Sept 28 (Reuters) - China's yuan has weakened more than 5% against the dollar this year and has lately been squeezed to the lower extremity of its trading band as the U.S. currency climbed.
It is unusual and partially caused by Chinese authorities leaning against market forces in setting the trading band's level.
Here's a breakdown of how that works:
** WHAT IS THE TRADING BAND AND MIDPOINT FIXING?
China's yuan is not a fully-convertible currency and its onshore exchange rate is a managed floating rate mechanism.
The central bank sets a daily midpoint rate against the dollar at 9:15 a.m. (0115 GMT) every day. The onshore spot price can trade in a band either side of the rate, which has been widened over the years from 0.3% in 1994 to 2% since March 2014.
** HOW IS IT CALCULATED?
Fourteen midpoint contributing banks set prices with reference to the yuan's previous-day official domestic close at 0830 GMT and moves in global markets overnight. Their quotes are sent to a unit of the central bank which then sets the midpoint rate.
China introduced a so-called "counter-cyclical factor" into the midpoint formula in 2017 in what regulators said was an effort to better reflect market supply and demand. The factor was adjusted multiple times since then.
Analysts, who calculate their own estimates for the fix by reverse-engineering the formula, said the goal was to dial down the input from the closing price and increase the influence of fundamental factors.
** WHAT'S BEEN HAPPENING TO THE FIX?
China's central bank has been setting far firmer-than-expected midpoint guidance for months, in what traders and analysts interpret as a sign that the authorities are getting increasingly uncomfortable with the currency's weakness.
The gap between the midpoint and Reuters' estimates hit a record on Sept. 26, when the fix was 1,447 pips stronger.
Setting the midpoint so far from the market level means that the currency, without necessarily moving much, trades close to the edge of the band - such as on Wednesday when it was within 14 pips of the downside limit.
** WHAT HAPPENS IF THE LIMIT IS REACHED?
Currency traders said they are not sure what will happen when the yuan hits the limit, and whether trading will be suspended.
In the past, it has only ever brushed it; touching the down limit in 2011 when the trading band was only 0.5% and coming within 1 pip of the limit last October.
State-owned banks have been selling dollars for yuan to steady the currency, and such trading could also protect the downside.
** DOES IT WORK?
It avoids spending reserves to stabilise the currency and, so far, the market has been heeding the authorities' signals.
Ahead of the Golden Week break, beginning on Friday, the yuan has held steady in spite of a rising dollar. This means that the Chinese currency has strengthened against the currencies of its other trading partners.
The CFETS basket index, a gauge that measures the yuan's value against its peers, is up 0.9% this year while the yuan has lost more than 5% against the dollar during the same period. (Reporting by Shanghai Newsroom; Editing by Jacqueline Wong)
