SHANGHAI/HONG KONG, Jan 13 (Reuters) - China's yuan, fresh from a second year of weakening against the U.S. dollar, is enjoying an unusual turn as a haven as Washington and Beijing prepare to sign an eagerly awaited Phase 1 trade deal this week.
Analysts and traders say Beijing might also be encouraging a firmer yuan as a concession to U.S. President Donald Trump, who has repeatedly accused China in the past of unfairly devaluing its currency, with some speculating that the trade deal could include a moratorium on currency manipulation.
That could set the stage for further strength as attractive valuations for Chinese assets boost global demand for the tightly managed yuan, which has risen more than 2.5% against the dollar since early December.
Beijing's steady hand on the yuan's tiller in a week that saw global asset prices buffeted over tensions in the Middle East is also burnishing its appeal.
"Compared with their peers, yuan-denominated assets are a preferable choice," said Li Haitao, fund manager at Hexa Asset Management in Shanghai.
Record foreign holdings of Chinese bonds illustrate the rising interest.
China's foreign exchange trading platform said last week that net purchases of bonds by offshore investors reached 1.1 trillion yuan ($158.93 billion) in 2019, and official data shows that foreigners held 1.31 trillion yuan worth of Chinese government bonds at the end of December, the 10th straight month of record-high holdings.
The inclusion of Chinese bonds in global indexes is driving purchases by index trackers, while higher yields are luring foreign investments.
"In China, government bonds yield about 3%. In developed countries, bonds yield 1% or less," said Desmond Soon, senior portfolio manager at Western Asset Management in Singapore. Western Asset started buying Chinese bonds last year and will increase its exposure, he said.
China's equity market is also attracting investors, even after strong gains last year.
"Compared with the U.S. stock market, the valuation of Chinese equities remains relatively low. And markets are very optimistic toward the signing of the Phase 1 trade deal," said Zhu Chaoping, global market strategist at J.P. Morgan Asset Management in Shanghai, adding that inflows into Chinese equities are underpinning the yuan.
There are clear risks, however, for the yuan. It fell 5.3% in 2018 and 1.3% last year amid faltering economic growth and the Sino-U.S. trade rift.
If trade tensions rise, Beijing may find the cost of a strong yuan hard to justify with the economy growing at its slowest pace in three decades. A Reuters poll last week found the yuan's recent gains may be temporary and projected further losses this year.
A Chinese bank trader said the yuan's future direction is highly dependent on the central bank's attitude, and Zhu at JPMorgan Asset Management said that Phase 2 trade negotiations are likely to be difficult.
Moreover, the yuan's safe-haven characteristics only emerge periodically, said Li at Hexa Asset Management, echoing analysts who say the currency lacks many attributes of a proper haven, including full convertibility.
"The yuan is now in a time period that attracts foreign investors amid high yields in China's bond market," said Li. "In the long run, it is hard to tell."
Market players believe the People's Bank of China (PBOC) has been encouraging the currency higher in recent days, with traders seeing major state-owned banks selling dollars. Some strengthening in January is normal as companies traditionally sell dollars for yuan to make payments before the Lunar New Year holiday, but the bank sales reinforced the trend.
The yuan hit a peak of 6.8968 per dollar on Monday, its firmest level in more than five months.
"This round of yuan appreciation was very likely led by the central bank," said the trader at a Chinese bank.
Major state-owned banks are widely believed to trade on behalf of the PBOC, but they can also trade for their clients and with their own accounts.
The PBOC has also consistently set the currency's daily midpoint in line with market forecasts, rather than attempting to rein in appreciation expectations.
With regional currencies under the sway of the yuan, Beijing's apparent willingness to accept a stronger currency has had an impact beyond China. Jimond Wong, senior fixed-income portfolio manager at Manulife Investment Management in Hong Kong, said the tempering of the depreciation expectations for the yuan made it an anchor in the region.
"That gave us more comfort to overweight some of the higher-yielding currencies, such as Indonesian rupiah and Malaysian ringgit."
($1 = 6.9214 Chinese yuan)
Reporting by Winni Zhou and Noah Sin; Additional reporting by Samuel Shen; Writing by Andrew Galbraith Editing by Shri Navaratnam