China"s yuan on Friday weakened sharply from a 3-1/2-year high against the dollar, after the central bank set a much weaker-than-expected midpoint following a directive the previous day that banks hold more foreign exchange in reserve. Before the market open on Friday, the People"s Bank of China (PBOC) set the midpoint rate at 6.3702 per dollar, 204 pips or 0.32% weaker than the previous fix of 6.3498. But the guidance was much softer than market projections, traders and analysts said, and was 203 pips weaker than Reuters estimate of 6.3499 per dollar. "I have never seen such big deviation (between forecast and official guidance) since the FX reform," said a trader at a Chinese bank, referring to China"s one-off sharp yuan devaluation on Aug. 11, 2015 by fixing its midpoint suddenly weaker by about 2%. The midpoint dragged both onshore and offshore yuan to their lowest in about two weeks. The onshore yuan touched a low of 6.39 per dollar in early trade, the softest level since Nov. 26 and lost about 0.75% against the dollar from Thursday"s peak. Its offshore counterpart eased to 6.3892 per dollar at one point, the weakest since Nov. 29. "The PBOC"s two-pronged approach to suppress the yuan"s appreciation sent out a strong policy signal. And the yuan is expected to return to the 6.4 per dollar level," said Ken Cheung, chief Asian FX strategist at Mizuho Bank. Late on Thursday, the PBOC directed financial institutions to hold more foreign exchange in reserve for a second time this year, seen as an attempt to slow down a recent rapid appreciation of the yuan. read more "It basically means banks need to set aside more of their FX deposits and means these banks will need to replace these "lost" FX deposits elsewhere, basically by selling yuan and buying FX," said Stuart Cole, head macro economist at Equiti Capital in London. "This should help to stem the appreciation we have been seeing since August in the value of the yuan, a strong currency being the last thing the Chinese authorities will want as it attempts to address the slowdown in domestic growth it is seeing." Reporting by Winni Zhou and Andrew Galbraith in Shanghai and Saikat Chatterjee in London; Editing by Jacqueline Wong Our Standards: The Thomson Reuters Trust Principles.