China sent its clearest signal yet that it was ready to allow yuan appreciation after an 18-month hiatus, saying on Wednesday it would consider major currencies, not just the dollar, in guiding the exchange rate.

In its third-quarter monetary policy report, the People's Bank of China departed from well-worn language on keeping the yuan "basically stable at a reasonable and balanced level." It hinted instead at a shift from an effective dollar peg that has been in place since the middle of last year.

"Following the principles of initiative, controllability and gradualism, with reference to international capital flows and changes in major currencies, we will improve the yuan exchange-rate formation mechanism," the central bank said in a 46-page monetary policy report.

The comments, published just days before a visit to Shanghai and Beijing by U.S. President Barack Obama, set out the possibility of a return to exchange rate appreciation that began with a landmark July 2005 revaluation.

The yuan strengthened by nearly 20 percent against the dollar until concern over the impact of the global financial crisis prompted Beijing to hit the brakes in the middle of last year to protect exporters.

The yuan has been stuck at around 6.83 per dollar ever since, drawing increasing ire from other countries, especially as it has followed the dollar downwards against other currencies.

The dollar has dropped 13 percent against a basket of major currencies including the yen and euro since mid-February.

Back to a Basket?

Some analysts have called for the return to a genuine basket of currencies, which the central bank said in 2005 it would use as a reference for the yuan.

"I think the wording change ... shows that it is an irresistible trend for China to resume yuan appreciation," said Xing Ziqiang, an economist at China International Capital Corp (CICC) in Beijing.

"It is not sustainable for the yuan to always be pegged to the U.S. dollar; after all, the repegging since late 2008 was just part of China's measures to address the global financial crisis, and now the impact of the financial crisis is fading, so the yuan should resume appreciation sooner or later."

The central bank's report came just hours after data that showed the world's third-largest economy had firmly put the worst of the global financial crisis behind it. Factory output growth surged to a 19-month high of 16.2 percent in October.

While exports were still down in year-on-year terms, economists pointed to the likelihood that they would start growing again soon.

Some analysts said the statement could have been timed to send a signal ahead of Obama's Nov. 15-18 visit to China.

Obama told Reuters on Monday that he planned to raise the currency issue during his trip.

However, Beijing is increasingly facing complaints about its currency from other emerging economies, which see an undervalued yuan as undercutting them in global markets.

No Sudden Shift

Those concerns were evident in a draft statement from APEC finance ministers circulated on Wednesday, in which they call for flexible interest rates and exchange rates as a way of redressing economic balances.

"We agreed that flexible prices, including exchange rates and interest rates, play a critical role in allocating resources efficiently, and can facilitate the adjustments needed to support balanced and sustainable global growth," said the latest draft statement by the finance ministers dated Nov. 10.

While the statement could change in its final form, a deputy Chinese finance minister was present at discussions on it, suggesting some level of agreement by Beijing on the wording.

However, analysts were quick to caution against expecting any sudden shift in the yuan's actual value, given China's penchant for carrying out any reforms gradually.

"The central bank's worries about capital flows, liquidity, and inflation signal growing pressure for yuan appreciation," said Ben Simpfendorfer, strategist with the Royal Bank of Scotland in Hong Kong.

"But I'm not looking for gains in the currency until the second quarter as the export sector still faces large challenges and margin pressure." Markets priced in a slightly greater appreciation over the coming year.

Offshore one-year dollar/yuan non-deliverable forwards (NDFs) fell to 6.6075 bid late on Wednesday compared with Tuesday's close of 6.6320.

Yuan appreciation implied by NDFs, which moves inversely with the forwards, was around 3.3 percent in a year compared with 3.06 percent before the announcement.

Xing with CICC said he was expecting even greater appreciation, of 3 to 5 percent next year, in the face of growing external and internal pressure.

"For China's own sake of balancing its economic growth and reducing its large surplus in the trade account, it is also necessary for the government to make the yuan more flexible."

http://www.cnbc.com/id/33850971

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