China's Central Bank Provides Glimpse Into New Yuan Policy

[HenryTo]

At last - some transparency on the basket of currencies that the "new yuan" is tied to:
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China's Central Bank Provides
Glimpse Into New Yuan Policy

Currency Basket Contains
Dollar, Euro, Yen, Others;
Inclusion Linked to Trade
By JAMES T. AREDDY
Staff Reporter of THE WALL STREET JOURNAL
August 11, 2005

SHANGHAI -- The chief of China's central bank yesterday offered clues to a closely guarded secret: just what goes into a basket of currencies that is supposedly guiding the yuan up and down.

In a speech, People's Bank of China governor Zhou Xiaochuan said the U.S. dollar, euro, yen and South Korean won are "naturally" key currencies in a basket used to help manage the yuan exchange rate. The currency of any country with more than $10 billion in annual trade with China also would likely be included in the basket, Mr. Zhou added. He named Singapore, the United Kingdom, Malaysia, Russia, Australia, Thailand and Canada as examples.

Mr. Zhou's speech was seen as significant because it shed light on one of the least transparent parts of China's recent currency overhaul. Sparse as the details were, they provided a glimpse of the criteria Beijing used to build the basket. Coupled with the introduction of new hedging products for the foreign-exchange market this week, the central bank appears to be making good on pledges that the yuan will become more flexible and less closely tied to the U.S. currency, analysts said.

"These things to us are important markers," said Rob Subbaraman, an economist at Lehman Brothers in Tokyo.

Last month, China dropped a decade-old peg to the dollar when it revalued the yuan and said it would use a basket of currencies in managing the exchange rate. At the time, it provided no details.

Beijing continues to withhold information on how the basket will operate. The Chinese central bank has committed only to use the basket as a "reference," suggesting a more arbitrary approach than used in the baskets adopted in Singapore and Israel.

Yet the push toward further developing China's currency markets has been swift since last month's abandonment of the dollar peg. In recent days, the central bank has liberalized the use of currency derivatives, such as forwards and swaps. These products are designed to protect companies from adverse swings in currency exchange rates, but are tough to regulate and historically have been nonexistent in China. In other steps announced by the central bank yesterday, insurance companies, brokerage houses and other nonbank players may apply to participate on the domestic interbank foreign-exchange market.

In practice, since the initial 2.1% revaluation against the dollar last month, the central bank has continued to intervene in the foreign-exchange market to carefully limit how market forces might influence the rate. Analysts say trade and investment flows still support a more valuable yuan, but the currency has, for instance, never neared the 0.3% daily movement theoretically permitted against the dollar.

In addition to outright exchange-market intervention, the central bank has engineered a sharp drop in yuan market interest rates by flooding the banking system with cash. Traders say that is an attempt to reduce demand for the yuan and keep it from strengthening. The dollar finished at 8.1062 yuan yesterday, compared with the initial revaluation level July 21 of 8.11 yuan.

Any true shift in the central bank's emphasis away from the dollar could be a concern for investors in U.S. Treasury securities. That is because China could start reducing the dollar's weighting in its official reserves, which total more than $700 billion. So far, traders involved with managing dollar holdings at big Chinese commercial banks, a proxy for the official reserves, say they continue to overweight the dollar and that there has been no shift in their portfolio-management plans.

While he noted he is looking at more than 10 currencies for the basket, Mr. Zhou said pointedly yesterday that the dollar is becoming less important for trade and investment in China. "We encourage this development," he added.

Some Chinese businesses confirm the trend. Dollar-based invoicing used to be the norm for Shanghai Knitting Group, which exports $200 million of clothing annually under the Nike, Adidas and other brands. "Now, customers, especially from European countries, opt for the euro as well as the U.S. dollar," said Lu Longsheng, the textile group's vice general manager.

--Ellen Zhu contributed to this article.

Write to James T. Areddy at james.areddy@wsj.com