China’s reserves pose the next hurdle for yuan

Deutsche Bank on China's capital controls
Markets still watching yuan closely: Investor
'China Jan FX reserves data won't be positive'

China has recently struggled to shore up the yuan amid hefty capital outflows. Reserves data over the weekend may offer a glimpse of the severity of the challenge.

Analysts are generally calling for a drawdown of around $100 billion, following a decline of $107.9 billion in December.

Reserves plunged by $512.66 billion in 2015, a record drop for the country, to $3.33 trillion, a move attributed in part to Beijing's moves to prop up .

In addition, China suffered almost $700 billion of capital flight in 2015, according to the Institute of International Finance. Local companies rushed to repay overseas loans as the yuan depreciated, while global investors grew increasingly wary of the country's economic slowdown and Chinese authorities' interventions in the financial markets.

The reserve data due Sunday will be closely watched, even though China's financial markets will be closed for the Lunar New Year holiday for the next week.

"Global markets aren't closed. I think we'll see some contagion effect there if we see a very significant drainage coming through," Steve Brice, chief investment strategist at Standard Chartered Wealth Management, told CNBC's Street Signs. "If there were a trend acceleration we've seen in December and extended to January that would lead to people putting more pressure on the Chinese authorities to be more clear on their communications."

A customer holds a 100 Yuan note at a market in Beijing.
Why the Chinese currency took the spotlight

China's policymakers have struggled recently to implement changes to the currency, attempting to move from a dollar-peg to a trade-weighted basket. The move was targeted at shifting the currency towards an exchange rate that better reflects China's trade links as well as divert attention away from the dollar/yuan exchange rate, which has risen sharply amid the divergence in monetary policy between the U.S. and China.

The PBOC has also let market forces play a greater role in setting the value of the yuan although its recent actions have increased rather than curb confusion.

In January, the central bank, the People's Bank of China (PBOC), guided the currency sharply lower without providing much indication to the market about its endgame -- one factor in the China market selloff that triggered a global stock rout amid expectations the yuan would fall further.

That spurred policymakers to intervene in the market by keeping the currency from falling further, but propping up the yuan also likely required selling dollars.

That's opened up concerns about whether China's reserves, the world's largest, could become too depleted.

Using International Monetary Fund (IMF) methodology, Khoon Goh, senior foreign-exchange strategist at ANZ, estimates that China will need a minimum of around $2.7 trillion in reserves if it keeps a fixed exchange-rate regime without capital controls.

That leaves China only around a half a year of continuing to stabilize the yuan at the current drawdown rate, Goh said in a note Friday.

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Others have expressed concern about how the currency policy is affecting the reserves -- and expectations of when the yuan will be allowed a freer float.

"Chinese foreign-exchange policy seems to have changed three times in six months so we're back to essentially a fixed exchange rate and it is not going to last very much longer. We're talking about another couple of weeks maybe," Michael Spencer, global head of economics and head of Asia research at Deutsche Bank, told CNBC's Squawk Box. "At some point, the PBOC is going to have to step back and allow more volatility in the market and that's the real challenge for the government."

To be sure, policymakers in China have gotten a fillip in their efforts to contain the yuan's moves this week as the dollar weakened. , which weights the dollar against a basket of currencies, is down more than 2 percent so far this week.

"A strong dollar environment is really challenging" for Chinese policymakers, Brice said. "If we were to see a temporary or even a permanent reversal in dollar strength, for the Chinese authorities, that would be a really big win."

Even though policymakers have said they want to focus the yuan on a trade-weighted basket, they still need to stabilize expectations around the yuan's value against the dollar, Brice said.

"You can talk about the currency being managed on a trade weighted exchange rate, but if I'm a Chinese investor, I don't really care about that. I care about whatever bilateral exchange rate I'm worried about, which is usually the dollar," he said.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1