SHANGHAI China's central bank loosened its grip on the yuan on Saturday by doubling the daily trading range for the currency, adding teeth to a promise it would allow market forces to play a greater role in the economy and its markets.
Analysts said the move was a sign of confidence that the central bank had successfully fought off a plague of currency speculators, and at the same time signalled that regulators believe the economy is stable enough to handle more promised reforms going forward.
But as far as Beijing's project to encourage the international usage of the yuan is concerned, there is less consensus, with some warning that more volatility could discourage firms from using the yuan in the short run.
The People's Bank of China (PBOC) said the exchange rate will be allowed to rise or fall 2 percent from a daily midpoint rate it sets each morning. The change is effective from Monday.
"This is a major step towards building more market-oriented exchange rate mechanisms in China, signifying a gradual withdrawal by the central bank from regular intervention in the foreign exchange market," said Fu Qing, head of foreign exchange trading at Standard Chartered Bank in Shanghai.
"However, with more volatility in the yuan's exchange rate created by the reform, Chinese companies will face an uphill task learning how to hedge their currency risks."
Many market participants have long viewed the yuan as a one-way appreciation bet. Authorities are trying to change that by demonstrating that it is now more of a genuine market that can go up and down like any other.
"The People's Bank of China will continue to increase the two-way flexibility of the renminbi exchange rate, keeping the exchange rate fundamentally stable within reasonable and balanced levels," the PBOC said in a statement on its website.
A PBOC spokesman in a separate statement said that the new flexibility would help improve efficiency and increase the decisive role of the market to allocate resources.
The widening of the band had been broadly expected after the yuan fell in value from mid February through early March. Traders suspected that the central bank, working through state banks, pushed the currency down to try to force those speculating on appreciation to unwind their positions.
The idea was to leave the market more balanced between buyers and sellers to reduce the chances of dramatic moves once the trading band was widened.
The central bank's clamp down came after it had guided the yuan to rise 2.9 percent against the dollar in 2013, far outperforming other emerging economy currencies and surprising markets, which had not been so bullish.
That rally encouraged capital to flow into the country betting on a steady increase in Chinese interest rates, which made Chinese assets relatively attractive given the weakness of the dollar.
Many Chinese importers even inflated their receipts to bring in more cash to speculate on the yuan, which repeatedly and massively distorted the country's trade figures in certain months.
However, since the beginning of 2014, the central bank's action has pushed the currency down 1.6 percent. While that is not a major move for many currencies, for the yuan it marked a bigger slide than the currency posted over six months during the Greek debt crisis in 2012.
In pushing the yuan lower, the risk was that traders bullish on the yuan would see the weaker levels as a buying opportunity.
However, foreign exchange traders said that the yuan continued to fall in recent weeks and stay closer to the central bank's midpoint, even though state-owned banks had stopped intervening, indicating many bulls had been shaken out of the market.
A senior money manager for an international investment fund in Shanghai, who spoke off the record because of the sensitivity of relations with regulators, said that the wider trading band would likely discourage foreign investors.
"It's what China needs to do, and the smart money says, OK, this is great, this is two way, we'll have more money coming in and out. But for the next tier of investor, they see China as very hairy still, not a lot of transparency, and the only news is bad news. They don't look at this as good news they just look at it as more volatility."
Currency analysts said the shake out of bullish positions cleared the way for the PBOC to widen the trading band without worrying that the currency would immediately leap to test the upper limits of the new range.
"Conditions for a band widening were ripe," said Li Heng, economist at Minsheng Securities in Beijing.
Li Huiyong, an analyst at Shenyin Wanguo in Shanghai, said that allowing the yuan to trade in a wider range each day and so respond more to market forces would make the currency more attractive internationally.
"China needs to internationalise the yuan and a 1 percent fluctuation cannot adequately reflect market demand for and supply of the yuan," said
Beijing wants to expand the Chinese currency's footprint beyond Hong Kong, where more than 80 percent of yuan trade settlement transactions are handled, and foster greater confidence among offshore businesses to adopt the yuan, also known as the renminbi, as a currency for trade.
Its efforts have paid dividends so far, with the yuan already overtaking the euro to become the second-most used currency in trade finance, data from global transaction services organisation SWIFT showed.
The central bank's announcement follows rising concerns about the implications of slowing growth in China, with some warning that Beijing might have to ease up on the pace of long-term structural market reforms aimed at migrating China to a more sustainable model.
"That the central bank chose to widen the band right now shows, in some ways, that it is confident about the economy," Shenyin Wanguo's Li said.
How the wider band will play into Beijing's efforts to reduce debt and wasted investment while maintaining enough growth to keep employment stable is an open question.
Although widening the trading band is aimed at introducing more two-way price swings into the market, the last change in April 2012 - doubling the band to 1 percent - largely failed to do so.
Instead, the spot price consistently traded near its strongest permissible level after briefly heading lower following the band widening.
"The market will welcome the PBOC's move, but it will also ask one question," said a trader at a European bank in Shanghai.
"The yuan's midpoint is now the base rate for the currency's daily movements. That means if the PBOC sets the midpoint far off from market rates, the market actually has no role in deciding the yuan's exchange rate."
(Reporting by Pete Sweeney and Lu Jianxin; Additional reporting by Kevin Yao and Koh Gui Qing; Editing by Neil Fullick)