By Lingling Wei

In recent weeks, triggered by a surging dollar, the Chinese yuan has been weakening faster than expected, raising the specter of accelerated capital outflows that could destabilize the Chinese economy. To help steady the yuan, the country's central bank is now diluting the dollar's role in a basket of currencies it uses to help set the yuan's daily rate.

Here's what the adjustment means for the yuan, which is headed for its steepest annual decline against the dollar in more than two decades:

1. What does China want for its currency?

The short answer is: to be weaker, but not too weak. In the past year, the central bank has been seeking to let some air out of the yuan but at the same time trying to control its decline so as not to trigger excessive capital outflows. A cheaper yuan helps make Chinese goods more competitive in foreign markets. Even though China has repeatedly pledged not to engage in beggar-thy-neighbor devaluation to boost exports, there has been a strong belief in official and academic circles that the yuan had become overvalued after years of appreciation.

However, policy makers also don't want to risk having a sharply weakened currency driven entirely by market forces. That, in their view, could cause the yuan to "overshoot" on the downside, potentially hurting the public's overall confidence in the economy. As a result, the People's Bank of China has been trying to balance the need to use the currency to support the economy against the need to prevent too much money from leaving China.

2. What is the currency basket in focus?

Currently, there are 13 currencies in the basket that is being used by the central bank to help set the yuan's official rate against the U.S. dollar, dubbed the daily "fix." The greenback has the largest weighting with 26.4%, and has played the dominant role in driving the yuan's value in the past year.

Now, as concerns grow over a sustained dollar rally -- likely to be triggered by a faster pace of U.S. interest-rate increases next year, China's central bank is adding 11 currencies, including the Korean won and the Saudi riyal, to the basket. The change dilutes the dollar's role in setting the yuan's value. Starting Jan. 1, the greenback and currencies pegged to it, such as the riyal and the Hong Kong dollar, will make up 30.5% of the new basket, down from the current 33%. Many analysts say the move could help ease recent depreciation pressure on the yuan.

3. How does this move affect the effort to stabilize the yuan and reduce outflows?

The newer currency basket can only do so much to stabilize the yuan. That's partly because most investors still focus on the yuan's performance against the greenback as opposed to its value against the basket. The fresh mix in the currency group, therefore, likely won't change many investors' pessimistic outlook for the yuan. On the other hand, by adding some of the underperforming emerging-market currencies like the Turkish lira to the basket, the yuan is likely to perform better overall against the broader grouping. The yuan is already near a four-month high versus the basket, even though it is at an eight-year low against the dollar.

A bigger issue China is contending with is how to break the negative feedback loop that has been developing between a weaker yuan and greater outflows. To keep money at home, the authorities may have to further tighten capital controls, many economists and analysts say.

4. What is behind China's capital outflows and falling currency?

There are three major forces behind China's escalated capital outflows: Chinese companies trying to pay down the huge amounts of dollar debt they have racked up in years past; Chinese individuals looking for higher returns overseas amid worsening asset bubbles at home; Chinese businesses investing more overseas as the domestic economy is plagued by persistent overcapacity. As the yuan gets weaker, the desire among companies and individuals to move money out becomes stronger, which in turn puts even more downward pressure on the yuan. To prevent more funds from exiting, the authorities have taken measures to restrict outbound investments by Chinese companies as well as individuals. But the battle to keep money at home is likely to get even tougher next year as many investors expect the yuan to weaken further.

5. Is there a political element associated with this move? Is there any message being sent to Washington?

Don't read too much into it. The adjustment, analysts say, is more a function of the central bank trying to arrest the steep decline in the yuan and curb outflows. The People's Bank of China has said in the past that it will continue "improving" the basket mechanism as it evolves. Those pledges were made months before Donald Trump won the U.S. presidential election. Even though Mr. Trump has threatened to label China a currency manipulator, all Beijing has done in the past year is to prop up the yuan and prevent it from falling too sharply. The latest move is in keeping with that strategy, even as some economists within China have urged the authorities to let the yuan find its bottom quickly.

6. Is this move overall about stability and control?

The basket adjustment, many analysts say, should give the central bank more room to maneuver to keep the yuan from falling too fast in the event of continued dollar strength. So it is a way for the authorities to have more control over theyuan's fate. That's in line with a key policy message sent from a top-level meeting earlier this month, where China's leaders indicated maintaining the yuan's "basic stability" will be a main economic task for next year.

Write to Lingling Wei at lingling.wei@wsj.com

(END) Dow Jones Newswires

December 29, 2016 12:42 ET (17:42 GMT)

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