China's central bank announced on Friday it would let the yuan trade more freely and delivered twin monetary tightening moves just days ahead of a key meeting with the United States to discuss trade.
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 it is serious about keeping the world's fourth-largest economy in check.
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 also 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, I think," 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 US side."
US Treasury Secretary Henry Paulson is set to 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.
"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. "We still think it will be a gradual appreciation with the new band not being fully used either."
The widening of the yuan's band from the previous 0.3 percent will take effect on Monday. The yuan will now be permitted to rise or fall by 0.5 percent each day from a mid-point set each morning.
"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. The currency closed on Friday at its highest level since it was revalued and untethered from a dollar peg in July 2005. It has appreciated by nearly 5.8 percent since then.
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 August 15, 2006. The daily band against other currencies - 3 percent - would remain unchanged, the central bank said.
The central bank reaffirmed its official line that it would keep the yuan basically stable, saying the widening of the band did not necessarily mean there would be large fluctuations in the exchange rate or that the currency would appreciate significantly.
The People's Bank of China also said on its Web site (www.pbc.gov.cn) that it would raise both deposit and lending rates, as well as the proportion of deposits that banks must hold in reserve. The rate changes will take effect on May 19 and will bring the one-year deposit rate to 3.06 from 2.79 percent. The one-year benchmark lending rate will rise 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 - the dollar sliding a third of a percent on the day to 120.85 yen while the euro fell 0.4 percent to 162.90.
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 groves 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. The People's Bank of China has now raised interest rates four times since April 27, 2006, and reserve requirements eight times since June 2006.
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