China makes good on flexibility vow, yuan falls

SHANGHAI Tue Jun 22, 2010 5:15pm EDT

1 of 5. An clerk counts yuan banknotes at a bank in Hefei, Anhui province, June 20, 2010. China will gradually make the yuan's exchange rate more flexible, the central bank said on Saturday, indicating that it was ready to break a 23-month-old U.S. dollar peg.

Credit: Reuters/Stringer

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SHANGHAI (Reuters) - China appeared to engineer a fall in the yuan on Tuesday to make clear that its newly flexible currency was not a one-way bet to appreciate, as markets reflected waning optimism over Beijing's new policy.

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 started to relax its control over the yuan ahead of this weekend's G20 summit of world leaders in Canada, easing a two-year dollar peg that was 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."

A Reuters poll of 33 economists forecast the yuan would rise to 6.67 per dollar by the end the year, an 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.

EUPHORIA OVERDONE

Under its new freedom, the yuan rose on Monday by more than 0.4 percent, the biggest rise in a day since its landmark revaluation in 2005. It 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 initially thought the central bank's decision to set the reference rate in line with Monday's close was a sign it was willing to let the currency strengthen further.

Crude oil fell below $78 per barrel on Tuesday on expectations that a slow rise in China's currency would have a more limited impact on global demand than initially anticipated.

"The knee-jerk positive reaction and euphoria related to the yuan news were definitely overdone. So it's logical to see the markets giving up the gains from yesterday," said Eugen Weinberg, head of commodity research at Commerzbank.

Stock markets slipped in Asia and Europe with traders saying optimism over China's move had dissipated and as equity investors took profits from multi-week highs. U.S. stocks also slipped on Tuesday.

Bank of Canada Deputy Governor Timothy Lane said China's move to let its currency appreciate will help reduce global imbalances and take some pressure off the Canadian dollar.

"China's recent decision to enhance the flexibility of its exchange rate is an important step forward. Its full implementation will contribute to strong, sustainable and balanced global economic growth," he said in Winnipeg.

China's state-owned banks stepped in to the market by mid-morning on Tuesday 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 it would not allow the yuan to appreciate too fast when it announced the currency reform at the weekend.

CALLS FOR MORE PRESSURE

China's critics in the United States -- who want flexibility to translate into appreciation and lower Chinese trade surpluses -- have already begun to call for renewed pressure on Beijing.

"We strongly urge further effort by both the U.S. and other G20 governments until China takes specific steps on a scale that addresses the scale of the imbalance," AFL-CIO President Richard Trumka said in a statement.

Trumka, head of the largest U.S. federation of labor unions, said G20 leaders should raise currency manipulation this week in Toronto and called on the U.S. Congress to "act on currency legislation without further delay."

Two lawmakers behind a bill that would punish China's currency misalignment, Republican Representative Tim Murphy and Democratic Representative Tim Ryan, said they would join a group called the Fair Currency Coalition on Wednesday in a rally seeking more pressure on China over the yuan.

By allowing for greater ups and downs, China's 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 center by 2020.

The central bank signaled another step on the way to ultimately allowing the yuan to become fully convertible, confirming it would expand a pilot program 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 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 Monday's rally.

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.

The central bank is likely using a basket of currencies as a reference for the exchange rate, meaning 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.

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 it has made a genuine move to a more flexible currency.

The United States and Canada gave China's move positive reviews on Monday, while saying that significance of the policy change depends on how it is implemented.

(Additional reporting by Koh Gui Qing, Karen Yeung, Rod Nickel and Doug Palmer; Additional writing by Paul Eckert; Editing by Neil Fullick and John O'Callaghan)

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