China should allow an immediate one-off appreciation in the yuan's value and widen the currency's trading band to stem inflows of speculative capital that might fuel inflation, said UBS AG economist Wang Tao.

"China's economic fundamentals mean that the yuan should strengthen," Beijing-based Wang told Bloomberg. "The central bank will find it harder to manage liquidity and inflation when a flood of speculative funds returns, betting on the yuan's appreciation."

The Chinese economy grew at the fastest pace in a year in the second quarter and export declines slowed in September, fueling speculation that policy makers will let the yuan resume appreciation against the dollar.

China's cabinet, the State Council, said last month that managing liquidity is increasingly difficult and signaled that inflation concerns will play a greater role in setting policy.

Policy makers should do "the unexpected", countering perceptions that the currency is a one-way bet, before expectations for gains strengthen, Wang said. She didn't say how much the currency should immediately appreciate.

Yuan forwards, which rose to a 14-month high late last month, suggest the currency will gain 2.3 percent against the dollar in the coming year. The yuan climbed 21 percent over three years after the government scrapped a fixed exchange rate in July 2005.

Yuan convertibility

Stephen Roach, chairman of Morgan Stanley Asia, recently predicted that China will "ultimately" allow the yuan to be freely convertible to other currencies.

While Chinese officials, including Central Bank Governor Zhou Xiaochuan, have called this year for an alternative to the dollar as the world's main reserve currency, they maintain controls on the yuan that prevent it for now from becoming a competitor.

In an interview with Bloomberg Television in Hong Kong, Roach added that the Hong Kong dollar's peg to the US currency "will relax" after China makes the yuan convertible. The un-pegging of the Hong Kong dollar is out of the question for now, he said.

Russian Finance Minister Alexei Kudrin said last month that the yuan could become a global reserve currency in about 10 years should China make it convertible. A change in Chinese policy would make the yuan a "notable and weighty" reserve unit, Kudrin said in an interview on the state-run Vesti television channel.

China will likely seek to slow capital inflows by convincing speculators they don't stand to make large returns, rather than allowing a one-off appreciation, said Mitul Kotecha, head of global foreign exchange strategies at Calyon in Hong Kong.

"China will need to be very careful," he said. "It needs to communicate to the market that yuan appreciation will be limited to about 5 percent to 6 percent a year. The danger in the past was that expectations of appreciation attracted hot money."

China's financial system is already flooded with cash from a record $1.27 trillion in new lending this year, the trade surplus, foreign direct investment, and inflows of speculative capital, or so-called hot money, adding to the risk of bubbles in stocks and property.

The nation's foreign exchange reserves rose $141 billion in the third quarter to a record $2.273 trillion, following an unprecedented $178 billion increase in the previous three months.

Central bank

"Foreign exchange inflows will force more liquidity into the financial system, making it more difficult for the central bank to manage inflation and control asset bubbles," Wang said.

The yuan is allowed to trade 0.5 percent on either side of a daily reference rate against the dollar set by the central bank, a limit that could be raised to 1 percent or 3 percent to increase uncertainty, the economist said.

China's currency has stayed at about 6.83 per dollar for the past 15 months as the government shields exporters from a slump in world trade. In September, exports fell by the least in nine months, suggesting that demand is starting to revive.

Wang said she doesn't expect policy makers to take her advice. She sees the yuan staying pegged to the US currency for six to nine months as the government continues to protect exporters, then rising to as much as 6.4 per dollar by the end of 2010.

US treasury

A more flexible Chinese currency is needed for "a stronger, more balanced global economy," the US Treasury said in a report to Congress, released Oct 15. That report called the yuan "undervalued".

Asian Development Bank economist Yolanda Fernandez Lommen cautioned last month that excessive gains by the currency could lead to instability in the world's most populous nation.

The Ministry of Commerce said recently that the government would stick to a "gradual" approach to currency reform.

Central Bank Vice-Governor Ma Delun warned on Oct 20 that policy challenges will increase as expectations for a stronger yuan boost inflows of capital.

The State Council said on Oct 21 that the policy focus in coming months will need to "balance" the need to aid growth with "the need to better manage inflationary expectations".

Consumer prices gained for a second month in September from August, rising 0.4 percent. Year-on-year, prices slid for an eighth month.

Bloomberg News

(China Daily 11/23/2009 page3)