China pushed its currency sharply lower against the U.S. dollar Thursday, surprising markets and essentially wiping out gains the yuan had made since Beijing loosened its peg against the dollar in June.
China's handling of the yuan is a highly sensitive political issue. The yuan's latest move could renew congressional efforts to pass legislation aimed at pressuring China to revamp its currency policy.
The yen, meanwhile, softened as Japanese officials stepped up the rhetoric over the yen's recent strength amid more predictions that Japan's already fragile economy could be imperiled by the currency's rise. On Wednesday the yen had hit its strongest level against the dollar in 15 years. The dollar was trading at 85.91 yen late Thursday, compared with 85.40 Wednesday.
The dollar was broadly stronger as investors continued to gravitate toward the U.S. currency as a haven amid worries about the global economy. The euro, which fell steeply against the dollar on Wednesday as investors reassessed the global growth outlook, lost ground to $1.2827 late Thursday.
But much of the attention was on China, where the People's Bank of China set the dollar-yuan central-parity rate at a seven-week high 6.8015, up from 6.7768 yuan on Wednesday. Traders had been expecting the PBOC to set the dollar-yuan rate at 6.7800.
"I thought I had read the number wrong," said a Beijing trader at a European bank.
In subsequent over-the-counter-market trading, the dollar closed at 6.7851 yuan. At that level the yuan is up just 0.6% against the dollar since June 19, when China announced it would allow greater flexibility in the yuan's exchange rate.
The unexpected move was interpreted as China driving home the point that it wanted to see the yuan move not just higher, as many economists believe it should, but also lower.
"The only way to explain [the yuan's drop] is that the PBOC wants to artificially create two-way moves in the yuan, pushing the dollar-yuan level higher for the sole purpose of giving it room to fall later," Wang Qing, an economist at Morgan Stanley.
"When the dollar weakened steadily [against major currencies] in recent weeks, the yuan reacted very little," Mr. Wang said. "At the same time, recent data show China's trade surplus has risen significantly. All this suggests the yuan should appreciate."
Just this week data showed that the U.S. trade deficit with China hit its widest level in two years during June. The Commerce Department reported Wednesday that the trade gap with China widened 17% in June from the previous month to $26.2 billion. China this week reported that its surplus hit an 18-month high of $28.7 billion in July.
The trade deficit, coupled with the yuan's drop, could spur lawmakers in Washington to act. A Treasury Department spokeswoman on Thursday declined to comment on the yuan's latest move, but referred to comments made by Treasury Secretary Timothy Geithner on Aug. 4.
Mr. Geithner noted that China is "only at the beginning of that process and what matters is how far and how fast they let it move." The last time China let the exchange rate move in a period between 2006 and 2008, he said, the yuan moved 20%. "What's important to us and I think to all of China's trading partners is they actually let it appreciate significantly in response to market courses."
Ted Truman, a former assistant Treasury secretary in the Clinton administration, said that if the trend of softening persists against the dollar, "it would be problematic," especially given that the Chinese currency hasn't moved much since June. "If it persists, it's a problem for us and for them and for the world," he said. "The probability of Congress acting [on some punitive legislation aimed at pressuring China over its currency policy] will go up. And the difficulty the president might have to veto the legislation in an election year will go up. Ultimately it could be a big mess."
"This is not at all surprising," said Sen. Charles Schumer (D., N.Y.), "The only way we will ever get the Chinese to back off their mercantilist policies is by pressuring them to change. History has shown that the minute the pressure is off, the Chinese back off any reform."
The yuan's move also comes against the backdrop of news showing that China's red-hot economy continues to cool off. China reported that industrial-production growth eased to 13.4% in July from 13.7% in June. In addition, data on bank lending and retail sales came in softer than expected.
Meanwhile the yen's retreat against the dollar came as Japanese officials increased their warnings about the currency's strength in recent weeks. So far this year the dollar has fallen by 7.7% against the yen and traders have been wondering if the move might spark efforts by Tokyo try and temper its gains by to sell yen in the market.
On Thursday, Finance Minister Yoshihiko Noda said he would "extremely closely watch currency-market movements with great interest," and that the government "will take appropriate action while closely monitoring economic developments." In the past, Japanese officials have used the term "appropriate action" as an indirect reference to currency-market intervention.
In a statement, Bank of Japan governor Masaaki Shirakawa also expressed concerns over "substantial fluctuations" in exchange rates and stock markets.
The International Monetary Fund officials joined the fray, saying that the yen's strength undermines Japan's export-dependent economic outlook and urged the central bank to follow the U.S. Federal Reserve in easing monetary policy.
"We do see further yen appreciation as a downside risk to the outlook … and obviously, if the yen continues to appreciate, we would be concerned," Kenneth Kang, division chief for IMF's Asia and Pacific Department, said in an interview.