MercoPress. South Atlantic News Agency

China announces cautious “floating” of the Yuan

China will press ahead with changes to its foreign exchange rate mechanism giving a greater role to demand and supply plus liberating interest rates, announced Monday China's central bank.

"China will further improve the yuan exchange rate mechanism and will allow the market to play its role in establishing the exchange rate" said the People's Bank of China which also advanced that it will let foreign investors take larger stakes in financial institutions.

However the bank also underlined that the State would retain overall control, "to ensure the strengthening of financial institutions and guarantee the country's economy security". No details were revealed.

Ma Kai, head of the National Development and Reform Commission, is quoted saying China should continue making use of economic, legal and administrative measures to keep control of the economy. The Chinese economy expanded 10.7% in the first nine months of 2006 and is in track to a fourth year of double digit growth.

The central bank has raised interest rates twice since April, while the government has introduced tougher land-use and environmental standards in an attempt to deter wasteful investment.

Foreign financial institutions holdings of Chinese banks are limited to a 25% stake and for an individual investor to 20%. The People's Bank report reveals that by December 2005 a total of 154 foreign banks had been awarded licenses to operate with yuans in 25 different Chinese cities.

Under conditions for the incorporation to the World Trade Organization, China by next December 11 must eliminate all restrictions pending for foreign banks which operate in yuans with Chinese clients.

After the foreign exchange announcement the yuan on Monday achieved its second biggest daily gain against the US dollar since it was revalued in July 2005. It closed at 7.8738 to the dollar, up 0.20% on Friday's close of 7.8896, the second biggest rise since Beijing revalued the yuan by 2.1% and de-pegged it from the US currency in 2005.

Peoples' bank statistics also show that in the coming days China will reach the trillion US dollars mark in international reserves. At the end of September they totaled 987.900 billion US dollars and the monthly average increase in 2006 has been in the range of 18 billion.

This milestone presents a new challenge for Chinese authorities who are considering a diversification of reserves from US dollars into Euros and sovereign bonds from other countries.

Li Yongsen Finance Professor from the Peoples' University said the US dollar fluctuations "are an enormous risk for China and its international reserves holdings".

"The central bank could begin purchasing sovereign bonds from other important economies and cutting the volume of US dollars", said Li Yongsen.

Other options considered are investing in energy resources since China is short of energy but this could lead to world speculation on commodities with a negative impact on the global economy.

The most viable option seems to be promoting domestic demand, helping to reduce tensions with trade partners and reduce the rate of growth of international reserves.