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China's announcement on Saturday to enlarge the floating band of the yuan's trading price against the US dollar was viewed as a breakthrough in the process of forming its market-based currency exchange rate.
The People's Bank of China, the country's central bank, said in a statement published on its official website that the floating band in the inter-bank spot foreign exchange market will be enlarged from 0.5 percent to 1 percent effective April 16.
To keep the exchange rate stable, the PBOC has set a daily reference rate for the yuan and it will be allowed to fluctuate only to the daily limit on either side of the reference rate. The trading range was widened to 0.5 percent from 0.3 percent in May 2007.
It also raised the spread between dollar selling and buying prices offered by the foreign exchange-designated banks to their customers to 2 percent of the reference rate, from the current level of 1 percent.
The PBOC said the move is to "meet market demands, promote price discovery, enhance the flexibility of the yuan exchange rate in both directions, and further improve the managed floating yuan exchange rate regime based on market supply and demand with reference to a basket of currencies."
In the future it will keep the currency basically stable at an "adaptive" and "equilibrium" level to preserve stability in the Chinese economy and financial markets, the bank said.
Cao Yuanzheng, chief economist of the Bank of China Ltd, said earlier that a daily limit of 1 percent is more appropriate and in line with international conventions, and a wider trading range will help to form a market-based exchange rate by encouraging more market hedge behavior.
The move fell within market expectations and now is a good time to expand the spread, said Wang Tao, head of China economic research at UBS Securities Co Ltd.
"Since the ratio of China's current account surplus to GDP has dropped to below 3 percent, and is likely to remain at a low level," she said, "the yuan exchange rate should not still be seen as significantly undervalued. Appreciation expectation of the currency has weakened, and speculative capital inflows related to the yuan seem very small, too."
China's trade surplus may drop to 3.1 percent of GDP this year from 3.4 percent in 2011, while the current account excess will rise to 3 percent from 2.8 percent, the World Bank predicted in a report released on Thursday.
China registered a trade surplus in March after February's deficit of $31.48 billion, the biggest trade deficit since at least 1989.
Wang predicted the yuan will show greater volatility against dollar this year. "Given political factors and the threat of protectionism in the US, we still expect the yuan will continue to appreciate by 2 to 3 percent in 2012."
She added that, in the long term, expansion of the yuan's floating flexibility will make the Chinese monetary policy more independent, which would allow interest rates to play a bigger role in monetary management.
"Chinese authorities have started to gradually push forward opening-up of the capital account, which means that if the central bank hopes to maintain independence of monetary policy, it must allow more flexibility of the yuan," said Liu Ligang, head of China economics at the Australia and New Zealand Banking Group Ltd.
The more likely two-way fluctuation of the yuan in the future, after the floating band expands, means companies will hedge foreign exchange trading risks, Liu said.
"It may also encourage wider use of the yuan as a settlement currency in foreign trade to reduce related risks. This all means there will be a substantial development of China's financial market and financial products."
However, the central bank's move on Saturday - together with a weaker-than-expected GDP growth of 8.1 percent in the first quarter - may spur worries over potential depreciation of the yuan, and drag down the currency's performance after the market opens on Monday.
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