China Cuts Currency Link To U.S. Dollar

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China Cuts Currency Link To U.S. Dollar

Thursday July 21, 2:37 pm ET
By Stephanie Hoo, Associated Press Writer 

China Cuts Currency Link to U.S. Dollar in Move That Could Raise Export Prices

BEIJING (AP) -- After months of lobbying by its trading partners, China on Thursday cut its currency's link to the U.S. dollar and raised its value by about 2 percent in a move that could make Chinese exports more expensive and make foreign assets cheaper for China to buy. The government's increase of the state-set exchange rate of the yuan could give a respite to foreign companies that are trying to compete with an avalanche of low-cost Chinese goods.

But Chinese companies also could get a break as prices of imported oil and other raw materials fall. And a stronger currency could prompt more takeover bids by China like those launched recently for U.S. oil company Unocal Corp. and appliance maker Maytag Corp.

The U.S. government welcomed the move but said it would closely watch the changes. The small increase in the yuan's value isn't likely to be enough on its own to satisfy trading partners who have said Chinese exporters had an unfair price advantage because the currency was undervalued by up to 40 percent.

But by dropping the U.S. dollar link and switching to a more flexible system based on a basket of foreign currencies, the Chinese have opened the door to a further, gradual rise in the yuan's value.

The government announced the change to an exchange rate of 8.11 yuan to the dollar in a surprise announcement on state television's evening news. That raised the value of one yuan by about one-quarter of one U.S. cent to 12.33 cents.

The effect on U.S. financial markets was immediate: The dollar fell against other major currencies and yields on U.S. Treasury securities rose. If that rise in interest rates is sustained, it could make it more expensive for U.S. consumers to finance purchases of new cars, homes and other big-ticket items.

There was no clear indication of a single factor that prompted China to take the step now after rejecting foreign pressure for years and insisting that such a decision would be based solely on its own domestic economic concerns. China's central bank said the change was being made to "improve the socialist market economic system."

Economists have warned that China's economy may be overheating. The  government's latest figures showed the country's gross domestic product grew by 9.5 percent in the first half of 2005, despite efforts to rein it in.

The previous rate of 8.277 yuan to the dollar -- where it had been fixed for more than a decade -- kept China's exports inexpensive but also forced Chinese companies to pay more for imported products such as oil and iron ore.

A more flexible rate could help Chinese firms deal with price shocks and boost exporters' profits even if sales fall, said Frank Gong, managing director of JPMorgan Chase & Co. in Hong Kong.

"It will help balance Chinese trade flows," he said. "It will help reduce the trade tensions that China has experienced with all of its major trading partners."

A stronger yuan could also encourage domestic spending, making China's economic growth less dependent on exports, he said.

China's decision to base the yuan's value on a basket of foreign currencies such as the euro or Japanese yen could see the yuan rise in value as the dollar weakens against those currencies, dragged down by mounting U.S. budget and trade deficits.

A further rise in the currency would push up the price of Chinese goods in dollar terms, heightening competition with other low-wage makers of shoes, clothes and appliances such as Bangladesh or Indonesia. It also could prompt more Chinese tourists to travel abroad.

"It will slow down the growth in exports a little in China," said Nariman Behravesh, chief economist for the financial firm Global Insight in Lexington, Mass. "This kind of a change in currency isn't going to change China's competitiveness a lot. But it will take Chinese competitiveness down a notch."

U.S. Treasury Secretary John Snow said Washington would watch to see whether the yuan will move to "alignment with underlying market conditions," while Federal Reserve Chairman Alan Greenspan welcomed the decision as "a good start."

China's new system puts tight limits on daily changes in the yuan's value but could allow it to change substantially over time.

Beginning Friday, the yuan will be limited to moving within a 0.3 percent band each day against a collection of as-of-yet unnamed foreign currencies, the government said. But the officially announced price at the end of each day will become the midpoint of trading for the next day, which could let the yuan edge up incrementally.

Malaysia also announced Thursday it was dropping its own policy tying its currency, the ringgit, to the U.S. dollar and would adopt a currency basket arrangement similar to China's.

Hong Kong said it would keep its currency peg to the U.S. dollar, making it the only Asian economy left with such a link.