SHANGHAI, Oct 12 (Reuters) - China's yuan fell versus the dollar on Wednesday on speculation that a U.S. bill prodding China to let the yuan rise at a faster pace could spark retaliatory steps, but the currency recovered from its lower daily limit after government-controlled Chinese banks sold dollars into the market.
The People's Bank of China (PBOC) has at times in the past engineered declines in the yuan to coincide with U.S. pressure for it to strengthen its currency, in what analysts have interpreted as an effort to signal that it will move at its own pace on the currency, officially known as the renminbi.
Expectations that it could take a similar response to the bill approved by the U.S. Senate on Tuesday, aimed at pushing China to let its currency rise at a faster pace, led to a sharp fall in the yuan in the opening minutes of trade.
Spot yuan was pushed briefly to the bottom end of the daily trading band at 6.3916, even though the PBOC had set the day's mid-point higher than Tuesday's close. It later trimmed its losses to stand at 6.3829 per dollar by midday, down only slightly from Tuesday's close of 6.3750.
"Since a sort of panic prevailed in early trading, the big state banks were seen offering dollar liquidity to the market that then helped the yuan to move away from its limit-down level," said a trader at a U.S. Bank in Shanghai.
"This is actually not a surprise as the PBOC and the Big Four are the only sources of dollar liquidity in the domestic market."
NO SIGN OF RETALIATION - YET
Currency politics have hung over the local currency market in the last couple of days, as the U.S. Senate late on Tuesday approved a bill aimed at imposing penalties for what it says is an undervalued yuan that is hurting the American job market.
Although that bill is considered unlikely to pass through the House of Representatives or to be signed into law by President Barack Obama, China wasted no time in responding to it.
The foreign ministry issued a strongly worded statement just hours after its passage, and the central bank following up by saying the currency was not the main cause of trade imbalances.
Still, the PBOC set its mid-point against the dollar at 6.3598, shy of a record high the day before at 6.3375 and still stronger than the close in the spot market on Tuesday.
The central bank uses the reference rate, from which the dollar/yuan exchange rate may rise or fall 0.5 percent each day, to signal the government's intentions for the yuan.
"Market jitters over a potential trade dispute between the United States and China loom very large, although the PBOC did not give an indication of an immediate retaliation via its mid-point," said a trader with a major European bank.
"Past experience shows that excessive U.S. pressure on China for yuan appreciation is temporarily counterproductive, with China often halting yuan appreciation for a while to show resistance to what it thinks is interference in its internal affairs."
UNWINDING OF POSITIONS IN HK
While onshore yuan volatility on Wednesday was related to speculation over the prospects of yuan appreciation, the currency also fluctuated sharply earlier this week and in late September, but for different reasons, according to traders -- dollar demand from exporters and importers, traders said.
Similar reasons were behind a sharp drop in the offshore yuan , also known as CNH, in early trade on Wednesday, as companies that had built up positions in offshore yuan sold heavily.
That was later balanced out by yuan buying in both the CNH and non-deliverable forwards by a large U.S. bank, bringing offshore yuan from a low of 6.5530 per dollar back up to 6.4550 at midday.
Spot yuan has now appreciated 3.24 percent since the start of this year and 6.95 percent since it was depegged from the dollar in June 2010.
"I suspect foreign banks, affected by weakening expectations of yuan appreciation overseas, were the main dollar buyers today although transaction details are not available here," said a trader at an Asian bank in Shanghai.
"Recent increased volatility has also allowed speculation in the yuan exchange rate. More experienced foreign banks are in a better position to conduct profit-targeted speculation."
