China Increases Yuan Leeway, Raises Rates

China's central bank raised interest rates and announced that the yuan would be allowed to trade more freely on Friday.

China's central bank raised interest rates and announced that the yuan would be allowed to trade more freely on Friday, just days ahead of a key meeting with the United States to discuss trade tensions.

The steps, which prompted the yen to jump sharply against the euro and dollar, are likely to be interpreted as both an olive branch to Washington and as a signal that China is serious about keeping the world's fourth-largest economy in check.

The U.S. Treasury welcomed the policy moves but said it would continue to press for greater appreciation of the yuan.

"The Treasury view is that this is a useful step towards greater currency flexibility," U.S. Special Envoy for China Alan Holmer told a news briefing.

The yuan will now be permitted to rise or fall by 0.5 percent each day against the dollar, up from a 0.3 percent margin. The central bank raised its one-year lending rate by 0.18 percentage point and the one-year deposit rate by 0.27.

"The band widening announcement is a gift to the Americans," said Mei Xinyu, researcher with a think-tank under the Ministry of Commerce in Beijing.

"Everybody knew that the band would be widened sooner or later, and announcing it right ahead of the talks is not bad timing. China can maybe ask something back from the U.S. side."

U.S. Treasury Secretary Henry Paulson will play host to a Chinese delegation led by Vice Premier Wu Yi from May 22-23 in Washington to discuss sticking points in trade relations, including the value of the yuan, as part of a "strategic economic dialogue" set up last year.

Paulson, under pressure from Congress, said on Thursday he would keep trying to persuade China to let markets set the value of the yuan.

"They are showing they are willing to show more flexibility but we have to see how the currency will behave," said Marios Maratheftis, currency strategist at Standard Chartered in London, of China's moves. "We still think it will be a gradual appreciation with the new band not being fully used either."

Chairing a meeting of G8 finance ministers near the eastern German city of Potsdam, German Finance Minister Peer Steinbrueck also backed the move. "There has been strong agreement in the G7 circle ... that exchange rates should develop on the basis of the market and that we are not interested in abrupt changes," he said.

Japanese Finance Minister Koji Omi, also attending the G8 meeting, said the Chinese move was a welcome step, but further action would be needed.

"We greatly welcome the decision. As far as we are concerned, we would like to tell (China) that we would want to see China move further towards a free market, increase flexibility," Omi told reporters.

GREATER FLEXIBILITY?

The widening of the yuan's band will take effect on Monday, when it will be permitted to rise or fall by 0.5 percent each day against the dollar from a mid-point set each morning and, as previously, by 3 percent against other currencies.

On most days, the yuan ranges less than 0.15 percent from its dollar midpoint. The biggest move was a 0.28 percent fall on Aug. 15, 2006.

"This is favourable for further promoting the development of the foreign exchange market and will increase the flexibility of the yuan's exchange rate," the central bank said in a statement.

The United States has been pressing China to let the yuan, which critics say is artificially undervalued, to strengthen more quickly to help narrow its trade deficit with China, which hit $233 billion last year.

But the central bank reaffirmed its official line that it would keep the yuan basically stable, saying the band widening did not mean that the currency would appreciate significantly.

The currency closed on Friday at its highest level since it was revalued by 2.1 percent and untethered from a dollar peg in July 2005. It has appreciated by nearly 5.8 percent since then.

YEN BOUNCES

The central bank also said it would raise both deposit and lending rates, as well as the proportion of deposits that banks must hold in reserve -- a rare parallel step.

The rate changes will take effect on May 19 and will bring the one-year deposit rate to 3.06 from 2.79 percent and the one-year benchmark lending rate to 6.57 percent from 6.39.

Markets responded strongly to the news.

The yen, often seen as a proxy for the closely-managed yuan, bounced decisively away from record lows against the euro struck earlier this week.

Early in the New York session, the dollar had slid 0.2 percent on the day to 120.93 yen, while the euro fell 0.4 percent to 163.08.

Increasing deposit rates by more than lending rates would help ease the current situation of negative real deposit rates, which has prompted individuals to flock in droves into the country's red-hot stock markets, causing concerns over a bubble.

Trimming the differential between deposit and lending rates would also help discourage banks from giving out loans, thus helping to rein in an investment frenzy, analysts said.

"I think the government just wants to send the market a very clear-cut signal that it is very committed to steering the economy towards safe waters," said Zhu Jianfang, chief economist with China Securities in Beijing.

Banks' reserve requirement ratio would be increased by 0.5 percentage point, effective June 5, the central bank said. That takes the ratio for big banks to 11.5 percent.

China has now raised interest rates four times since April 27, 2006, and reserve requirements eight times since June 2006.