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China unshackles yuan and investors rejoice

China's yuan surged on Monday the most since its revaluation in 2005, sending a clear signal ahead of this weekend's G20 summit that Beijing is sticking to its word of allowing greater currency flexibility.
/ Source: Reuters

China's yuan surged on Monday the most since its revaluation in 2005, sending a clear signal ahead of this weekend's G20 summit that Beijing is sticking to its word of allowing greater currency flexibility.

The central bank has maintained the peg since the middle of 2008, a controversial policy aimed at steadying the world's fastest-growing major economy during the global economic downturn.

But the central bank stepped aside on Monday to back up its surprise weekend announcement that it would allow greater flexibility for the yuan, buying some time against Western critics who argue the currency is undervalued and gives China an unfair advantage in world trade.

After the People's Bank of China (PBOC), the central bank, set the daily reference point for trading, the yuan rose by 0.45 percent to as high as 6.7969 per dollar -- the biggest intraday rise since China revalued the currency in 2005.

Still, while the yuan's rise may signal China's intention to let financial markets play a bigger role, the central bank showed it had ultimate control of the market by setting the reference rate for the day's trading at the same level as Friday's fixing.

"If they want to show that the exchange rate is more market driven, then why not allow the market to drive the change rather than drive a change through the fixing?" said Stephen Green, head of China research at Standard Chartered in Shanghai.

"Some people suspect the PBOC guides the fixing, so if you allow the market to determine the rate and intra-day trading, then that's a more flexible exchange rate than guiding the fixing," he said.

The yuan is permitted to rise or fall 0.5 percent from the daily reference rate, but it has rarely tested that band.

China's economic strength gave policymakers confidence to end the peg, but they remain worried demand for China's exports is not on a solid footing given risks like Europe's debt woes.

The central bank ruled out a one-off revaluation of the currency and suggested the yuan's value was close to fair value.

Still, analysts said China needs to show the G20, whose leaders meet June 26-27 in Canada to discuss issues including global trade imbalances, that it is serious in its commitment to make the yuan more flexible.

Indeed, the United States called for "vigorous implementation" of the policy.

"You have to assume the yuan will rise this week given all the political angst. They need to turn up at the G20 with something real," said Sean Callow, senior currency strategist at Westpac in Sydney.

China's decision to keep the currency pegged to the U.S. dollar since the middle of 2008 has been a lightning rod for criticism that Beijing has been gaining an unfair trade advantage during the global downturn.

Its announcement at the weekend that it would give the currency greater flexibility was welcomed globally, albeit with some caution as policymakers waited to see what the words would mean in practice.

Markets, for their part, were not so circumspect.

Asian currencies and stocks rose and U.S. Treasuries fell on expectations that China's promise to give the currency new room to move would ease political tensions with the West and encourage investors to snap up riskier assets.

Commodities and oil also surged, as a stronger currency would give the world's third-biggest economy more purchasing power to buy foreign goods, which would be positive for world trade, especially for commodity exporters such as Australia, Brazil, Canada and New Zealand.

Crude prices rose 2 percent to the highest since early may, while copper and zinc traded in Shanghai both rose by their daily limits.

Many economists see the currency strengthening further in coming days, albeit at a very modest pace, meaning some of Monday's early exuberance could turn out to be overdone.

A Reuters poll of 33 economists showed they expected the yuan to end the year at 6.67 per dollar, a rise 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 may also be keen in the months ahead to increase the volatility of the yuan to discourage the hot-money flows that accompanied its steady appreciation from 2005 to 2008.

Economists say a higher yuan could help temper inflation in China by pushing down import prices, which in turn could reduce the need for Beijing to tighten monetary policy. Markets had been worried that China could over-tighten and suffer a hard landing.

Still, some in China were not so pleased to see what they viewed as their government's bowing to outside pressure on its yuan, also known as the renminbi.

"The renminbi should appreciate, but not now, only when our national power has also risen. We're still a country that relies on exports," wrote one online reader of popular tabloid the Global Times.

"The renminbi's appreciation should be based on the national need, and should not be forced on us by any other country," wrote another.