China edges towards dropping dollar/yuan peg

By Alan Wheatley, China Economics Editor

BEIJING (BestGrowthStock) – Expectations in markets have hardened to the point that a decision by China to drop the yuan’s 21-month-old peg to the dollar is a question of when, not if.

But the agreement ends there.

It is impossible to tell how and when Beijing will reintroduce exchange rate flexibility given the clashing priorities of various constituencies within the administration and the highly political nature of the issue, which has become a touchstone of Sino-U.S. ties.

The decision is of such importance that it will be taken by President Hu Jintao and the ruling Communist Party’s top leaders. Here are some of the options they will be considering.

TIMING OF ANY CHANGE

* Second quarter a good bet; could be delayed till Q3

After being allowed to gain 21 percent against the dollar between July 2005 and July 2008, the yuan was then quietly repegged near 6.83 per dollar to help Chinese exporters ride out the global credit crunch.

A solid consensus appears to have formed among policymakers — with some dissenters in the pro-export Ministry of Commerce — that this policy has now reached its sell-by date: it no longer makes sense for a dynamic China to slavishly track the dollar, a currency that many in Beijing regard as volatile and unsound.

President Hu signaled Beijing’s intentions at a BRICs summit in Brazil last week: “China will firmly stick to a path of reforming the yuan’s exchange rate formation mechanism.”

But politics are muddying the waters. China cannot be seen to be bowing to foreign demands. At the same time, Beijing is alert to the pressure from Congress on the administration of U.S. President Barack Obama.

“In making reforms, we will give careful consideration to global economic developments and changes, as well as to China’s economic condition,” Hu said last week.

The United States will take action if China fails to take steps in the coming months to raise the value of its currency, Sander Levin, an influential lawmaker in the U.S. House of Representatives, said on Monday.

U.S. Treasury Secretary Timothy Geithner bought time by delaying an April 15 report on whether China manipulates its currency and then flew to Beijing for hastily arranged talks with Vice Premier Wang Qishan on April 8.

In postponing the “manipulation” report, Geithner said the high-level U.S.-Chinese Strategic and Economic Dialogue in late May and a Group of 20 summit in Canada in June offered the best avenues for getting China to budge.

Assuming Geithner and Wang reached an understanding on how the diplomatic dance would unfold, one possibility, according to a government adviser in Beijing, is that China will let the yuan resume its climb before the U.S. talks due on May 24-25.

Economists at Standard Chartered are also betting on a May move, possibly in the week of May 10 after the Shanghai World Expo has opened, though some analysts think the move will come later.

SCOPE OF ANY CHANGE

* Gradual rise very likely; small revaluation possible

The government adviser said he expected the People’s Bank of China to quietly take the brakes off the yuan by nudging the currency’s daily midpoint higher.

Standard Chartered, in an April 19 report, said it was looking for much more flexibility in the PBOC’s daily fixings.

The bank ruled out a big one-off move, which it said would look strange given comments last month by Premier Wen Jiabao that the currency was not undervalued.

At the other end of the market spectrum is Societe Generale, which expects a revaluation of 5 to 10 percent in April or May. That is a minority view.

Ting Lu at Merrill Lynch is hedging his bets. “We think it’s likely there will be a token small one-off revaluation, (smaller than the 2.1 percent we saw in July 2005), and it’s possible that there will be no such small jump at all.”

Few, if any, in the market now expect the yuan’s peg will remain until the end of the year.

Offshore yuan forwards are now pricing in 3.25 percent appreciation against the dollar over the 12 months, in line with the median forecast of a Reuters poll last month.

TO ANNOUNCE OR NOT TO ANNOUNCE?

* Confirmation of a shift likely, but maybe not right away

China has repeatedly said that it will continue exchange rate reform. Repegging the yuan in mid-2008 was a “special policy,” according to PBOC Governor Zhou Xiaochuan.

Seen through that prism, China might feel no need to announce it was letting the yuan resume a gradual rise, just as it did not publicize the re-pegging two years ago.

After all, any statement could be interpreted by domestic critics as buckling under U.S. pressure for action.

Conversely, Beijing will want to weigh the international reward of an announcement effect, given that the United States has not been alone in pressing for a shift in the currency.

One compromise, according to the government adviser, would be to acknowledge the shift after the event, for example in the joint communique that will be issued after the Sino-American talks in late May.

ONCE THE INITIAL MOVE HAS HAPPENED

* Gradual band widening likely, possibly accompanied by a shift to managing the yuan against a basket of currencies.

Many economists assume that the PBOC will widen the yuan’s daily trading band, currently plus or minus 0.5 percent from its morning midpoint against the dollar, introducing two-way risk into the market. Traders would no longer be able to assume that the yuan was on the up escalator day in, day out.

A growing number of economists expects China to introduce even more flexibility by managing the yuan in relation to the value of a basket of currencies, much as Singapore does, rather than simply tracking the dollar.

Because the currencies in the basket would bounce around, the day-to-day direction of the yuan would be uncertain — thus deterring the speculative hot money that China abhors — even if Beijing was targeting a gradual trend appreciation.

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(Editing by Tomasz Janowski)

China edges towards dropping dollar/yuan peg