Chinese policymakers are tolerating moderately faster yuan appreciation to help curb inflation, though there is a limit to how much they will stomach if currency strength starts to hurt the vast export sector and the broader economy.

A recent jump in the yuan has fueled speculation that China could soon widen its trading band to give currency policy a bigger role in fighting imported price pressures.

Such talk gained steam last week after the official China Securities Journal said the time "is ripe" for such a move.

Conversations with analysts familiar with Beijing's policy-making process, however, show that expectations of an imminent shift in day-to-day management of the yuan are overblown, especially as fears grow that the U.S. and European economies may be sliding back into recession.

"The possibility of a yuan widening band isn't big in the short term. We need some currency stability, especially when there is increased turbulence in global financial markets," said Wang Jun, an economist at CCIEE, a Beijing-based think-tank.

"A stronger yuan could help ease inflation pressures. But we do not want to see the yuan strengthening too quickly to affect export competitiveness," he said, predicting the yuan could appreciate 5-6 percent against the dollar this year.

Beijing has allowed the yuan to gain more than 3 percent versus the U.S. dollar so far this year and close to 7 percent since it freed the currency from its peg to the dollar in June 2010, though its moves have at times been erratic as Beijing tries to deter speculation on non-stop appreciation.

INFLATION STILL PUBLIC ENEMY NO. 1

Chinese officials don't see inflation as being out of control, but price pressures have been persistently strong. Inflation hit a three-year high of 6.5 percent in July, and is not expected to peak for another few months.

In recent weeks, top policymakers have repeatedly stressed that controlling price pressures remained the country's top priority, even as data shows China's red-hot growth is cooling amid a global slowdown.

China's exporters face weakened external demand and rising costs, the Ministry of Commerce said on Tuesday, warning that the debt problems of advanced economies would bring challenges to China.

Further yuan appreciation, at a modest pace, would allow the central bank to continue to tampen down imported inflation without resorting to further hikes in interest rates or banks' required reserve ratios that risk stifling domestic growth further.

YUAN OUTLOOK

Gao Shenwen, chief economist at China Essence Securities in Beijing, believes the central bank will let the yuan move more freely, but only when upward pressures on the currency ease in line with a narrower trade surplus and less capital inflows.

"Right now, conditions for a band widening are not mature, especially given the greater uncertainties in the global economy. The government wants to play it safe," Gao said.

The yuan currently is allowed to rise or fall 0.5 percent a day from its daily mid-point rate, which is set by the central bank. In practice, however, the central bank has rarely allowed the yuan near the lower or upper ends of that band.

Speculation has been for a band widening to 1 percent.

The central bank last widened the yuan's trading band to 0.5 percent from 0.3 percent in May 2007, nearly two years after its landmark revaluation of the yuan.

Analysts say Beijing tends to push major currency reforms when there are fewer external risks.

Furthermore, major changes such as a yuan band widening are a political decision that needs the green-light from President Hu Jintao and Premier Wen Jiabao. But analysts say the government will probably tread cautiously on the currency ahead of a leadership reshuffle next year.

NO ABRUPT POLICY CHANGE

The People's Bank of China let the yuan rise 0.8 percent in the week ended Aug 12, the fastest weekly pace since the global financial crisis in 2008, sparking talk that some policy move was in the pipeline.

But many analysts caution against reading too much into the yuan spike, which has been propelled in large part by the dollar's global decline following Standard & Poor's downgrade of the U.S. government debt rating earlier this month.

"We do not think the faster yuan move means that China has moved away from the gradual appreciation and gradually more flexibility strategy," said Tao Wang, China economist at UBS.

"Domestically, maintaining a relatively rapid growth and social stability are always top concerns -- and a sharp renminbi appreciation may hurt exports and job growth too much," she said. The yuan is also known as renminbi.

Despite the yuan's gains against the dollar since it was depegged in June last year, its nominal effective exchange rate (NEER), or its value against a trade-weighted basket, dropped 4.6 percent in the same period and fell 2.3 percent in real terms, according the Bank for International Settlements.

Still, Wang predicted the yuan could gain 5-6 percent versus the dollar this year to 6.2 per dollar and a further 3-4 percent in 2012.

Offshore forward markets are much less optimistic given some fears of a sharper slowdown in China's growth, implying a yuan rise of around 1.9 percent in a year's time.

ONE-WAY BETS ON YUAN COMPLICATE POLICY MAKING

In the long-run, Beijing appears committed to turning the yuan into a global currency with full convertibility, perhaps by 2020, and has made a slew of announcements in recent months to promote its use offshore.

In the near-term, however, it is facing some teething pains.

The yuan would likely climb even faster if the central bank allowed it move more freely at this stage, attracting more speculative inflows that would fuel inflationary pressures.

A stronger yuan could only have a delayed effect on the politically sensitive trade surplus, while the backlash on exporters' sales and profit margins would likely be much more immediate.

"Any sharp yuan rise could attract more hot money inflows and force the central bank to issue more local currency, on contrary to our objective," said Liang Youcai, senior economist at the State Information Centre, a top government think-tank.

However, Beijing has limited policy choices in the face of the dollar's prolonged decline, which is being exacerbated by the U.S. debt crisis.

Leaders can push longer-term changes, including internationalizing the yuan to reduce the reliance on the dollar and dollar assets such as U.S. Treasuries, analysts say.

"We expect the government to gradually increase the renminbi flexibility, to allow it to appreciate against the dollar at a gradual but visible pace, and to slowly but surely push for the greater use of the yuan internationally," UBS' analyst Wang said.

Source:Reuters