China’s central bank is adjusting the mix of foreign currencies used in setting the yuan’s official daily value, a change analysts said should help support the weakening currency.

The move, which goes into effect Jan. 1, reflects the delicate dance Chinese policy makers face with the yuan. China wants a slightly weaker currency to help exporters and maintain competitiveness with other economies as the dollar rises. But it also worries that a sharp decline in the yuan’s value would raise fears the central bank is losing control, undermine the public’s trust and trigger excessive capital outflows.

By diluting the dollar’s share and bringing in currencies from the Korean won to the Saudi riyal and Swedish krona, the People’s Bank of China is giving itself more room to maneuver to keep the yuan from falling too fast, analysts said.

In recent weeks, the yuan has buckled under uncertainty about China’s economic performance, a surging U.S. dollar following Donald Trump’s presidential-election victory and escalating flows of Chinese currency moving offshore.

The potential for faster U.S. interest-rate increases could add even more downward pressure on the yuan, with some analysts and investors predicting the currency could break the psychologically important seven-yuan-per-dollar level as soon as next month. The yuan has dropped 7% against the dollar this year, nearly double the decline from the year before.

China’s move is the latest by global policy makers trying to adjust to a powerful dollar rally that has recently lifted the U.S. currency to a 14-year high. In emerging markets, a stronger dollar makes it more expensive for governments and companies to pay back their dollar-denominated loans.

Mexico raised interest rates this month, looking to head off inflation as the peso tumbled against the dollar. Central banks in other developing countries, including Indonesia and Malaysia, have also taken steps to support their currencies against the dollar.

In China, how to manage the yuan’s value has become a hot topic in official circles since a nearly 2% devaluation 16 months ago shocked global markets. In the past year the central bank has sought a less abrupt path, constricting channels for moving money out of the country and managing the pace of depreciation.

The central bank controls the mainland trading of the yuan by specifying an official rate against the dollar and then allowing the currency to move 2% above or below the so-called daily fix. Since the beginning of this year, the central bank has been taking into account the yuan’s performance against both the dollar and a wider selection of currencies when determining the daily fix. That move has paved the way for the yuan’s gradual deprecation.

With the pressure building for further depreciation, Chinese leaders have been trying to assert greater control. At a top-level meeting earlier this month, Chinese leaders said maintaining the yuan’s “basic stability” would be a main economic task for 2017.

Starting in January, the central bank will expand the number of currencies in the basket it uses to calibrate the yuan’s value to 24 from 13 and reduce the weighting given to the U.S. dollar to 22.4%, from 26.4%, according to an announcement by the central bank’s China Foreign Exchange Trade System late Thursday.

Expanding the currency basket and reducing the dollar’s weighting could help “reduce fluctuations of the daily fix and stabilize market expectations” for the yuan, said Zhu Chaoping, China economist at UOB Kay Hian Holdings Ltd., a Singapore investment bank.

When calculating the yuan’s daily fix against the dollar, the central bank considers both the yuan’s previous close versus the greenback and the overnight changes in the value of the currency basket against the dollar. As more currencies are included in the basket, the currency group likely will become more stable, potentially making the yuan’s official value against the dollar less volatile.

However, most investors still focus on the yuan’s performance against the dollar. The fresh mix in the currency group, therefore, likely won’t change many investors’ pessimistic outlook for the yuan, analysts say.

The new basket will include the currencies of almost all of China’s trading partners and therefore will be more representative of the yuan’s performance against its peers, the announcement said.

Many analysts and investors said the basket can play only a limited role in steadying expectations for the yuan. A bigger issue, they said, is how to break the cycle of greater depreciation leading to more outflows and more stress.

“The one-way depreciation has led to rising depreciation expectations, resulting in huge capital outflow pressure,” said China economist Larry Hu at Macquarie Securities, a Sydney investment bank.

Authorities face an imminent test as the clock is reset on individuals’ foreign-exchange quotas. Chinese citizens are allowed to exchange up to $50,000 worth of yuan a year. The opportunity to exchange yuan in 2017 is expected to set off fresh outflows, many analysts and economists said, potentially forcing Beijing to further tighten capital controls.

In recent weeks, the central bank has sought to slow the pace of the yuan’s depreciation by market interventions and a stronger-than-expected daily fix. Some of those efforts, like the actions to sell dollars and buy yuan, threaten to drain more liquidity from China’s financial system. The tightened liquidity caused upheaval in Chinese bond markets as the dollar rallied in December. China is coming up to a period when the demand for cash from ordinary Chinese grows ahead of Lunar New Year in late January. Chinese traditionally make cash gifts during the celebrations.

That demand has led to calls on the central bank to release more funds for commercial banks to lend. The central bank appears to be maintaining a tightening bias in its monetary stance, analysts said, as any credit-loosening could add to more pressure on the yuan.

(Source: www.wsj.com)