China Says It Will Increase Yuan's Flexibility

China's central bank moved Saturday to head off resurgent international criticism of its currency policies with a pledge to make its tightly controlled exchange rate more flexible, a surprise announcement that was quickly welcomed by the U.S. and others even though the central bank also ruled out a big rise in the yuan.

The People's Bank of China statement, issued on its website, didn't announce any specific changes to the exchange-rate regime. But it was seen as a clear signal that China will let the yuan resume a gradual rise against the U.S. currency—possibly as soon as Monday—after nearly two years of being effectively pegged around 6.83 yuan per dollar. The move comes a week ahead of the Group of 20 summit at which China's exchange-rate policy was expected to be discussed.

"In view of the recent economic situation and financial market developments at home and abroad, and the balance of payments situation in China, the People's Bank of China has decided to proceed further with reform of the renminbi exchange rate regime and to enhance the renminbi exchange rate flexibility," the central bank said in the statement, referring to the Chinese currency by its official name.

China's government fixed the yuan against the dollar in mid-2008, when the global recession was intensifying, as part of several measures to stabilize its economy. But international reaction to the policy has grown increasingly negative in recent months, with many of China's trading partners saying the currency is undervalued and thus gives Chinese-made goods an unfair edge. By abandoning the much-criticized peg, China may be able to defuse a potential political crisis and aid the long-term prospects of its economy, officials and economists said.

How much China allows the yuan to actually appreciate won't be apparent until markets open on Monday, and is likely to depend on the government's assessment of how well the global economy is performing. With the debt crisis in Europe worrying Chinese officials, the movement may not be fast. "The basis for large-scale appreciation of the renminbi exchange rate does not exist," the central bank said in the English-language version of its statement.

China's announcement was timed just ahead of the summit of the G-20 next weekend in Toronto, where Chinese President Hu Jintao will meet U.S. President Barack Obama and the leaders of the world's other major economies. China wanted to avoid its currency policies from becoming a focus of international criticism at the summit, analysts say. Emerging markets like Brazil and India had become increasingly unhappy with the effects of China's pegged currency, and the U.S. political calendar was also starting to heat up.

Many analysts felt the prospects for an early move on the currency had dimmed after the European debt crisis brought in financial markets and the prospect of weaker global growth. And China didn't announce either a one-time appreciation of the currency or a widening of the yuan's daily trading band, measures that some economists had speculated would be included in any reform package. That may indicate that China's appetite for significant change in the currency is limited. As of last week, currency derivative markets were pricing in an appreciation of a little more than 1% against the U.S. dollar over the next 12 months.

On the other hand, China's consumer price inflation went over 3% in May for the first time in a year and a half, which may have increased the pressure on authorities to use a stronger currency to tame higher prices.

When China last followed what it called a managed float with reference to a basket of currencies, it resulted in a 21% gain against the dollar from 2005 to mid-2008, with the fastest appreciation coming in periods of high inflation.

But because of the strength of the dollar this year, China's peg has actually resulted in a sharp appreciation of the yuan against a basket of other currencies. The euro's recent plunge against the dollar means that its value has risen 15% this year against the currency of Europe, China's largest trading partner. So China can legitimately argue that its currency is al..., WSJ
6/19/2010 4:57:56 PM