* China yuan revaluation won't halt emerging forex rise
* Emerging economies could tolerate stronger currencies * Euro/dollar rate could slip in tandem with yuan rise
By Sebastian Tong
LONDON, Nov 17 (Reuters) - When China finally heeds the global chorus and loosens its grip on its currency, yuan appreciation could prompt a rare divergence that pushes the dollar further down against other emerging currencies yet up against the euro.
The near-40 percent decline of the U.S. dollar over the past eight years has been felt disproportionately on free-floating major currencies such as the euro while many emerging economies -- notably China -- have pegged their exchange rates tightly to the falling greenback to keep exports competitive. Central banks who have been buying dollars to maintain those pegs quickly diversify by selling approximately a third of those dollars for other currencies, mainly euros.
"The euro has been the refuge because there are few options out there and the euro/dollar would probably weaken if the Chinese allow the yuan to rise," said Thomas Falloon, head emerging markets at La Francaise des Placements in Paris.
China's central bank last week stoked speculation of a shift from its effective dollar peg by tweaking long-standing wording on its currency policy..
The pressure for a yuan revaluation has been huge.
The Chinese currency rose about 20 percent against the greenback in the three years after the last adjustment to the peg in July 2005 but has remained essentially flat since mid-2008 when the Western credit crunch began to send shockwaves across the world economy.
In contrast, emerging economies with more flexible exchange rates have had to grapple first with plummeting exchange rates and then, since March, with sharply rising currencies that are threatening to erode their export competitiveness.
Among China's BRIC peers, Brazil's real has surged a blistering 35 percent against the dollar since the start of the year, prompting the government to slap a two percent tax on foreign investments in fixed income and stocks.
Unsurprisingly, Brazil is among the developing countries increasingly vocal about the need for China to let the yuan rise to pave the way for a rebalancing of the global economy that would revive a waning dollar.
But the move could snap the euro's eight-month-long rally against the dollar while accelerating capital inflows into emerging markets, leading to further strength, rather than weakness, in those currencies.
Investors say they are likely to position themselves for further appreciation for emerging currencies as any adjustment on the yuan would only be the start of a longer process.
Although the yuan is seen anywhere between 20 and 30 percent undervalued to the dollar, benchmark one-year dollar/yuan non-deliverable forwards imply a 12-month appreciation in the Chinese currency of 3.4 percent.
EURO REVERSAL?
Even a modest yuan rise could make other emerging economies, particularly China's export-focused rivals in Asia, more tolerant of currency appreciation.
In recent months, authorities from Moscow to Seoul to Brasilia have acted to curb what they say are 'hot money' speculative flows threatening their economic recovery.
Russia's central bank, which spent $15 billion last month to slow the rise of the rouble, has bought over $5 billion in currency interventions since the start of November while Brazil bought $6.7 billion on the spot market in October, almost double its September levels.
"Policy response has been the only obstacle to currency appreciation," said Benoit Anne, head of EMEA and Latam forex and debt strategy at Bank of America-Merrill Lynch.
The euro has taken the brunt of efforts by the People's Bank of China and other central banks to keep a lid on their currencies, rising some 20 percent against the dollar over the last 12 months, and less foreign exchange intervention could help euro zone exporters by halting its ascent and possibly sparking a reversal.
"A renewed appreciation trend for the yuan not only implies less flow into the euro and other freely floating currencies from China but also from other central banks in Asia," Calyon said in a research note.
It forecast a slump in the euro/dollar from the beginning of 2010 to 1.42 by the year's end.
But the dollar's recovery on the back of a stronger yuan won't necessarily translate outside the euro zone.
In fact, the Federal Reserve's determination to keep U.S. interest rates low to nurse the economy back to health will sustain the carry trade in which investors borrow in dollars to buy higher yielding assets, particularly in emerging markets.
"The hunt for yield still goes on. It won't stop the feeding frenzy if China revalues the yuan. Instead, people may become more optimistic on emerging markets," said Nigel Rendell, emerging markets strategist at RBC Capital Markets. (Reporting by Sebastian Tong; Editing by Ruth Pitchford)