(Reuters) – The euro zone’s debt woes offer China a golden opportunity to unshackle the yuan from its virtual peg to the dollar, taking advantage of the U.S. currency’s surge to create more two-way trading activity.

China

The raging crisis over the fiscal troubles of weaker euro zone economies has driven the dollar index up to 15-month peaks and gives Beijing the right environment for yanking the yuan out of its sideways drift of nearly two years.

While Chinese authorities would wait for renewed market calm after the severe volatility seen in May, the dollar’s broad gains relieve their worries that any shift in yuan policy would invite a torrent of speculative capital hoping to jump on such a move.

“Now is a good time to free the yuan from the dollar,” said Wang Haoyu, economist at First Capital Securities in Shenzhen.

“A depegging at this moment would enable China to reach its goal of deterring speculators from one-way bets on yuan appreciation while appeasing foreign critics, creating a win-win situation.”

China is expected to manage the yuan against a trade-weighted basket of currencies, and as part of the shift it may start to allow the yuan — also known as the renminbi, or people’s money — to lose ground against the dollar and major currencies.

The leeway to engineer such periodic falls in the yuan is vital to Chinese policymakers, who want to make it risky for speculators to bet heavily on the yuan embarking on a steady rise.

Such bets would ordinarily be a no-brainer, given China’s robust economic growth and its large trade surplus with many major world economies.

But Beijing fears an influx of speculative money would fuel asset price bubbles and destabilize the economy, just as it is trying to cool the hot property market.

The slide of the euro and other currencies against the dollar also means those countries are less likely to complain that Beijing is defying their appeals for yuan appreciation, which they believe would ease chronic trade deficits with China.

Market players have slashed their expectations for a near-term move. One-year offshore forwards are pricing in slightly less than 1 percent appreciation, down from about 3 percent a month ago.

WINDOWS

A few windows of opportunity are coming up for China to shift toward allowing the yuan to edge higher — especially as U.S. officials remain mostly mum on the subject.

Analysts are now penciling in a move in the third quarter, while some are looking at July as a possibility.

July marks the fifth anniversary of the yuan’s initial revaluation and is also when the IMF typically conducts its economic consultation with China — giving authorities the cover of an impartial international agency suggesting action for a move.

When Beijing revalued the yuan by 2.1 percent in July 2005, it adopted a “managed floating exchange rate system based on supply and demand” — meaning that it was managing the currency against a trade-weighted basket.

But Beijing suspended the system in July 2008 as the global financial crisis escalated, virtually reimposing its previous system of fixing the yuan to the dollar in a very tight band around its “mid-point” reference rates.

Pressure for China to resume yuan appreciation has mounted since late 2009 as the global economy recovered.

While China has resisted external pressure to avoid appearing weak in its relations with other powers, it has said it would move ahead, paving the way for a depegging.

Last month the People’s Bank of China (PBOC) said it would improve the yuan’s exchange rate mechanism in reference to the performance of a basket of trading partner currencies.

Such a system would let the PBOC engineer a controlled float of the yuan against a wide range of currencies, including the euro, sterling and the yen, regardless of the dollar’s direction.

The yuan’s 2.5 percent fall against the euro last year and 14.6 percent jump so far this year are almost identical to the dollar’s moves against the euro in global markets.

But after the 2005 revaluation, the yuan’s movements against the euro diverged markedly from those against the dollar once it was linked to a trade-weighted basket.

The yuan fell 7.2 percent in 2006 and another 4.3 percent in 2007, even as the dollar jumped 11.5 percent and 10.6 percent respectively.

This divergence indicated that Beijing was using the yuan’s depreciation against non-dollar currencies to compensate for its rise against the dollar in 2006 and 2007, and only allowed it to rise against a wide range of currencies in 2008.

“Allowing the yuan to move versus a currency basket may initially be based more on political than economic considerations from the Chinese side, ” said Liu Dongliang, currency strategist at China Merchants Bank.

“But by gradually enhancing the importance of the currencies of China’s trade partners other than the U.S. dollar, the move will help to push the yuan eventually to full convertibility.”

In the basket-based system, the yuan’s pricing would be calculated by the nominal effective exchange rate (NEER) and the real effective exchange rate (REER) — that is its trade-weighted index and the trade-weighted index adjusted for inflation.

Pricing versus the basket will make the yuan’s moves versus trading parter currencies more independent, thus better reflecting whether the Chinese currency is undervalued or not.

Only when the yuan rises against a wide range of currencies of countries with which China has large trade surpluses can Beijing offer convincing evidence that it is permitting real currency appreciation that will contribute to global rebalancing.

(Editing by Eric Burroughs)