China Loosens Yuan Grip

It will allow the currency to trade against an overseas basket.
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Updated from 7:51 a.m. EDT

China took a symbolic first step toward currency deregulation Thursday by unhitching the yuan from the dollar and agreeing to set its value according to a basket of foreign currencies. Opinions differed on exactly how the new system will operate.

According to a government statement, the step will result in an immediate appreciation of the Chinese currency to 8.11 per dollar from its longstanding peg of 8.28. From now on, the yuan's value will be nominally tied to a basket of currencies that would presumably include the dollar, yen and euro.

Once the new benchmark is established, China said, the yuan will be allowed to rise or fall in a 0.3% band against the dollar. The narrow range will prevent the kind of appreciation many believe the yuan is due, and makes Thursday's move more symbolic than economically meaningful.

"When the U.S. political pressure was put on, it wasn't envisioning a 0.3% band. But it is a start," said Barry Hyman, equity market strategist with Ehrenkrantz King Nussbaum. "It's their acknowledgement that they're entering into the world economy."

The new policy is described by China's government as a "managed floating exchange rate regime." Carl Weinberg, the chief economist at High Frequency Economics, says a close reading of the statement suggests the dollar will in fact be one of several foreign currencies to which the 0.3% variance is applied daily at the discretion of Chinese authorities.

"There are a lot of mechanical issues that are left unresolved by this statement," Weinberg said. "It would be wrong, we think, to assume anything about the way this peg will be directed, either in terms of magnitude or direction over time."

The dollar fell as traders bet that China's government will step up purchases of other foreign currencies. According to

Bloomberg

, China spent $193 billion to maintain the 8.3-per-dollar peg in 2004, up 41% from its 2003 layout. Oil firmed on the news but remained below its Wednesday close.

"The first reaction was the dollar trading off against the Asian currencies," said Brian Williamson, equity trader with Boston Co. Asset Management. "You'll see a strengthening yuan versus the dollar, which will make their exports more expensive to us and our exports cheaper to them."

Thursday's action is the first major overhaul of Chinese currency policy in a decade and follows several years of increasingly harsh criticism from trading partners. In June, the Treasury Department threatened to sanction China as a "currency manipulator" if something wasn't done to allow market forces to influence the yuan's value.

Maintaining the currency at what most economists believe is an artificially low level has crimped China's ability to use interest rates to cool its red-hot economy. On Wednesday, China's National Bureau of Statistics said the country's gross domestic product grew by 9.5% in the first half of 2005, more than expected, and that domestic retail fuel sales jumped by 37% in the same time period.