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By Bloomberg View

Ten years after China scrapped a yuan peg against the dollar, the central bank is again anchoring the exchange rate to the greenback. Witnesses to the 2005 float say too much has changed for that to last.

The economy is now five times bigger, having overtaken Japan and Germany, and the yuan has risen to become the world’s second most-used currency for trade finance. Currency watchers of the time, including U.K. government official Jim O’Neill and ski gear entrepreneur Benedikt Germanier, say the yuan will sustain its gradual ascent. While it has appreciated 34 percent since the 8.3 per dollar peg ended, it’s in the fifth month of a pause at 6.2.

“Ten years on, what is clear is that China is moving toward a much more flexible exchange-rate system and is making good progress,” said O’Neill, a former Goldman Sachs Asset Management chairman who is now commercial secretary to the U.K. Treasury. The economist, who remembers being flooded with calls during a family holiday in Greece in July 2005, said the yuan will “play an increasing role in the global financial system.”

China has been preventing declines in the yuan partly to strengthen its bid to win International Monetary Fund reserve status this year and challenge the dollar for domination of global trade. A successful bid could trigger a $1 trillion switch of global reserves into Chinese assets, Standard Chartered Plc estimates.

Reform Agenda

The People’s Bank of China first pegged the currency in 1995 shortly after abandoning a dual exchange-rate system for imports and exports. Governments in the U.S. and Europe criticized China for obtaining an unfair trade advantage by keeping its currency undervalued. The PBOC scrapped the peg on July 21, 2005, and allowed a one-time, 2.1 percent appreciation, a move welcomed by then-U.S. Treasury Secretary John Snow.

Germanier, a UBS AG strategist at the time, remembers shouts on the trading floor and explaining to eager fund managers that they may not see an “explosion” in the currency.

“Chinese leaders are up for a gradual opening of the economy, a master plan that will take many years,” he recalls telling investors.

Surprising Pace

The yuan’s gains in the past decade have been tightly managed and punctuated by a restored peg in the two years ended June 2010, a decline last year and finally the most recent pause. Currency reserves ballooned to almost $4 trillion, before sliding to $3.7 trillion at the end of June, as PBOC intervention switched from buying the dollar to selling it.

Capital account opening has accelerated in the past five years. China has expanded the yuan clearing-bank network to 17 cities including London, Seoul, Sydney and Johannesburg. This year, it opened up the short-term loan market to foreign banks and removed some restrictions on overseas sovereign investors in its inter-bank bond market. The currency failed to qualify for the IMF’s reserves in 2010 because it was deemed not “freely usable.”

“I had assumed wrongly that the absence of full capital account convertibility would limit the endorsement of the currency in trade finance,” said Chia Liang Lian, Pasadena- based co-head of emerging-market debt at Western Asset Management. “As it turned out, the pace of yuan internationalization has been significantly more rapid.”

Lian, who was dining with bankers in Beijing while working for Pacific Investment Management Co. that day in 2005, said he’s “constructive” on the currency as “the world’s focus appears set to tilt from greenback to redback in the coming decade.”

Different Landscape

The yuan has been trading within 0.35 percent of 6.2 per dollar since March 31, even as the greenback gained 0.8 percent in the same period against major trading partners. Exchange- rate stability contrasts with a collapse in domestic stock prices and an economy set to expand by about 7 percent this year, the least since 1990.

“It’s a policy choice,” said Dariusz Kowalczyk, an economist at Credit Agricole CIB in Hong Kong. “It’s by showing the strength of renminbi against a backdrop of a strong dollar to get people to hold the yuan. The market is more controlled than it used to be, after the government said it would give market forces a bigger role. There’s a big element of contradiction.”

The authorities “prefer a stable currency at the current time,” said Michael Spencer, Hong Kong-based economist at Deutsche Bank AG, who was called for an interview while in a London cab on the day 10 years ago. The market, which was positioned for devaluation earlier this year, is now “quite flat.”

“The de-pegging came at a time when the rest of the world was really only beginning to understand China’s opening up and its impact on global trade and investment flows,” he said. “It convinced people that there was a financial market component to China’s reform agenda.”