(Bloomberg) -- Beijing’s currency defense against the dollar risks coming undone by the side effect it is having against the other major currencies in China’s trading orbit.

The official CFETS RMB Index, which measures the yuan’s performance versus 24 peers, has climbed 2.7% since end-December and rallied to the highest in a year this week. The strength is at odds with China’s flagging recovery and threatens to erode competitiveness of its exports, especially at a time when other Asian currencies are depreciating under the weight of a resurgent dollar.

As a stronger fixing fueled the trade-weighted appreciation, the authorities’ recent moves to weaken the reference rate suggested they are switching tack to allow for more currency flexibility. A looser hold on the yuan would also be in line with the People’s Bank of China’s easy policy stance, although such a strategy risks fueling capital outflows and undermining consumer confidence.

“They could let the dollar-yuan fixing slowly grind higher to contain the CFETS index strength,” said Lemon Zhang, a strategist at Barclays Bank Plc. “The central bank will tolerate higher foreign-exchange volatility if the dollar index’s strength continues beyond the third quarter.”

The PBOC first set the yuan’s reference rate, or fixing, against the dollar at a weaker-than-expected level on March 22, causing the currency to drop the most in more than two months onshore. It repeated the move on Tuesday, leading more investors to believe that policymakers are recalibrating the currency strategy. 

The fixing moves were likely a policy reset that “should alleviate recent yuan appreciation against major trading partners amid resilient dollar strength, and to downplay the psychological level of 7.10,” Goldman Sachs Group Inc. strategists led by Danny Suwanapruti wrote in a note. 

Down less than 2% versus the greenback so far this year, the yuan’s decline is smaller than most of its Asian peers, thanks to a steady fixing that has stayed close to 7.10.

As a result, the Chinese currency recently hit a record high versus the yen and is near the strongest level in about a year against the Korean won. 

“The appreciating yuan is counteracting with the PBOC’s easy policy stance,” said Alvin Tan, head of Asian currency strategy at Royal Bank of Canada. “To end the policy contradiction, the PBOC needs to accommodate US dollar strength.”

No Free Fall

To some observers, the PBOC remains capable of engineering yuan depreciation gradual and steady enough to better reflect a weaker economy and yet avoid market panic. It has a variety of tools to manage the process, ranging from the currency’s 2% onshore trading band to hiking its funding costs offshore.   

A strong dollar may continue to dominate until the fourth quarter and the PBOC will keep using the fixing to anchor currency expectations and prevent excess volatility, said Jeff Ng, head of Asia macro strategy at Sumitomo Mitsui Banking Corp. The central bank will likely “tweak once in a while when it deems necessary,” he added.

Still, the PBOC’s constant efforts to defend the yuan against the dollar at certain levels may backfire. 

“There’s no point to keep setting such a firm line,” said Becky Liu, head of Greater China macro strategy at Standard Chartered Bank. “If they do so, the cost of currency management will go higher and higher, and foreign exchange rate loses its role of auto-stabilizer for overall financing conditions.”

--With assistance from Tania Chen.

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