How significant is China's move?

Many of China's trading partners argue that its currency is undervalued by between 10 per cent and 20 per cent and should rise further as China's economy becomes stronger.

The immediate effect is to revalue the yuan by just 2.1 per cent against the dollar, which is much less than American business, and also Europe, would have wanted to stem the flow of Chinese consumer and electronic goods. In that sense it is disappointing.

But the decision to move from pegging the yuan against the dollar to keeping its value stable against a basket of currencies is more significant.

How will it work?

The Peoples Bank of China will aim to keep an index of the yuan's value against other currencies stable. So the yuan could rise against the dollar but fall against the euro, or vice versa.

Managing the currency against an index allows more flexibility day to day but is harder to manage, even with exchange controls. At the start, the dollar is likely to fill much of the basket, because it is much the most important currency for China's trade and dollar assets dominate its currency reserves.

The Japanese yen and the euro will fill much of the rest of the basket, with other Asian currencies. But the basket could be rearranged later to give more emphasis to other currencies prior to floating the yuan altogether.

How does it affect the UK and Europe?

When the yuan is pegged to the dollar, then changes in the pound/dollar and euro/dollar exchange rates automatically make the yuan worth more or less. In future, a rise in the euro against the dollar will not necessarily make it more expensive against the yuan.

Is this the start of reform or is that it?

China is still determined to maintain control of its currency but will find it harder. Markets are likely to develop in the yen versus the yuan and possibly also the euro against the yuan.

These currencies also have active markets against the dollar, so it will be harder for the Chinese authorities to maintain exact stability.

They will inevitably move towards a managed float. As this happens, the yuan may rise much further against major currencies, though this will probably happen slowly and may even be disguised as changes in the basket.

Will China's move affect Western markets?

China is the world's second biggest owner of foreign exchange reserves behind Japan and is rapidly building up holdings of US assets, particularly government bills and bonds. Rumours that China might switch to yen or euro assets periodically hit the US bond market.

Inevitably, China will diversify its reserve assets but it will be anxious not to move the market against itself and lose money on its dollar holdings. Interest rates on US bonds are likely to rise if Chinese demand slows but the market should only be badly hit if China becomes a big seller.

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