Editor's Note: Jimmy Zhu is chief strategist at Singapore-based Fullerton Research. The article reflects the author's opinion, and not necessarily the views of CGTN.

The Chinese yuan pared some of its earlier gains after the People's Bank of China (PBOC) decided to adjust the foreign exchange (FX) reserve requirement for banks. Moving forward, many factors suggest further massive gains in yuan value are not likely in the coming months. 

Onshore financial institutions will need to hold 9 percent of their foreign exchange in reserve starting December 15, a 2-percentage-point increase, the Chinese central bank said in a statement earlier last week. Onshore yuan declined over 300 percentage points to 6.38 against the U.S. dollar after the announcement.

The PBOC's decision clearly demonstrates the authorities are not comfortable with the recent gains in currency. Since the end of the first half of the year, the yuan has gained around 1.4 percent versus the dollar even with the dollar index rising around 4 percent during this period. Also, the yuan has outperformed all other emerging markets' currencies since the beginning of the second half of this year.

The adjustment for FX reserve ratio itself should not have direct impact on the level of yuan exchange rate, but the policy will force some companies to purchase dollars instead of borrowing from the banks. For example, a company that needs $1 million in cash to pay suppliers may find it more difficult to borrow from banks now, as commercial lenders must hold more dollars to fulfill their FX reserve ratio requirement.

In the end, this company may either purchase dollars from their yuan holdings or get this dollar amount from somewhere else. As a result of that, onshore dollar liquidity is expected to be tighter than before, increasing the upward pressure on the dollar value versus the yuan. 

Still, the FX reserve ratio's adjustment itself will not have much sustainable impact on the yuan, as the currencies will continue to be driven by various fundamental factors, including the dollar's outlook, interest rate differentials and cross-border capital flows.

Over a long period of time, the yuan's moves versus the greenback have been closely tracking the dollar index. For the next 12 months, the dollar index may continue to move higher amid policy divergence between the Federal Reserve and European Central Bank (ECB). Recent inflation readings in the U.S. have strengthened the case for the Fed to accelerate its tightening pace this week, paving the way for it to raise policy rates as soon as next May.

However, a sharp uptick in the spread of COVID-19 has weighed on the eurozone's economic activities recently, with some major economies in the region applying more stringent lockdown measures. Growing supply pressures and the reintroduction of new social restrictions in some euro-area countries have come to the attention of the International Monetary Fund, which may consider downgrading the eurozone's growth forecast in the near future.

The soft economic outlook also prompted ECB President Christine Lagarde to state that an interest rate increase in 2022 is "very unlikely." The yield gap between the U.S.' 10-year government bond yield and Germany's 10-year government bond yield has widened to 183 base points (bps), approaching the highest levels since March this year. A widening yield spread suggests the dollar may continue to move higher versus the single currency, directly pushing the dollar index higher as the euro has a weighting of over 50 percent.

Yield spread between the China and U.S. 10-year government bonds, which has been gradually narrowing in recent months, suggests further substantial gains for the yuan against the dollar are not likely in the near term. The interest rate differential in the past few years has been a key gauge to decide the yuan-dollar exchange rate; for example, a widening spread implied a stronger yuan and vice versa.

Since the beginning of the second half of this year, the spread between the two has narrowed to 139 bps from 162 bps. Looking ahead, the spread may further shrink from the current level as the Fed is expected to accelerate its tightening pace, which should be seen to boost the U.S. Treasury yield, while the Chinese central bank is expected to keep its monetary policy relatively stable in the coming months.

Still, continuous inflows, especially into the onshore bonds market, will continue to offer a key support to onshore yuan. The FTSE World Government Bond Index decided earlier this year that Chinese government bonds would be included in the index over three years starting from the end of October.

With about $2.5 trillion tracking the index, the inclusion is expected to drive over $100 billion in index-related foreign inflows over the next three years. 

However, we expect that cross-border flows in bond trading will be more balanced in the coming few years, as the Chinese policymakers have already opened the "Southbound Bond Connect," which allows mainland investors to purchase overseas debts, thereby mitigating some of the yuan's appreciation pressures from massive capital inflows.