Pressure On China For Bigger Yuan Depreciation, Sources Say

China's central bank is under increasing pressure from policy advisers to let the yuan currency fall quickly and sharply, by as much as 10-15 percent, as its recent gradual softening is thought to be doing more harm than good.

The People's Bank of China (PBOC) has spent billions of dollars buying yuan over recent months to defend the exchange rate, but has failed to stabilize market sentiment. The currency has steadily lost another 2.6 percent against the U.S. dollar even after the bank sprung a surprise devaluation of nearly 2 percent in August.

That gradual, managed depreciation makes the yuan a one-way bet for investors who see the currency weaken even as the central bank intervenes to prop it up.

Policy insiders are now calling for a quick and sharp yuan depreciation, backed by tighter capital controls to curb speculation and the flight of money out of the country.

"We should let the yuan have a considerable depreciation, but we should have a bottom line; it cannot create a big impact on the economy and the financial system, and big panic in the capital market," an influential government economist told Reuters, suggesting the yuan be allowed to depreciate by 10-15 percent over an unspecified timeframe.

Letting the yuan fall sharply and quickly could help cushion many of China's debt-laden companies as the government pursues far-reaching structural reforms. Beijing is keen to restructure industry through "supply side" reform, especially reducing industrial over-capacity, but fears the corporate sector is too weak to handle that.

INDUSTRY BURDEN

To restructure without triggering mass bankruptcies and redundancies, sources said the PBOC is being encouraged to let the yuan fall, keeping downward pressure on interest rates and relieving some of the debt servicing burden on businesses.

"If the economy slows sharply and we can't stabilize employment, how can you push reforms?" asked the influential government economist.

"The yuan should depreciate at least 10 percent to have any impact on exports ... but I don't think the authorities will take this step," said a researcher at the commerce ministry. "If China wants to rely on expanding exports to spur growth, other countries may follow suit."

While a weaker yuan would make Chinese exports cheaper overseas, and foreign products more expensive in China, it would be unlikely to go down well among the country's trading partners. The United States, for one, regularly accuses Beijing of manipulating its exchange rate to dump under-priced goods on foreign markets.

HIGH COST

The cost of the PBOC's intervention has been high. China's foreign exchange reserves fell by more than half a trillion dollars last year as the central bank bought yuan to support the exchange rate, with reserves dropping by a record $107.9 billion in December alone.

And the yuan's continued slide since August is impacting other Chinese financial markets.

When the PBOC weakened its morning yuan guidance rate by 0.5 percent on Thursday, stock market investors panicked and pushed the CSI300 index down 7 percent within the first half hour, triggering circuit breakers and bringing the day's trading to a premature halt - for the second time in only the first week that these mechanisms have been in operation.

Policy advisers are worried the PBOC's gradualist approach risks reinforcing expectations for more depreciation - a sort of self-fulfilling prophecy - and a thesis supported by a sharper fall in the offshore exchange rate, which is not regulated by the central bank, than in the onshore rate.

"Because of depreciation expectations, residents and firms want to convert their yuan into dollars. Those expectations are man-made," said another policy adviser, reflecting a common view. "Gradual depreciation sends a signal to the market (that) the yuan still has room to depreciate further. This helps form the one-sided expectations."

Sources cautioned that the debate over whether and how to depreciate had not yet been settled, especially as depreciation has knock-on risks on other projects, such as increasing the international use of the yuan for trade and investment - which stronger capital controls would reverse.

And there's no guarantee it would work. The August move, which was also supposed to serve as a sort of floor for the market, ended up having the opposite effect.

Indeed, the central bank has so far publicly resisted calls for sharp yuan falls. PBOC Vice Governor Yi Gang said on Dec. 1 there was no basis for continued depreciation, and an editorial on the bank's website on Thursday reiterated that the PBOC can keep the yuan "basically stable at a reasonable equilibrium level" despite "speculating forces."

"The biggest risk in China is not really the economy," said Qian Wang, senior Asia economist for Vanguard Investments Hong Kong. "The real risk is, number one; the policy uncertainty, and number two; the currency. China is walking on eggshells."

(Reporting by Kevin Yao and Pete Sweeney, with additional reporting by Lu Jianxin andElzio Barreto; Editing by Ian Geoghegan)