From this morning's Wall Street Journal Online (subscription required):
China's central bank on Friday executed a deal in the domestic foreign-exchange market in what traders interpreted as a signal that a mild appreciation in its currency will be tolerated over the next year.
The People's Bank of China's "swap" with state banks allows it to buy $6 billion in 12 months at an exchange rate of 7.85 yuan. To make the deal attractive for the central bank, the yuan would need to rise at least 2.9% from current levels, not including interest. Traders said the central bank could therefore be trying to telegraph its expectations that the yuan will edge higher over the coming year.
The swap transaction was the first ever conducted by China's central bank and marks the latest advancement in the system's market orientation. More swaps could follow in the next few weeks and provide further clues of the central bank's thinking.
Here is the "however" part:
While Friday's swap transaction could signal there will be more flexibility in the currency in coming months, traders also said the central bank just as easily could have been trying to temper enthusiasm for a stronger yuan. Before the swap with what Dow Jones Newswires said were 10 banks, foreign exchange derivatives markets were already pricing in expectations the yuan would rise about 4% versus the U.S. dollar over the course of the year. Other non-deliverable forward derivatives contracts traded in Singapore and elsewhere outside China quickly matched the narrow appreciation level suggested by the swap transaction.
Meanwhile the evolution of the financial markets continues:
In another move that suggested China intends to introduce additional flexibility into the currency-exchange-rate system, the central bank said late Thursday it will tap market makers for dollar-yuan trading in 2006.
A market maker system could be a step toward relaxing the direct control China's central bank maintains over the yuan's value. Analysts say active participation by market-making firms could eventually replace the buying and selling of yuan often attributed to the People's Bank of China. Still, until China's yuan is fully convertible, the central bank would be expected to retain indirect control over the currency exchange rate by requiring qualified markets to follow certain instructions that would limit foreign-exchange volatility.
Note: If you are unfamiliar with currency swaps, you can find several simple definitions here, and a more extensive discussion here.