Yuan traders are reckoning the widely-held assumption that the currency would appreciate 2-3% this year as an unexpected worsening of economic conditions globally and a looming slowdown in China would subsequently drive investors towards safer haven assets. The brewing debt crisis in the euro zone has of late developed into a major political problem with risk aversion driving the dollar index to its highest since September 2010 further casting doubts on whether Beijing can afford to let the Yuan to continue strengthen against the greenback.

Recently, China posted scores of weak data reflecting the struggling nature of the economy for April, which caused the People’s Bank of China (PBOC) to immediately reduce banks’ reserve requirement ratios, injecting liquidity into the economy. The news and the ensuing cut aggravated concerns over the health of the world’s second-largest economy. Subsequently, traders say the banks and their clients started to short Yuan during the dollar rally this month.

A sharp depreciation in the Yuan could divert funds from China and may end up adding pressure to the desired growth. Growth in China’s GDP slowed to a near three-year low of 8.1% in the first quarter. Many economists now instigate that the growth of the world’s second-largest economy could fall below 8% in the second quarter. Ironically, at the start of this year, many economists forecasted that 8.5% growth for China for the year 2012 would severely startle markets.

The wild card, of course, is how the United States, which faces presidential election this year, will respond to a pause in Yuan appreciation. There has always been a strong diplomatic aspect to the Yuan exchange rate, and much of the rise in its value against the dollar has been in reaction - although usually delayed - to U.S. pressure.