* C.bank eyes steps to slow yuan decline to 7/dollar -sources
* Bill issuance in HK seen signaling bid to curb offshore selling
* Weaker yuan helps China exports, but sharp falls not welcome
* Sharp yuan falls may fuel capital flight, hit stability
By Zheng Li and Kevin Yao
SHANGHAI/BEIJING, May 17 (Reuters) - China's central bank will use foreign exchange intervention and monetary policy tools to stop the yuan weakening past the key 7-per-dollar level in the near-term, three people familiar with the central bank's thinking said.
"At present, rest assured they will certainly not let it break 7," a source told Reuters. A defence of the 7 level could help boost confidence in the currency and soothe investor fears about a sharp depreciation in the yuan, or renminbi, even as souring trade relations with Washington make competitive devaluation a compelling option for Beijing.
"Breaking 7 is beneficial to China because it can reduce some of the effects of tariff increases, but the impact on our renminbi confidence is negative and funds will flow out," the source said.
The yuan fell to its weakest level since December on Friday, and to within striking distance of the 7 mark last seen during the 2008 financial crisis.
It has weakened 3 percent in the past month on fading hopes of a deal being struck in the long-running trade war between Beijing and Washington. The latest flare-up in those tensions saw U.S. President Donald Trump increase tariffs on Chinese imports, provoking a similar tariff rise from China.
Although a weaker yuan would support Chinese exporters, the decline would need to be significant to offset the impact of higher U.S. tariffs. Such a fall could in turn fuel capital flight and undermine China's economic stability, policy insiders said. The source told Reuters that China's issue of central bank bills in Hong Kong this week was a clear indication the People's Bank of China's wanted to soak up offshore yuan to discourage investors from short-selling it.
The PBOC did not immediately respond to Reuters' request for comment on Friday.
A second source familiar with the PBOC's thinking said the monetary authority might tolerate the yuan weakening to 7 on fundamental factors but would act to prevent speculative short-selling of the currency.
STABILITY VS COMPETITIVENESS
A stable currency is imperative for China as it seeks to balance its investment-driven economy, attract more portfolio inflows and push for global equity and bond index inclusions.
The tightly managed currency fell heavily in 2018 and, before that, in 2015 when the PBOC devalued the currency.
The stakes are much higher now, said Bryan Carter, head of emerging market fixed income at BNP Paribas Asset Management in London.
"A rapid devaluation would shake confidence in the local market and among domestic investors, proving counterproductive," Carter said before Reuters reported source comments on PBOC. China's balancing act goes beyond maintaining domestic confidence. As the country's current account is seen swinging from a decades-long surplus toward a deficit, the yuan's exchange rate is expected to become more volatile.
A majority of more than 12 money managers, traders and economists Reuters spoke over the past week expected PBOC to defend the renminbi.
While China primarily used direct dollar-selling intervention in 2015, it switched to more unconventional methods such as tightening yuan funding costs and using swaps as the currency fell in 2018.
The PBOC re-introduced a counter-cyclical factor, a secret component it uses in adjusting the daily reference point for the yuan's trading band, in August last year. Market participants say it has been using that factor to temper depreciation expectations in the past week, by setting a firmer benchmark for yuan than implied by the moves of global currencies.
"I don’t believe we will rely on yuan depreciation to boost exports. The yuan is not only for facilitating foreign trade, but it could also affect capital flows," one of the sources said.
"Barring any sharp rise in the dollar, the possibility for a near-term dip in the yuan below 7 is relatively small."
Going against this thinking is market positioning, which points to further weakness.
In the offshore markets, the currency's value one-year out had weakened to 6.9770 per dollar on Friday, slipping from 6.8482 a week ago just before Trump raised tariffs.
A sharp change in the risk-reversal measures in the yuan options market, which indicates the bias towards the currency, also showed investors were betting the currency will weaken.
However, even with these dynamics, there are firmer expectations the PBOC won't tolerate a sharp selloff.
Liam Spillane, who manages $11.5 billion in emerging market debt for Aviva Investors, told Reuters he was positioning his portfolio "a little bit more" defensively following renewed escalation in the trade war.
As a result, Spillane has cut exposure in Indonesian government bonds and South African debt while adding small long dollar positions against the Turkish Lira and Taiwanese dollar. At the same time, he is "overweight" the renminbi.
"We've had a long-held belief that Chinese authorities will not allow the renminbi to materially depreciate. We firmly believe they won't use the renminbi as a bargaining tool in the ongoing trade talks with the United States," he said.
(Additional reporting by Swati Pandey in SYDNEY, Daniel Leussink in TOKYO, Noah Sin in HONG KONG, Winni Zhou in SHANGHAI and Karin Stroeker in LONDON; Writing by Vidya Ranganathan in SINGAPORE; Editing by Sam Holmes)
