The big news coming out of the weekend was China announcing that it would  end its two-year peg of the Yuan to the Dollar. The exchange rate was frozen in July 2008 as the Chinese government was worried about the effect of the global recession on its exports.

The end of the peg means that Chinese authorities will return to a “managed float” of the Yuan. In that while they will let the yuan rise it will not let the market determine the rate all by itself and will keep the yuan in a trading band that can be adjusted by officials.

Prior to freezing the exchange rate, China had “allowed” – and that’s where the managed part comes in – its currency to rise 21% against the Dollar over the previous three years. While there will be no one-off revaluation as the Chinese central bank said there’s no basis for a “large scale” move, the exchange rate will be allowed increased “flexibility.” According to Bloomberg, the yuan will appreciate about 4% this year and 5% next year.

Here’s a look at the CNY/USD over the past 10 years. We see that China moved to a managed float in the middle of 2005, before fixing its currency again in mid-2008.

By maintaining a trading band, the authorities can curb inflows of short-term speculative capital and prevent “excessive” fluctuations. Following the announcement, the yuan rose the most since a July 2005 revaluation and forward contracts in the yuan jumped. Stocks in China were also up, as were the government’s bonds.

Implications For Chinese Economy

A stronger yuan will boost the purchasing power of China and its consumers. Countries that export to China, such as Australia and New Zealand, will see greater demand for their goods as they become cheaper to buy for Chinese. A stronger yuan will also help to curb inflation since it makes imports cheaper. That would decrease the pressure on the Chinese central bank to hike interest rates.

It will also, most importantly, put China on a path to shift its country’s economy away from an export-dominated one to a more domestic consumption one. That would mean more investment towards services industries and away from export-manufacturing.

It may be hard to believe considering how many people are in China, but there is actually a bit of a worker shortage in the coastal cities. That is creating conditions in which wages are rising and workers are demanding pay increases. Some of this is to compensate for lack of wage increases during the recession, but there have been strikes at Honda plants for instance that were met with 24% rate hikes. That trend will accelerate a shift towards domestic demand as rising incomes stoke retail industry. However, a stronger yuan will be detrimental to Chinese exporters with very small profit margins, so it could cause some to go out of business. This shift will be gradual, but it could help to address some of the imbalances in global trade.

Finally, depegging the Yuan will help to deflect criticism that China is unfairly using an undervalued currency to help its growth – a charge made by US lawmakers and one that would have been a topic of conversation ahead of the upcoming G-20 meeting.

Rebalancing the Global Economy

The global economy is out of balance right now and the upcoming G-20 meeting will focus on what needs to be done to realign those imbalances.

In the previous expansion, US consumers borrowed in order to fund demand, which drove up the current account surpluses of many Asian nations, especially China. As China and others accumulated dollars from trade surpluses, they bought U.S. debt and depressed global yields. Those lower borrowing costs helped stoke the U.S. housing and credit booms that turned to bust in 2007.

Therefore, the ideal solution would be for the US to spend less and save more, while others like China, Germany and Japan to save less and purchase more. The U.S. savings rate was 3.6 percent of gross domestic product in April. That compares with Germany’s rate of about 11 percent. China’s savings rate stood at 54 percent in 2008.

A 5% increase in the yuan’s value against the dollar would improve the overall U.S. trade deficit, at $378.6 billion in 2009, by about a fifth.

Impact on Currency Markets

The immediate impact over the next few weeks will be felt by commodity currencies that rely on global growth and exports to China, especially the Australian Dollar. China has been buying so much iron and coal from Australia that Australia skirted a recession last year. It’s feeding a jobs boon in mining and the RBA has been hiking rates as a result.

The AUD/USD pair hit a bottom near 0.81 in the midst of the Euro-zone sovereign debt crisis. After testing that level three times, we pushed above 0.85 two weeks ago as the fears around Europe calmed. Last week we pushed above resistance at 0.8650. And to start this week we gapped above the 0.8750 area.

Plotting a fibonacci retracement from that high to our low near 0.81 we see that we are currently at the 61.8% retracement of that full slide. If we push above that level (pretty much todya’s high) we can move to the 0.90/0.9050 level in the next week or two. Again provided we continue the recent risk sentiment, which is positive.

Following the close of the European session, we declined from today’s highs, as oil prices slid. That caused a pull back from today’s moves.

We’ll see if fears of a global double-dip depress risk sentiment in the weeks to come, but if not, the Aussie has a chance to continue its climb, retracing more of its fall from the 0.92/0.94 level.