China seen ending yuan peg to hold back inflation

China may end the yuan's decade-old fixed exchange rate to the US dollar, allowing its currency to strengthen and slow export-led economic growth and inflation, analysts and economists said, adding that they expect China to revalue the yuan by the end of the year.

China, which pegged its currency to the dollar in 1994, first said in March 2002 it may consider linking the yuan to a basket of currencies as it has had to buy US dollars to keep a value of 8.3 yuan per dollar, putting more money into circulation.

"China needs exchange rate flexibility," said Fred Hu (胡祖六), chief China strategist at Goldman Sachs Group Inc in Hong Kong.

"The economy is booming, inflation is heating up and money and credit growth is so fast. That implies China would be better off to do this sooner rather than later," he said.

China's economy, the world's sixth largest, will grow 8 percent this year, from an estimated 8.6 percent last year, the fastest among the world's top 10 economies, economists said.

Federal Reserve Chairman Alan Greenspan said on Dec. 11 China's increased dollar-buying to preserve the peg was "overheating" the economy. The next day, the Beijing-based statistics bureau said on its Web site inflation accelerated to 3 percent in November, the fastest in 6 1/2 years.

"Rising inflation is ultimately the most likely trigger for a shift in the exchange-rate regime," said Harvard University Professor Kenneth Rogoff, the former chief economist of the International Monetary Fund. "There are strong pressures" for the yuan to appreciate.

Traders have been increasing bets that China will allow the yuan to strengthen through freely traded forward contracts, which imply the yuan would rise to 7.847 in a year's time if not pegged.

China will wait until at least the third quarter to widen its band, analysts said. On average, they predicted a widening of 3.1 percent either side of the fixed rate, compared with the current 0.3 percent.

Analysts also said China will adopt a peg against a basket of currencies, including the dollar.

"The chances are high for a move by the spring," Jim O'Neill, Goldman's head of global economic research, wrote in a Dec. 8 report. Goldman in June predicted China would allow the yuan to move by 2.5 percent above or below the fixed rate by year-end and by 5 percent within a year.

China's M2, the broadest measure of money supply, expanded faster than the central bank's 18 percent targeted growth rate in each of the first 11 months of this year. China does not publish figures on how much it spends to maintain the currency peg, a central bank spokesman said.

Though Chinese officials including Central bank Governor Zhou Xiaochuan (周小春) have repeatedly said they're committed to moving toward a free-floating currency, they haven't said when.

"It's very unlikely China would change its currency arrangement in 2004," said Mike Newton, a currency strategist in Hong Kong at HSBC Holdings Plc, the biggest trader of Chinese yuan, according to Euromoney magazine. "I can't see any upside for taking such a step" before China eases restrictions on the flow of capital.

China may allow the yuan to move 1 percent above and below the pegged rate, said Frank Gong, chief strategist at Bank of America Corp in Hong Kong, who used to work for the Federal Reserve writing research reports for the Federal Open Market Committee.

"They may widen the band, most likely in September, just before the US election," Gong said. Then, "US politicians can claim some kind of victory. That would be a politically right time to do it."