By Bloomberg News

June 21 (Bloomberg) — China’s signal of an end to the
yuan’s fixed rate to the dollar may accelerate a shift toward
domestic demand as the prime driver of growth as President Hu
Jintao seeks to strengthen household incomes.

The People’s Bank of China two day ago indicated it’s
abandoning the 6.83 yuan peg to the dollar adopted during the
global crisis to shield exporters. The central bank said while
there’s no basis for “large scale” moves in the currency, the
exchange rate will be allowed increased “flexibility.”

A stronger yuan will boost the purchasing power of China’s
households that have helped propel imports to a record level,
and companies from Orient Paper Inc. to Air China Ltd. that
purchase goods from overseas. The lift adds to trends already
under way that are stoking wages, as workers demand higher
paychecks from employers including Honda Motor Co.

“Over a longer time, today’s announcement opens the door
for increased yuan appreciation that will help adjust China’s
economy towards a consumption-driven economy,” said Ma Jun,
chief China economist at Deutsche Bank AG in Hong Kong, who is a
former researcher for China’s State Council, or Cabinet, and
used to work at the International Monetary Fund.

The Chinese central bank made its announcement at 7 p.m.
Beijing time on June 19 in a posting on its website, a week
before leaders from the Group of 20 meet in Toronto.

Economic Restructuring

The PBOC said in a follow-up statement yesterday that a
more flexible currency will “direct resources to domestic-
demand driven sectors such as services” and help curb an
excessive reliance on exports, signaling it anticipates the
currency will rise.

Authorities will resume a managed float of the yuan, also
known as the renminbi, against a basket of currencies, according
to the June 19 statement. Before the exchange rate was frozen in
July 2008, Premier Wen Jiabao’s government had allowed a 21
percent advance versus the dollar over three years.

While the International Monetary Fund reaffirmed its view
that the currency is “substantially” undervalued, analysts at
banks from Goldman Sachs Group Inc. to Royal Bank of Scotland
Group Plc predicted gains in the coming year will be held to
less than 6 percent. The median of 14 forecasts in a Bloomberg
News survey indicates a rise to 6.7 by Dec. 31.

Goldman’s Bet

Goldman analysts said in a note to clients that the weekend
statement reaffirmed their recommendation to purchase 12-month
non-deliverable forwards, with a target of 6.50, compared with
last week’s close of 6.7125.

The small move anticipated in coming months means there
will be limited impact on the economy in the short term, said
Ma. At the same time, exchange-rate strengthening will likely
over time lead to greater household purchasing power, according
to the Washington-based IMF, which conducts annual reviews of
its member economies.

Yuan flexibility “will help increase Chinese household
income and provide the incentives necessary to reorient
investment toward industries that serve the Chinese consumer,”
IMF Managing Director Dominique Strauss-Kahn said in a
statement. It may also damp inflation, John Lipsky, the fund’s
No. 2 official, said in a Bloomberg Television interview.

Consumer prices rose 3.1 percent in May from a year before,
exceeding the government’s 3 percent target average for 2010.

Paper Profits

A stronger currency will benefit Chinese paper makers as
the costs of pulp imports will drop. That’s particularly true as
exports aren’t an important part of the business, according to
Winston Yen, chief financial officer for Hebei, China-based
Orient Paper, speaking in April.

It would also be a boon to China Southern Airlines Co.,
China Eastern Airlines Corp. and Air China by cutting dollar-
denominated fuel bills and the cost of debt payments for
purchases of Boeing Co. and Airbus SAS planes, according to Ally
Ma, an analyst at Citigroup Inc. in Hong Kong.

The yuan decision follows a strengthening in China’s
economy that saw gross domestic product expand 11.9 percent in
the first quarter from the same period of 2009. Surging
industrial production, exports, retail sales and property prices
have sparked concern of an overheating that may end in a bust.

U.S. Treasury Secretary Timothy F. Geithner had advocated
yuan flexibility as a means of addressing China’s price
pressures, outside of the argument of American lawmakers that
the yuan peg was an unfair subsidy for China’s exporters.

In an indication of confidence in the U.S., China increased
holdings of Treasury notes and bonds by 2.6 percent to $900.2
billion in April from the previous month, after reducing its
stake by 6.5 percent from November through March, according to
U.S. data released June 15.

Lesson From Crisis

China’s leaders are aiming to buttress domestic incomes and
reduce reliance on exports that collapsed during the crisis,
culminating in a record 26 percent drop in shipments in May 2009
from a year earlier.

A more flexible yuan “is not a panacea” for global trade
imbalances, Stephen Roach, chairman of Morgan Stanley Asia Ltd.,
said in an e-mail. Countries with large savings, such as China,
“still need to take additional actions to stimulate internal
private consumption,” he said.

In the past 10 years, China’s economy became more
unbalanced, with consumption’s share of GDP falling to 35
percent last year from 45 percent in 2000, according to Societe
Generale SA. Now, a rebalancing “seems to be occurring by
default” as labor shortages in coastal provinces encourage wage
gains that will boost consumer spending, Glenn Maguire, a Hong
Kong-based economist for the bank, said in a report last week.

Government’s Task

“Consumer spending won’t see significant advances unless
the government effectively reduces people’s precautionary
savings for education, health care and old age,” said Liu Li-
Gang, a Hong Kong-based economist at Australia and New Zealand
Banking Group Ltd.

The State Council earlier this month approved a program to
map out development strategies for each of the nation’s regions,
the official Xinhua news agency reported June 12. President Hu
plans to convene a meeting to discuss how to narrow the income
gap later in the year, the Hong Kong-based newspaper South China
Morning Post reported over the weekend.

More than 20 provinces and cities have overseen increases
in minimum wages in recent months to help support incomes, and a
focus of the 4 trillion yuan ($586 billion) stimulus package on
boosting inland regions has helped reduce reliance on the
export-linked coast.

Internal Regions

Manufacturers including Ningbo-based Dejin Textile Co.,
Shanghai-based China Crown Textile Co. and Shenzhen Jufeng
Handicraft Co. have said the development of internal regions,
such as Chongqing, has made it harder for them to attract
migrant workers to factories on the east coast.

Meantime, employees in foreign-owned plants have been
demanding higher compensation. Honda, Japan’s No. 2 carmaker,
raised pay by 24 percent at a parts-making factory in Foshan,
Guangdong province, after a strike crippled its production in
China. Labor unrest then spread to Toyota Motor Corp.

At the same time as seeking to strengthen household
incomes, China’s leaders have been pulling back on monetary
stimulus in an effort to stem asset-price inflation. Data on
June 10 showed property prices rose at a near-record pace, with
costs jumping 12.4 percent across 70 cities from a year earlier.

The move to allow a stronger yuan means authorities may not
need to tighten domestic monetary policy as much as previously
was the case, according to Morgan Stanley. Wang Qing, Greater
China economist at Morgan Stanley in Hong Kong, wrote in a note
that the PBOC likely won’t raise interest rates this year. He
also said the government may raise its target for 2010 credit
growth from 7.5 trillion yuan. A record 9.59 trillion yuan of
new loans were signed last year.

“The Chinese are increasingly confident they can make this
adjustment to a domestic-driven economy rather than the one
relying on exporting low-value-added stuff to the rest of the
world,” Jim O’Neill, chief global economist at Goldman, said in
an interview with Bloomberg Television in St. Petersburg,
Russia, after the PBOC statement.

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