China makes good on flexibility vow, yuan falls

China makes good on flexibility vow, and shows that floating the currency does not include one-way bets for appreciation

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22/06/2010 17:06

By Jason Subler and Lu Jianxin

SHANGHAI (Reuters) - China pulled back the veil on its new currency regime a little further on Tuesday, appearing to engineer a fall in the yuan to make clear its vow of flexibility did not include one-way bets for appreciation.
Big Chinese state-owned banks kept the yuan in check, a day after its biggest rise since the currency was revalued in 2005, and the Foreign Ministry said change would be gradual, indicating the yuan's appreciation will be far slower than the pace demanded by critics in the West.
The two-way movement in the yuan is not great by the standard of freely floated currencies but is rare in China, where until this week the central bank had squashed intraday volatility via intervention on most trading days.

China has started to relax its control over the yuan ahead of this weekend's G20 summit of world leaders in Canada, breaking a two-year dollar peg that had been a lightning rod for critics who say the currency is undervalued and gives Chinese exporters an unfair trade advantage.

"China has backed up all the talk with action, and President Hu (Jintao) will arrive in Toronto later this week with tangible evidence that China is serious about increasing the flexibility of its exchange rate," said Brian Jackson, strategist with Royal Bank of Canada in Hong Kong.

"We still may see moves in either direction from day to day, but we think the trend in the weeks and months ahead will be for the yuan to make limited but meaningful gains against the dollar."

Under its new freedom, the yuan rose on Monday more than 0.4 percent, the biggest rise in a day since its landmark revaluation in 2005. It also came close to hitting its trading limit of 0.5 percent, an amount the currency can move either side of a reference point set each morning by the central bank.

On Tuesday, the yuan fell just over 0.2 percent.

The fall disappointed many market players, who had initially thought the central bank's decision to set the reference rate in line with Monday's close was a sign that it was willing to let the currency strengthen further.

State-owned banks stepped in to the market by mid-morning and aggressively bought dollars, traders said, suggesting authorities want to control the pace of the yuan's appreciation.

The People's Bank of China, the central bank, made no secret that it would not allow the yuan to appreciate too fast when it announced the currency reform at the weekend.

The Foreign Ministry reiterated on Tuesday that any change in the yuan would come only gradually.

By allowing for greater ups and downs day to day, though, the central bank will move a step closer to its long-stated aim of developing a more mature market in which companies learn to hedge against foreign exchange risks, part of China's overall efforts to develop Shanghai into a global financial centre by 2020.

The central bank signalled another step on the way to ultimately allowing the yuan to become fully convertible on Tuesday, confirming it would expand a pilot programme under which companies can invoice and pay for imports and exports in yuan.

Still, markets and critics in the United States and other countries are unlikely to be easily convinced of the depth of the currency reforms unless they see a significant rise in the yuan.

Markets surged on Monday after Beijing's weekend vow, on optimism a stronger currency would boost the fast-growing economy's purchasing power.

But doubts about the speed of yuan appreciation had already begun to surface in the United States on Monday. Asian stocks then reversed their gains on Tuesday as investors took profits from the rally on Monday.

Commodities also pared their gains, as did commodity-linked currencies like the Australian and Canadian dollars.

HOW FLEXIBLE?

Many economists see China's currency strengthening further in coming days but at a very modest pace, further diluting hopes for big market gains.

A Reuters poll of 33 economists forecast the yuan would rise to 6.67 per dollar by the end the year, a increase of 2.4 percent from late last week before China's policy announcement and similar to the appreciation implied by offshore non-deliverable forwards.

The central bank is likely using a basket of currencies as a reference for the exchange rate, meaning that if other currencies such as the euro start to strengthen again, the yuan could rise against the dollar with them, said Ha Jiming, chief economist for China International Capital Corp in Beijing.

"There's an automatic adjustment mechanism embedded in this policy," Ha told Reuters Insider TV.
"By using a basket of currencies as a reference, it means that when the dollar appreciates against the euro, the RMB could appreciate against the euro as well but may not necessarily appreciate against the dollar. And the opposite is true."

Even with such increased movement expected in the long run, the challenge for China going into this weekend's G20 summit will be to convince other countries that it has made a genuine move to a more flexible currency.

"We're obviously encouraged, but we'll be monitoring the progress," White House spokesman Bill Burton said in Washington. "Implementation here is going to be key, and so we're just going to be keeping an eye on that."
Canada's Prime Minister Stephen Harper made a similar point.

"The proof will be in the pudding over time," he told Reuters in an interview.

"But I think it's fair to say this is a very positive announcement by China. More broadly it does show China not simply doing some positive things, but China assuming a more global view," he said.

(Additional reporting by Koh Gui Qing and Karen Yeung; additional writing by Wayne Cole; Editing by Neil Fullick)