July 21 (Bloomberg) -- China ended its decade-old peg to the dollar and said it will let the yuan fluctuate versus a basket of currencies, responding to criticism from the U.S. and Europe that its currency was undervalued.

The new yuan rate strengthens the currency by 2.1 percent to 8.11 per U.S. dollar immediately, the People's Bank of China said on its Web site. Until now, the yuan had been pegged at about 8.3 per dollar. The bank said it will continue to maintain a trading band of 0.3 percent.

The yen rose against the 16 most actively traded currencies and had its biggest gain against the dollar in 2 1/2 years. The yield on the 10-year Treasury note rose 5 basis points to 4.21 percent.

``This was the first step in a series of revaluations that we can expect in the coming years,'' said Paresh Upadhyaya, a currency portfolio manager who is part of a group that oversees $29 billion at Putnam Investments in Boston. ``They'll be gradual.'' Malaysia followed China's decision, abandoning its seven-year-old practice of pegging the ringgit to the dollar.

Letting the yuan strengthen may help President Hu Jintao control inflation by reducing the cost of imported products such as oil and copper, which are priced in dollars. It also gives the central bank, which has sold yuan to prevent the currency from appreciating, more scope to increase interest rates to cool an economy that expanded 9.5 percent in the second quarter.

`More Flexibility'

The yen gained against the dollar after China's decision, strengthening to 111.81. The Singapore dollar also gained and Treasury notes declined.

``What they're really doing is leaving the door open to further revaluations,'' said Jens Nordvig, a currency strategist at Goldman Sachs Group Inc. in New York. ``By not pegging the yuan to the dollar, it gives the Chinese more flexibility to engineer a gradual appreciation.''

Permitting the yuan to trade more freely would also answer criticism from the Bush administration and some members of the U.S. Congress that blame China's currency policy for a record trade deficit and the loss of 2.8 million manufacturing jobs.

The Treasury Department's twice-yearly review of exchange rate policies said last month that China needs to make the yuan more flexible or risk being branded a currency manipulator.

``China is now ready and should move without delay in a manner and magnitude that is sufficiently reflective of underlying market conditions,'' Snow told the Senate Finance Committee in Washington on June 23. ``Implementation of trade sanctions would lead to retaliatory policies against our exports, damaging the U.S. and global economy.''

Trade Deficit

The U.S. trade gap with China rose to a record $162 billion last year and the National Association of Manufacturers, a lobby group, expects it to grow to $225 billion this year.

Indiana Democratic Senator Evan Bayh and Maine Republican Senator Susan Collins presented legislation on June 23 that would let companies petition for duties on Chinese goods to compensate for government subsidies. The bill is one of more than a half- dozen in Congress that address what some lawmakers call China's unfair trade practices.

Currency Basket

Linking the yuan to a basket of currencies means China's currency wouldn't be tied so closely to swings in the dollar, said Adam Cole, a currency strategist at RBC Capital Markets Ltd. in London. The basket will probably be composed of the euro, yen and other Asian currencies as well as the dollar, he said.

``For instance, if we went through a prolonged period of dollar downward pressure then the yuan would feel all the pressure of that, but if it was using basket, then the move would be offset by other currencies doing better,'' said Cole. ``It's an easier way to manage a currency target.''

Singapore manages its currency by allowing it to fluctuate against a group of the nation's major trading partners. The Monetary Authority of Singapore, which reviews its policy every six months, hasn't disclosed the composition of the basket.

Investors have bet on a change in China's currency since 2002.

``If you let the exchange rate become more flexible, there is one clear direction it's going,'' said Marvin Barth, a currency strategist in London at Citigroup Inc., the world's largest bank. He spoke in an interview last month.

Investment in China

China's $1.6 trillion economy, which accounted for a 10th of world growth last year, has trebled in size since the yuan peg was introduced. Foreign direct investment jumped 14 percent to a record $60.6 billion in 2004, according to government figures. A year earlier, China surpassed the U.S. as the biggest recipient.

The People's Bank of China has to buy dollars that flow into the country to maintain the currency peg, adding yuan to the economy and diluting the impact of state lending curbs. The central bank spent $193 billion buying foreign currency in 2004, a 41 percent increase from a year earlier, it said on Feb. 28.

The central bank raised its lending and deposit rates on Oct. 28, the first increase in a decade, to complement limits on investment in property, steel and autos that have driven prices higher and strained power supplies.

``The next move is that people will estimate the stronger yuan's impact on the growth rate,'' said Steven Chang, vice president of global markets at State Street Bank & Trust Co. in Hong Kong. ``They may think the growth rate is going to slow down and wonder if it is going to be so much more positive for the Asian currencies.''

China is seeking to cap inflation at 4 percent this year from a peak of 5.3 percent in August. Inflation in 2005 is likely to slow to between 3.0 percent and 3.5 percent, the People's Bank of China said on June 14. The consumer price index climbed 1.8 percent in May from a year earlier, the National Bureau of Statistics said on June 13.

To contact the reporter on this story: Yumi Kuramitsu in Hong Kong ykuramitsu@bloomberg.net

Last Updated: July 21, 2005 08:45 EDT