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China is facing the biggest challenge to its currency policy since the start of the global recession as economists warn the peg to the dollar risks causing an asset bubble.

As recently as Nov. 9, People’s Bank of China Governor Zhou Xiaochuan said he didn’t feel much pressure to let the yuan rise, deflecting calls for an increase as exports start to recover and President Barack Obama prepares to discuss the issue in Beijing next week. China’s stance risks adding to liquidity after credit surged by $1.3 trillion this year, according to Fred Hu at Goldman Sachs Group Inc.

China’s sales of yuan to keep it fixed to the dollar contributed to a 29 percent jump in money supply, and the peg helped spur more than $150 billion in speculative funds from overseas in the past six months, China International Capital Corp. says. Record apartment prices and a 74 percent climb in the benchmark stock index this year are prompting warnings that the policy is inflating asset prices excessively.

“If China keeps the peg, it will be powerless to prevent asset bubbles,” says Hu, Hong Kong-based Greater China chairman at Goldman Sachs, the first foreign company to underwrite a domestic Chinese bond offering. “Politicians have a mistaken fear that any appreciation in the renminbi might be harmful to the export sector.”

Investors should sell the stocks of property developers as a way to minimize the risk of a bubble ending in collapse after their share prices gained 155 percent in the past year, Morgan Stanley says.

Obama Arrival
Obama will attend the summit of the Asia Pacific Economic Cooperation forum in Singapore this weekend before traveling to China on Nov. 15. Calls for greater yuan fluctuations may further escalate when European officials including central bank President Jean-Claude Trichet visit before year-end.

U.S. Treasury Secretary Timothy Geithner yesterday hailed a commitment by Asia-Pacific ministers to flexible exchange rates even as his Chinese counterpart at a Singapore meeting said the yuan’s peg contributed to the global economic recovery.

China’s drive to create jobs and maintain social stability through export-led growth means politicians aren’t ready to loosen controls on the currency, say Hu and Ha Jiming, chief China economist in Hong Kong at China International Capital, the first investment bank formed as a joint venture between a Chinese bank and a foreign firm.

Shift in Policy
Policy makers have kept the yuan at about 6.83 per dollar since July 2008, seeking to aid manufacturers battered by the collapse in demand abroad. The yuan advanced 21 percent in three years from July 2005, when officials loosened their controls.

Goldman yesterday reiterated its three, six and 12-month forecasts for the yuan to stay at 6.83 against the dollar. The New York-based firm said a PBOC quarterly report on Nov. 11 didn’t foreshadow an imminent change.

The central bank said in that report that currency policy will take into account global capital flows and changes in major currencies. Yuan forwards rose for a third day after the release, with 12-month non-deliverable contracts advancing 0.3 percent to 6.5895 per dollar as of 9:49 a.m. Shanghai time.

While the central bank’s 5.31 percent benchmark one-year lending rate is lower than the near-zero policy rate maintained by the U.S. Federal Reserve and Bank of Japan, China’s faster economic and credit growth rates mean it needs to boost borrowing costs, according to a survey of economists by Bloomberg News.

Rate Outlook
The central bank will take that step in the second quarter of 2010, the median estimate of 29 economists surveyed Oct. 22- 28 shows. Any move to raise rates would cause additional inflows of international capital that stoke asset prices, analysts say.

“An interest-rate hike would invite capital inflows,” says China International Capital’s Ha, who previously worked at the International Monetary Fund and Hong Kong Monetary Authority. “The root of asset-price inflation in China is the lack of an independent monetary policy.”

T.J. Bond, chief Asia-Pacific economist at Bank of America- Merrill Lynch in Hong Kong, says “the peg is a straitjacket on the PBOC, limiting its ability to tighten policy and head off asset bubbles.”

China’s benchmark Shanghai Composite Index of stocks has climbed 74 percent in 2009. The $1.3 trillion in new loans this year ignited private housing investment, which rose 35 percent in August from a year before, accelerating from a 20 percent gain in July, according to New York-based JPMorgan Chase & Co.

Apartment Prices
China Vanke Co., the nation’s largest developer by market value, increased average apartment prices in September, charging 10,168 yuan ($1,489) per square meter, 26 percent more than a year earlier. Property sales climbed 27 percent in September from a year earlier, according to the company.

