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China's deep pockets give it edge in yuan fight

China's central bank has gained the upper hand in its fight with currency speculators. The country's foreign exchange reserves nudged up in March as fears that the renminbi would slide receded. Though the fight is far from over, China's deep pockets give it an edge.

Sentiment is all-important in the struggle over the direction of the Chinese currency. Repeated promises by the country's leaders that the yuan would remain broadly stable - combined with aggressive intervention and a crackdown on loopholes used to take cash out of the country - have slowed outflows. In March, reported foreign exchange reserves actually rose by $10.3 billion to $3.21 trillion, the first increase since last autumn.

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The US Federal Reserve has helped. The American central bank's decision to tone down future interest rate increases has weakened the dollar. The yuan is now worth slightly more against the dollar than at the beginning of the year, before the latest devaluation scare started. The shift also boosts the reported value of China's FX reserves, because assets denominated in yen and euros are now worth more in dollar terms.

The battle is not over yet, though. Any pickup in the US economy could prompt the Fed to change course, pressuring the yuan again. Moreover, many of China's economic fundamentals remain gloomy. Growth is slowing and the central bank is responding by pumping money into the system. The tide of cash will push against the dam of China's increasingly tight currency controls.

The People's Bank of China has probably also carried out some maneouvres in the derivatives markets. The central bank on March 31 disclosed its derivative positions for the first time. Though its reported nominal short US position of $28.9 billion is lower than economists and investors had expected, this does not include positions held by state-owned banks.

Nevertheless, the PBOC can keep up this struggle longer than most investors can maintain a short position. Authorities can use the country's banking system and numerous currency controls to wage war on speculators. Though China may eventually be forced to devalue the yuan, there's little solace for hedge funds in being right at the wrong time.