WRAPUP 4-Peg is dead as China vows yuan flexibility before G20

Sat Jun 19, 2010 6:03pm EDT

* China to gradually make yuan more flexible

* But Beijing says no basis for big changes

* Likely to have small movements through daily rate

* Obama says China's move 'a constructive step'

* Move reduces risk of confrontation at G20 June 26-27 (Adds more background)

By Michael Wei and Alister Bull

BEIJING/WASHINGTON, June 19 (Reuters) - China said on Saturday it would gradually make the yuan more flexible, in a gesture that may deflect foreign criticism at next week's G20 summit but will not quickly yield a big move by its currency.

U.S. President Barack Obama, who prodded China over the yuan in a letter released on Friday, welcomed the news in an indication the danger of a market-roiling confrontation at the Group of 20 meeting in Canada had eased.

"China's decision to increase the flexibility of its exchange rate is a constructive step that can help safeguard the recovery and contribute to a more balanced global economy," Obama said in a statement. [ID:nN19274114]

Other Western leaders and the International Monetary Fund also voiced encouragement that an important strategic ally was making a concession which improves the chances of success at the June 26-27 summit. [ID:nLDE65I0CZ] [ID:nN19148339]

But the announcement by China's central bank, which strongly suggested it was ready to break the currency's 23-month-old dollar peg, was conditioned by an explicit warning ruling out a one-off revaluation or major yuan appreciation.

"The basis for large-scale appreciation of the RMB exchange rate does not exist," the People's Bank of China said.

The yuan is also known as the renminbi, or RMB.

<^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

For full coverage [ID:nSGE65I02M]

Breakingviews [ID:nLDE65I0D5]

Factbox on China's currency system [ID:nSGE65I02Q]

Text of China central bank statement [ID:nTOE65I017]

Graphic r.reuters.com/sut87k

^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

Analysts were broadly positive about the news but cautioned that China, the largest holder of U.S. sovereign debt, may reduce its demand for those securities in the future. China buys U.S. bonds to manage the yuan's peg to the dollar, and greater currency flexibility may dilute that necessity.

The peg, which Beijing defended as a source of stability during the recent global financial crisis, has come under intense criticism from abroad as China's export juggernaut roared back to life.

Much of the rest of the global economy remains sluggish and beset by unemployment in the wake of the financial crisis, and China's policy is seen as stealing jobs from foreign markets.

In particular, by keeping the yuan artificially cheap against the dollar, China makes its imports more attractive for U.S. consumers while making U.S. exports to China more costly.

That has contributed to a massive surplus in China's trade account with the United States, sparking protests that the policy is at the direct expense of American jobs.

TRADE WAR

U.S. patience with Beijing over the yuan has worn thin and lawmakers threaten to penalize it for a strategy they say is unfair and breaks the rules.

Democratic U.S. Senator Charles Schumer, a leading critic, said China's statement was too vague and pledged to press ahead with legal action to raise trade barriers. [ID:nN19183144]

U.S. Treasury Secretary Timothy Geithner, who has delayed publication of a potentially embarrassing report that could cite China as a currency manipulator, also stressed that China's actions would speak louder than words.

"This is an important step but the test is how far and how fast they let the currency appreciate," he said.

The currency report, due on April 15, was put on the back-burner until after the G20 to give China time to act.

Obama needs China's help on a range of other delicate issues, including sanctions against Iran and North Korea for their nuclear programs.

But he must balance quiet diplomacy against an urgent domestic political need to be seen fighting China for U.S. jobs before congressional elections in November.

U.S. businesses must also tread softly with China. Caterpillar Inc (CAT.N), which sells billions of dollars of earthmoving equipment and other products to China each year, said it was heartened by the decision. [ID:nN19167249]

BUBBLE TROUBLE

G20 leaders have promised to tackle so-called global macro imbalances, posed by massive trade surpluses and deficits.

Those are blamed for fostering a bubble in the U.S. housing market in 2008, and contributing to the recent European sovereign debt crisis. Economists say such imbalances are not sustainable in the long term, and warn they may trigger another damaging global financial crisis if investors take fright.

Beijing's recent insistence that the summit was the wrong place to talk about yuan flexibility could have overshadowed the meeting and damaged trust. China reduced that risk with Saturday's announcement.

"This is an important move as it signals recognition by Chinese officials that a more flexible exchange rate is in China's own interest and also acknowledges its responsibility to the international community," said Eswar Prasad, a former head of the International Monetary Fund's China division.

China has long said it would not bow to international pressure over its currency, and the central bank went out of its way to dampen expectations for any big yuan rise.

"We believe this is a positive gesture, suggesting the yuan will soon resume its appreciation against the dollar," said Goldman Sachs economists Yu Song and Helen Qiao.

The news could also ease fears of a trade dispute between the United States and China at a delicate time for the world economy and may propel world stocks markets higher on Monday.

It was clear that China intended its announcement -- published in English at around the same time as Chinese, a departure from usual practice -- to mark the end of the yuan's de facto peg to the dollar. That had been defended as a special protection policy during the global financial crisis.

"The global economy is gradually recovering. The recovery and upturn of the Chinese economy has become more solid with enhanced economic stability," the Chinese central bank said in a statement on its website.

"It is desirable to proceed further with reform of RMB exchange rate regime and increase the RMB exchange rate flexibility," it said.

China has held the yuan at roughly 6.83 to the dollar since July 2008 in an attempt to insulate the fastest-growing major economy from the turmoil sparked by the U.S. credit crunch. (Additional reporting by Phil Smith, Lu Jianxin and Zhou Xin, David Lawder, Andy Sullivan, Emily Kaiser and Lesley Wroughton in Washington, James Kelleher in Chicago; Writing by Simon Rabinovitch and Alister Bull; Editing by Neil Fullick, Kristin Roberts and Peter Cooney)

FILED UNDER: