(Bloomberg) -- China’s defense of its currency is heading toward a milestone moment that may trigger a more forceful response from authorities to punish short-sellers.

Having weakened the yuan to within a whisker of its fixed range against the dollar on Wednesday, traders are now in danger of being slapped with anything from direct intervention to a dramatic liquidity squeeze in the offshore market. Over the past decade, the People’s Bank of China has stepped in aggressively to stabilize the yuan on each of the five occasions it neared that policy red line.

In constant conflict trying to keep policy loose enough to stimulate growth but the currency strong enough to avoid disorderly capital outflows, the PBOC has a tendency to react slowly then take sudden action. That translates to a tolerance of moderate yuan depreciation which can quickly shift to measures to boost the currency to prevent market panic.

“A continued slide in the yuan undermines both investor and consumer confidence, which in turn weighs on growth conditions and is counterproductive to authorities’ longer-term economic ambitions,” said Simon Harvey, head of foreign-exchange analysis at Monex Europe Ltd. “A similar playbook to late last year can be expected — quasi-intervention through state banks, regulatory tweaks and adjustments to liquidity conditions.”

Recent resilience in the dollar — a result of bets that the Federal Reserve will keep its policy rates higher for longer — is making the PBOC’s mandate even more difficult. Other Asian central banks, including those in Japan and Indonesia, are also faced with defending their currencies more aggressively after they sank to multi-decade lows. 

On Wednesday, the yuan slid to a level that was within 0.01% of the edge of its range. Some trades were halted for a second time this week and state-owned lenders sold dollars onshore to support the currency, according to traders who asked not to be named as they aren’t authorized to speak publicly. 

Yuan History

Chinese policymakers have always been vigilant of currency depreciation pressure as it can easily spill over to local stocks and hurt the appeal of bonds. A rapid yuan drop can also lead to a vicious cycle of capital outflows and exacerbate currency losses, like it did after a shock devaluation in 2015. 

That’s why the PBOC keeps a tight leash over the yuan with its daily reference rate and fixed trading band for the currency. Onshore, the currency is only allowed to move 2% above and below the so-called fixing that’s released by the central bank on every trading session.

“If they continue with steady fixings, they may have to start utilizing other measures to curb depreciation pressure,” such as verbal warnings and unleashing dollar liquidity onshore, said Khoon Goh, head of Asia research at Australia & New Zealand Banking Group. “Next Monday’s fix will be critical.”

Since the most recent tweak of the band in 2014, the yuan has never moved outside of its permitted range. 

In previous cases where the yuan got this close, the PBOC has pushed back with aggressive measures. Apart from a sharply stronger fixing, it also adopted tools like verbal warnings, capital curbs and even dollar sales by state banks.

The downside is these measures carry a high reputational cost, hindering aspirations to make the yuan a more international currency.

No Panic 

Analysts agree that the PBOC will manage the yuan closely to prevent it from touching the trading band and that there has been no sign of a panic selloff. Demand for bearish bets in the options market remained muted and expected swings are still among the lowest in Asia, according to data compiled by Bloomberg. 

An action from Beijing can’t be ruled out if hawkish comments from the Fed or upbeat US economic data fuel further gains in the dollar. China’s onshore foreign-exchange markets will be closed for a holiday on Thursday and Friday.

“Whatever is happening to yuan will also spillover into the other Asia foreign-exchange,” said Woei Chen Ho, an economist at United Overseas Bank Ltd. “If the market continues to push back the start of Fed rate cut, it will be difficult for the dollar-yuan pair to back down.”

--With assistance from Ran Li.

(Updates with trader comment and adds quotes.)

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