By SHEN HONG and JOY C. SHAW
SHANGHAI—The yuan rose Monday to its strongest level against the dollar in the currency's modern era as traders bet on the likelihood of long-term appreciation despite the Chinese central bank's surprise move to keep the exchange rate flat ahead of trading.
The yuan's rise led to gains in China's stock market, where hopes of a stronger local currency buoyed demand for index heavyweights such as airlines and metals firms, which would likely benefit from lower yuan-denominated prices for imports of raw materials like fuel and iron ore. Yields on Chinese government bonds and local interest-rate swaps also fell on expectations that a stronger yuan will reduce the need for an imminent interest rate hike.
The yuan was quoted at 6.8015 to the dollar in China's over-the-counter market Monday afternoon, up strongly from its opening level of 6.8261 and its close on Friday at 6.8262. The 6.8015 level was the yuan's strongest against the dollar since the 1980s, before the currency was allowed to be traded as part of China's market-oriented reforms.
The central bank's move early Monday to keep the exchange rate unchanged from Friday had caught many in the market off guard. Its announcement over the weekend that it was, in effect, dropping the yuan's nearly two-year, unofficial peg to the dollar fueled expectations that it would let the yuan start resuming a gradual rise as early as Monday. Regional markets had already started to move on that expectation Monday morning when the People's Bank of China set the yuan's central parity rate, an official reference level for daily trading, at 6.8275 to the dollar, unchanged from Friday's level.
The central bank, as usual, gave no explanation for Monday's unchanged reference rate, but the move was interpreted by traders as a clear signal from the central bank that it won't tolerate any immediate sharp yuan appreciation.
The yuan was largely steady versus the dollar in the early minutes of trading after the reference rate was issued. But as the session progressed, traders started rethinking the central bank's signal.
"At the beginning the market was trying out around the level of Friday's close. But the market is now turning to focus on the prospect of a yuan appreciation in the near term," said a Shanghai-based trader at a foreign bank. He added that, barring central bank intervention, the spot exchange rate could head toward 6.8100 later Monday.
Chinese officials have been at pains to stress that the apparent return to a "managed float" for the yuan would mean only gradual moves—and could even result in downward moves against the dollar. In Saturday's announcement, the central bank said there was no basis for a "large-scale appreciation" of the yuan.
The central bank's unchanged central parity rate Monday may have been aimed at tripping up speculators, signaling that a steadily appreciating yuan isn't a sure bet. Officials have been worried that a rising yuan could attract inflows of speculative capital—so-called "hot money"--that could complicate its economic policies. That's what happened during the period from July 2005 to July 2008, when the yuan gained more than 20% against the dollar, before Beijing re-fixed it to the U.S. currency to help stabilize the Chinese economy amid the worsening global financial crisis.
But allowing the yuan to strengthen in the spot market despite the flat central parity could show that the central bank is actually tolerating a substantial rise in the yuan, traders said.
"We think the central bank could be signaling that it's willing to see more fluctuation in the market," said a Shanghai-based trader at a local bank.
The renewed bullish sentiment toward the yuan spilled over to China's equities and fixed-income market.
The benchmark Shanghai Composite Index was up almost 2% at 2562.36 at Monday's midday break, lifted by gains in major blue chips such as airlines and metal firms. Property developers also rose sharply because of expectations of intensifying hot money inflows driven by currency speculation.
Yields on Chinese government bonds and local interest rate swaps also fell.
The three-year government bond yield was at 1.90%, down 0.11 percentage point from Friday. The benchmark five-year yuan-denominated interest rate swap was trading at 3.18%, down 0.06 percentage point from Friday.
The dollar-yuan exchange rate is confined to a daily policy trading band of 0.5% on either side of the central parity level. That reference rate is officially based on the weighted average of prices submitted by market makers, but in reality it's largely at the central bank's discretion.
The yuan nominally had a higher exchange rate against the dollar in the 1980s—the first decade of its market-oriented economic revamp--but the Chinese currency wasn't actually tradable for foreign currency then. Instead, China had a second currency, called Foreign Exchange Certificates, that foreigners were supposed to use.
Beijing unified the exchange-rate system in 1994, fixing the yuan's value near 8.6 per dollar initially, before pegging it again in 2001 in a very narrow range around 8.277 yuan per dollar. Under enormous political pressure from major trading partners, China's central bank revalued the yuan again in July 2005 and let it appreciate steadily against the dollar until mid 2008, when it halted the yuan's rise amid the global crisis.
From The wall street journal published on JUNE 21, 2010, 3:24 A.M. ET