Scenarios: Where next for China's yuan?

BEIJING (Reuters) - China has vowed to resume currency reform by increasing the yuan's flexibility, indicating that it will end a 23-month-old peg to the dollar.

But it has said little about what this means in practice.

Below are scenarios for how Beijing will manage the exchange rate in the coming weeks.

GRADUAL APPRECIATION

* Probability: Most likely

In its announcement, the central bank said that exchange rate reform would be gradual, ruling out both major appreciation and a one-off revaluation.

The strength of China's economic recovery gave policymakers the confidence to end the peg that had helped cushion the economy from the global financial crisis, but they remain worried that external demand is still not on a solid footing, especially with European debt worries in the background.

Nevertheless, China needs to allow the yuan to rise, even if it is in tiny steps, to prove that it is serious in its commitment to make the currency more flexible. U.S. Treasury Secretary Timothy Geithner stressed that Beijing's actions would speak louder than words.

Under this scenario, the central bank could use its setting of the yuan's daily reference rate to nudge the exchange rate up by modest amounts each day, for example from 6.8260 per dollar to 6.8250 per dollar, for a few months until the global economic picture becomes clearer.

Any rally in global equity markets and yuan forwards may fade out quickly and even reverse as disappointment sets in that China's reform is not more radical.

TWO-WAY VOLATILITY

* Probability: Possible

In explaining how yuan reform will proceed, the central bank said it will increase the exchange rate's flexibility and ensure that it could both rise and fall depending on market conditions.

For a long time, China has wanted to introduce more two-way risk into the exchange rate. In theory, traders will no longer be able to assume that the yuan can only move in one direction -- up.

In the past, the yuan rarely fluctuated more than 0.1 percent in intraday trading, even though the trading band permitted a rise or fall of 0.5 percent against the dollar each day. Beijing will be more determined to increase volatility this time, to discourage the hot-money inflows that accompanied its steady appreciation from 2005 to 2008.

Li Daokui, an academic adviser to the central bank, said that a sustained fall in the euro against the dollar could also lead to a decline in the yuan against the dollar.

In other words, on days when the dollar is falling globally, Beijing may push the yuan up slightly. When the dollar is strong, the Chinese currency may pare these gains.

But marked depreciation of the yuan would infuriate lawmakers in Washington, auguring poorly for a trade dispute.

And given the widespread belief among investors that the yuan is undervalued, it will be hard to counter the view that the currency remains a one-way bet from a longer-term perspective, even if the day-to-day ride may be bumpier.

BIG EARLY GAINS

* Probability: Unlikely

Viewed abstractly, there is a strong rationale for allowing a major appreciation of the yuan right out of the starting blocks.

Speculators may be tempted to pour money into China to benefit from a stronger yuan, but if Beijing moves the yuan up quickly enough, many may conclude that they have missed the best opportunity and so stay away.

Similarly, hawks in the U.S. Congress are ready to pounce if China only tip-toes toward a stronger yuan.

But the government will be loath to push the yuan up too aggressively. Politically, it would look like an embarrassing about-face, having sworn off a one-off appreciation.

And concerns about the health of the global economy are real enough to dissuade Beijing from making a move that might prove too disruptive.

STATUS QUO

* Probability: Least likely

China's announcement that it was resuming yuan reform seemed calculated to disarm critics of its currency regime before a Group of 20 summit this coming weekend in Canada. If Chinese leaders are risk-takers -- and nearly all evidence suggests they are not -- then they might gamble that words alone will be powerful enough.

Keeping the yuan locked at about 6.83 to the dollar would please hard-liners at home who have accused Beijing of capitulating to foreign pressure.

And there is an economic justification for the status quo. The yuan's exchange rate against a basket of currencies has risen strongly in recent months even as it has remained pegged to the dollar, simply because of the broad strength of the U.S. currency.

But continuing the peg would infuriate U.S. lawmakers and strip China of any goodwill it earns from its promise to make the yuan more flexible.

The announcement alone implies that China's top leaders have forged a consensus to break the peg launched in July 2008. Any maintenance of it now would be a massive surprise.

(Reporting by Aileen Wang, Zhou Xin and Simon Rabinovitch: Editing by Neil Fullick)