In Shanghai’s downtown Xuhui district, developer Shanghai Greenland (Group) Co. paid 7.245 billion yuan for 90,000 square meters in September, a record for the city’s auctions, according to real-estate services firm Colliers International, a London- based property broker. In the eastern city of Shenzhen, home prices climbed 11 percent that month from a year earlier.

Policy makers have said they want to keep the yuan stable to help exporters, even as government figures last month showed gross domestic product rose 8.9 percent in the third quarter and exports dropped by the least since December.

Stable Target
Commerce Minister Chen Deming said Nov. 1 in Guangzhou that the yuan should be kept relatively stable to aid manufacturers and exporters, state news agency Xinhua reported. PBOC Governor Zhou, ahead of a G-20 meeting in Scotland this month, said international pressure for appreciation was “not that big.”The same day, Japan’s Vice Finance Minister Yoshihiko Noda said Noda it is “desirable for the yuan to be flexible.”

Premier Wen Jiabao didn’t mention currency policy in a Nov. 12 speech; in July, he said he favored keeping the yuan stable at a reasonable and balanced level.

“The exchange-rate issue is decidedly off the agenda,” says Goldman’s Hu, 46, a former International Monetary Fund economist who speaks with officials on his weekly trips to Beijing. He says policy makers will wait to judge the durability of the global economic and financial recovery before making any change to their stance on the yuan, also known as the renminbi.

By keeping the yuan unchanged against the dollar, officials have engineered a devaluation compared with other currencies as the dollar tumbled since March this year. It’s down 11 percent against the euro in that period.

Krugman’s Blast
China is “stealing” jobs from developing countries and hindering a global recovery by keeping the yuan low, Nobel laureate Paul Krugman says. “China’s bad behavior is posing a growing threat to the rest of the world economy,” Krugman, the Princeton University professor who won the Nobel prize for economics last year, wrote in an Oct. 22 New York Times article.

Harvard University Professor Martin Feldstein, the Reagan administration adviser who won the 1977 John Bates Clark medal for top economist under 40, said “China’s policy of expanding domestic spending while depressing the renminbi will lead to its economy overheating,” in a Financial Times article last month.

“Risks of asset-price bubbles and misallocation of resources amidst abundant liquidity need to be addressed,” Louis Kuijs, the World Bank’s senior economist in Beijing, said in a Nov. 4 report.

China won’t start allowing gains until the second half of 2010, says Peng Wensheng, head of China research at Barclays Capital in Hong Kong and former chief of China affairs at the Hong Kong Monetary Authority.

2010 Shift
“The currency will need to appreciate,” says Barclays’s Peng, also a former IMF economist. Officials may, starting in the second half of 2010, allow it to recoup the drop of about 10 percent on a trade-weighted basis it’s had since March, he says.

Contracts based on the yuan’s value in a year imply an appreciation of 3.6 percent against the dollar. Investors for years also bet on gains through the contracts with little result until authorities in 2005 let it rise from 8.28 per dollar.

“They may allow minimal gains to the yuan, but in the foreseeable future, I don’t expect a major change in policy,” New York University Professor Nouriel Roubini said in an interview at a conference in Tel Aviv.

In its effort to avoid the jump in credit undermining the quality of banks’ loan books and inflating asset bubbles, China’s banking regulator is toughening guidance to lenders.

Guidance to Banks
The agency in September told the five largest banks, Industrial & Commercial Bank of China Ltd., Bank of China Ltd., China Construction Bank Corp., Agricultural Bank of China Co. and Bank of Communications Ltd., to increase write-offs against bad loans and make sure their capital ratios don’t weaken.

“With developers and commercial banks, the market is already pricing in a lot of optimism and when policy tightens, they will be the first to go down,” says Jerry Lou, a Morgan Stanley strategist in Hong Kong. He declined to specify which firms should be sold.

China may raise banks reserve-requirement ratio, or the proportion of deposits required to set aside as reserves, by the end of March, according to the median estimate in the Bloomberg survey. The ratio for the biggest banks may rise to 17 percent by the end of 2010, from 15.5 percent now, the survey shows.

“When the system is filled with cash, it will find its way to property, whether it’s commercial or residential; it also finds its way to stock markets,” Zhang Xin, chief executive officer of Soho China Ltd., the biggest developer in Beijing’s central business district, said in an Oct. 20 interview. “We have banks coming to us and saying please borrow money.”