper for the U.S. and other countries. Meanwhile, the U.S. dollar has strengthened significantly this year as the Federal Reserve aggressively tightens monetary policy.

According to Reuters, a 2% cut in the reserve ratio would free up about $19 billion when Chinese financial institutions had $953.7 billion in foreign reserves at the end of July. The onshore and offshore yuan briefly bounced around 200 basis points after the PBOC statement.

Economists led by Goldman Sachs analyst Maggie Wei said in a note: “We think the People’s Bank of China may be tolerant of further yuan depreciation against the dollar, especially if the broad dollar continues to strengthen, although they may want to avoid a sustained and excessive one-way depreciation as much as possible.”

Analysts said they expect the yuan to weaken to seven against the dollar in the next three months. FX analysts at Nomura forecast a level of 7.2 by the end of the year.

He told CNBC: “I don’t think it’s going to be much lower than 7, certainly a bit more than the 7.2 we saw during the trade war,” Julian Evans-Pritchard, chief China economist at Capital Economics,

“I think that’s the key threshold,” said Pritchard, who believes Beijing is reluctant to allow that to happen, and if it exceeds that level, it could trigger a more significant outflow of capital.

The People’s Bank of China on Sept. 6 set the central parity rate of the yuan against the dollar at 6.9096, the lowest since Aug. 25, 2020.

According to Bloomberg, analysts expect more action from the People’s Bank of China if the yuan’s depreciation accelerates again.

Nomura Holdings expects the PBOC to cut the foreign currency reserve ratio by another 100 basis points by the end of this year. At the same time, United Overseas Bank said the PBOC might also increase offshore bill issuance to absorb liquidity in the yuan.

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