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Are the odds stacking up against the yuan?

Huchen Lu | E+ | Getty Images

As the Chinese yuan succumbs to further selling pressure against the U.S. dollar, concerns over China's slowing growth and speculation that Chinese authorities will devalue the currency to support growth, analysts are questioning how low it will go.

"We have been anticipating some RMB weakness versus the USD since the end of 2014. This, however, is happening faster than expected due to aggressive ECB (European Central Bank) QE (Quantitative Easing) and a sharp drop in the EUR," said Paul Mackel, head of Asian FX Research at HSBC.

He noted the yuan is very sensitive to euro because of both the design of the People's Bank of China's (PBoC) fix as well as close trade links with the EU.

For the yuan, there is "little light at the end of the tunnel" right now, he said.

The Chinese currency has fallen 1 percent against the U.S. dollar this year, extending the slide that began last November. Since November, it has depreciated 2.4 percent.

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Mackel says the current environment is conducive to more weakness, raising his dollar-yuan forecast to 6.34 by end-2015 and 6.44 by end-2016 - from 6.22 and 6.30 percent - on Monday. His forecasts mark a further 3 percent depreciation for the currency between now and end-2016. Dollar-yuan last traded around 6.259.

Additional headwinds

China's current account surplus is likely to narrow in the first quarter due to the seasonal pattern in the trade of goods, Mackel said, which is negative for the yuan.

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Another factor that could pressure the currency is monetary easing by the central bank to support growth, he said. A rate cut, for example, would erode the yuan's interest rate advantage and could trigger capital outflows.

Corporate foreign exchange hedging activity – which involves buying U.S. dollars – could also be a drag.

Central bank in control

Khoon Goh, senior foreign exchange strategist at ANZ, on the other hand, does not anticipate a further bout of yuan weakness. He expects the currency to stabilize around current levels.

"I don't buy the argument for further weakness," he said.

The yuan is still a closely managed currency, so in order to assess where it is headed, it's important to factor in what Chinese authorities would want.

The PBoC manages the yuan by setting a daily midpoint around which it can trade. The currency can move up or down 2 percent from midpoint.

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"If they really wanted to a weaker currency to support exporters – it would be weaker. I think their preference is to provide stability, particularly against the backdrop of reforms and rebalancing," he said. "At least having one arm of policy that's fairly stable is important."

Goh says while corporate hedging activity and narrowing interest rate differentials could be headwinds for the yuan, he doesn't believe these factors would put major pressure on the currency.

"We expect China to ease policy through cutting interest rates and the RRR but I don't think it will be of a significant magnitude to cause deterioration in the currency. In any case a lot of other countries are cutting borrowing costs."

No trend at hand

Haibin Zhu, chief China economist at JP Morgan agrees that the recent yuan weakness will not turn into a deprecation trend.

"We think the room for further CNY depreciation is limited in the near term. Stable currency with two-side volatility remains a preferred option for the PBOC," he said.

"First, the impact of currency depreciation on the export sector might be limited. Second, policymaker(s) [are] concerned about the risk of intensified capital outflows. Third, as the Chinese government pushes for progress on RMB internationalization, the authorities are unlikely to be keen to push for CNY depreciation, as it may hamper progress."