Published: Wednesday, 4 Nov 2009 | 6:53 AM ET

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China should unshackle the yuan from its dollar peg and follow Singapore's lead in targeting a basket of currencies to determine its exchange rate, Merrill Lynch's China economist said on Wednesday.

Linking the yuan to the dollar had done China more harm than good over the past two years, attracting both hot money inflows and international criticism, but a sudden shift to a fully market-determined exchange rate was off the table, Ting Lu said.

"The most important question is how to appreciate," he said. "We can find a middle path. We should fix the yuan to a basket of currencies."

The Singapore dollar provides China with a good model, said Lu, who is based in Hong Kong with Bank of America Merrill Lynch.

The Monetary Authority of Singapore manages the currency's value in a secret trade-weighted band against a basket of currencies, giving it the flexibility to track other Asian currencies up and down against the U.S. dollar.

After removing the yuan from a formal decade-old dollar peg in July 2005, the People's Bank of China said that it would manage the exchange rate against a basket of currencies, but, in practice, the yuan has remained closely tied to the dollar.

China has kept the yuan almost entirely flat against the dollar since the middle of last year when the financial crisis worsened, fuelling growing anger abroad in recent months as dollar weakness has led the yuan to depreciate against most of China's trading partners despite the economy's manifest strength.

"Next year, or even earlier, the People's Bank should publicly announce that it will once again use a basket," Lu said, noting that the central bank seemed to have experimented with basket-referenced management for a month or so early last year.

As in Singapore, he said that Beijing should keep the composition of the basket a secret.

By targeting a basket of currencies rather than single one, Singapore's currency regime also deters speculation by creating uncertainty in the minds of traders as to where the exact intervention bounds may lie.

Fending off speculative inflows has been a chief problem for China in reforming the yuan. Its gradual climb against the dollar from 2005 to 2008 sucked in hot money as investors viewed appreciation as a one-way bet.

Some analysts have called now for a large one-off revaluation, pushing the yuan to a high enough level to sew doubts about whether it will appreciate further.

But Lu dismissed such a strategy, saying that it would be hard to squelch all appreciation expectations and that returning the yuan to a de facto dollar peg after revaluation would only invite more foreign criticism down the road.

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