Nov. 25 (Bloomberg) -- China allowed market makers in the yuan and will sell currency swaps to local banks at a stronger exchange rate, two steps toward a more freely traded currency.

Commercial lenders will be able to quote and trade the yuan against foreign currencies from next year, the State Administration of Foreign Exchange said on its Web site. Prices for the dollar will still have to be within 0.3 percent of a daily rate set by the central bank.

U.S. President George W. Bush, who visited China last week, is pressing his counterpart Hu Jintao to make the yuan more flexible even after Hu dropped the currency's decade-old peg to the dollar. Market makers will end the central bank's monopoly on setting interbank exchange rates, paving the way for increased trading.

``Market making is a significant step on a long journey of making the yuan more flexible,'' said Stephen Green, an economist at Standard Chartered Plc in Shanghai. ``With the swap, the central bank is giving the market some guide to its expectation of how much the currency will appreciate next year.''

The central bank on July 21 reset the yuan's value at 8.11 to the dollar, a 2.1 percent appreciation from the pegged level where it had been held since 1995, and started managing its value against a basket of currencies including the euro and yen.

The yuan's value has changed little since the revaluation. It closed at 8.0815 to the dollar today, a gain of 0.35 percent since the revaluation.

Signaling Appreciation

In another sign China will let the yuan appreciate further, the People's Bank of China will conduct its first currency swap with commercial lenders, said traders at banks that deal with the central bank.

The central bank offered 12-month swaps to lenders at 7.85 yuan per dollar, an exchange rate 2.9 percent higher than today's closing level, said the traders, who declined to be named. The $6 billion swap deal was first reported today by the Shanghai Securities News, which is affiliated with the official Xinhua news agency. The yuan rate at which the transaction was offered was reported earlier today by Reuters.

``The significance of the move is that all the domestic banks and the PBOC agreed on the one-year forward rate of 7.85,'' said Frank Gong, chief economist for Greater China at JP Morgan Securities Asia in Hong Kong. ``The yuan has to be stronger than that in one year for the banks to be in the money.''

`Guide the Market'

Currency swaps are used to exchange payments in one currency to another. Under the agreement, the central bank will pay $6 billion to commercial banks in exchange for the equivalent in yuan at the spot rate, said the traders. In 12 months time, the parties will exchange back the payments at the contracted rate.

A spokesman for the People's Bank of China in Beijing declined to comment on the swap transaction.

``By doing the swap, the central bank is trying to guide the market's expectations of the exchange rate,'' said Tai Hui, a Hong Kong-based economist at Standard Chartered. ``If it works, the central bank might do it on a regular basis.''

Yuan forwards traded in Hong Kong fell after the central bank offered the swap at a lower rate than signaled by the market. The yuan would climb to 7.7895 against the dollar in a year if freely traded, according to forward contracts as of 5:38 p.m. in Hong Kong. Late yesterday, the yuan forwards market was suggesting China's currency would strengthen to 7.745.

Banks that have been approved to trade in the foreign- exchange interbank market for at least two years may apply for approval to start quoting and trading the yuan against foreign currencies at the start of 2006, the foreign-exchange regulator said on its Web site last night. HSBC Holdings Plc, Citigroup Inc. and Bank of China are among firms that trade in the interbank market.

Pressure From U.S.

The People's Bank of China allows the yuan to move by as much as 0.3 percent either side of a daily fixing rate that it sets. The maximum fluctuation allowed against the euro, yen and other currencies is 3 percent.

Lawmakers and manufacturers in the U.S. and other countries say the yuan is undervalued, giving Chinese exporters an unfair advantage by holding down the value of China-made goods abroad.

China's trade surplus swelled more than sevenfold to $80.4 billion in the first 10 months of this year, from $11.1 billion a year earlier. The U.S. trade deficit with China for the first nine months reached a record $146.3 billion, compared with $114.3 billion at the same time last year, according to U.S. figures.

``Given the U.S. pressure, China will probably need to allow the yuan's appreciation to speed up next year and they may be preparing for a wider fluctuation of the currency,'' said Masashi Hashimoto, a foreign exchange and treasury manager in Tokyo at Bank of Tokyo-Mitsubishi Ltd.

Treasury Report

China will ``unswervingly press ahead with reform'' of how it manages the exchange rate, Hu said in Beijing on Nov. 20 after meeting Bush, who urged China to continue moving toward a market- based currency.

The introduction of market makers and the swaps deal may be timed to coincide with the release of the U.S. Treasury's semi- annual report on whether China or any nation is manipulating its currency, said Shahab Jalinoos, head of Asian currency strategy at ABN Amro Holding NV in Singapore.

``Given these are steps forward to flexibility, then it will be a lot harder to describe China as a manipulator,'' said Jalinoos. ``The central bank is trying to develop the currency market, and they're emphasizing flexibility.''

Tony Fratto, the U.S. Treasury Department's chief spokesman in Washington, declined to comment.

To contact the reporter on this story: Rob Delaney in Beijing at robdelaney@bloomberg.net.

Last Updated: November 25, 2005 11:57 EST