China Ends Yuan Dollar Peg, Moves to Currency Basket (Update13)

China Travel Services

July 21 (Bloomberg) -- China let the yuan strengthen against the dollar for the first time in a decade, responding to criticism from the U.S. and Europe that an undervalued currency gives the nation an unfair trade advantage.

China ended the yuan's peg of about 8.3 per dollar that had been in place since 1995 and will allow it to fluctuate versus a basket of currencies, the central bank said on its Web site. The new yuan will appreciate 2.1 percent to 8.11 per dollar under today's new rate. The bank kept a trading band of 0.3 percent.

The shift may ``bring imports and exports into balance,'' the People's Bank of China said, after the trade surplus swelled to a record. The change will also give the central bank more scope to cool an economy that grew 9.5 percent in the second quarter and help ease concern in the U.S. Congress that China's fixed exchange rate is contributing to the loss of factory jobs.

``This was the tiniest and smallest move China could make,'' said Stephen Jen, head of global currency strategy at Morgan Stanley in London. ``The motivation for making such a small move is due to political concerns and that the Chinese could buy some time with the Americans.''

Federal Reserve Chairman Alan Greenspan and U.S. Treasury Secretary John Snow welcomed the decision as the first step in a series of adjustments to China's exchange rate. German Finance Minister Hans Eichel said the statement complies with demands from the Group of Seven major industrial nations.

`First Step'

The yen rose against 15 of the 16 most actively traded currencies and had the biggest gain versus the dollar in more than three years on speculation Asian governments will be more tolerant of stronger exchange rates. The yield on the 10-year Treasury note rose 7 basis points to 4.23 percent.

The shift will reduce the pressure on China's competitors such as Korea and India to prevent their currencies from gaining. Malaysia immediately scrapped the ringgit's seven-year peg to the dollar and said it would adopt a managed float. Hong Kong kept its own currency peg.

China's decision may also raise costs for U.S. companies such as Wal-Mart Stories Inc. and Target Corp. that buy inexpensive clothing and jewelry from China. Target shares fell 1.7 percent $58.95 at 1:04 p.m. in New York. Wal-Mart stock lost 0.9 percent to $49.53.

``This was the first step in a series of revaluations that we can expect in the coming years,'' said Paresh Upadhyaya, a currency portfolio manager who is part of a group that oversees $29 billion at Putnam Investments in Boston. ``They'll be gradual.''

Monetary Policy

China's central bank will announce the yuan's exchange rate against currencies such as the dollar each day at the close of trading in China. Letting the yuan strengthen may help China control inflation by reducing the cost of imported products such as oil and copper, which are priced in dollars. It also gives the central bank, which has sold yuan to prevent the currency from appreciating, more scope to increase interest rates.

``Adjusting the yuan exchange rate will enhance the independence and efficiency of monetary policy and help bring imports and exports into balance,'' the central bank said in a statement in Chinese on its Web site.

Currency Basket

The People's Bank of China didn't identify the contents of the currency basket. The group may consist of 10 currencies, including the dollar, euro, yen, British pound and South Korean won, said Monica Fan, head of foreign-exchange strategy at RBC Capital Markets Ltd. in London.

Singapore manages its currency by allowing it to fluctuate against a group of the nation's major trading partners. The Monetary Authority of Singapore, which reviews its policy every six months, hasn't disclosed the composition of the basket.

China's announcement raises more questions than it answers, said Greg Anderson, a currency strategist at ABN Amro Holding NV in Chicago. The central bank didn't mention any limit on the extent of appreciation it will allow, suggesting the yuan may strengthen 0.3 percent each day, to about 7.61 per dollar in a month, Anderson wrote in a report.

Permitting the yuan to trade more freely would answer criticism from the Bush administration and some members of the U.S. Congress who blame China's currency policy for a record trade deficit and the loss of about 2.8 million manufacturing jobs. White House spokesman Scott McClellan called the change a step toward a market-based system.

Pressure From U.S.

The Treasury Department's twice-yearly review of exchange rate policies said last month that China needs to make the yuan more flexible or risk being branded a currency manipulator.

``I welcome China's announcement today that it is adopting a more flexible exchange rate regime,'' Snow said in a statement. ``I particularly noted China's objective of allowing the market to fully play its role.''

The U.S. trade gap with China rose to a record $162 billion last year and the National Association of Manufacturers, a lobby group, expects it to grow to $225 billion this year.

Charles Schumer, a Democratic senator from New York and author of a measure that threatens new duties on Chinese goods, said China's move is a ``good first step.''

Chinese Economy

China's $1.6 trillion economy has tripled in size since the yuan peg was introduced. Foreign direct investment jumped 14 percent to a record $60.6 billion in 2004, according to government figures. A year earlier, China surpassed the U.S. as the biggest recipient.

The People's Bank of China has to buy dollars that flow into the country to maintain the currency peg, adding yuan to the economy and diluting the impact of state lending curbs. The central bank spent $193 billion buying foreign currency in 2004, a 41 percent increase from a year earlier, it said on Feb. 28.

The central bank raised its lending and deposit rates on Oct. 28, the first increase in a decade, to complement limits on investment in property, steel and autos that have driven prices higher and strained power supplies.

``The next move is that people will estimate the stronger yuan's impact on the growth rate,'' said Steven Chang, vice president of global markets at State Street Bank & Trust Co. in Hong Kong. ``They may think the growth rate is going to slow down and wonder if it is going to be so much more positive for the Asian currencies.''

China is seeking to cap inflation at 4 percent this year from a peak of 5.3 percent in August. Inflation in 2005 is likely to slow to between 3.0 percent and 3.5 percent, the People's Bank of China said on June 14. The consumer price index climbed 1.8 percent in May from a year earlier, the National Bureau of Statistics said on June 13.

To contact the reporter on this story:
Yumi Kuramitsu in Hong Kong ykuramitsu@bloomberg.net