SHANGHAI China's milestone move to widen the yuan's trading band will give banks and companies the most space to speculate on the currency since the country established its foreign exchange market in 1994.
In the near term, the widening of the band to 1 percent from 0.5 percent from the central bank's mid-point is unlikely to alter market views for a gradual yuan appreciation of around 2 to 3 percent this year, traders said.
But the move, announced by the People's Bank of China on Saturday, sends a strong signal that the days of non-stop, one-way appreciation in the yuan against the dollar are gone forever, traders said.
"The message of this move is that RMB's appreciation story is over. Greater two-way volatility will be the name of game going forward," said Qu Hongbin, China economist at HSBC.
That means both opportunities and risks for exporters and importers trying to manage their foreign exchange assets.
"If the yuan could move constantly more than 200 pips in a day, permanent speculative opportunities will emerge," said a senior trader with a major European bank in Shanghai.
"That will create a two-way trading environment which will make it much more difficult for banks and companies to manage their exchange rate risk. Speculation and risk will eventually create a real market for the yuan's exchange rate."
The yuan's move has so far been mostly confined to a daily range of 100 to 200 pips in the Shanghai-based China Foreign Exchange Trade System (CFETS), the domestic market, with movements sometimes even being limited to less than 100 pips.
Traders expect that the PBOC's widening of the band will mean the currency eventually moves more than 200 pips a day, possibly even 400 pips on occasions, over the next 12 months.
The yuan closed at 6.3030 against the dollar on Friday, having appreciated about 30 percent since a revaluation in July 2005, as China tries to balance its economy and yield to pressure from its major trade partners, including the United States, to allow the currency to appreciate more rapidly.
But investors are not betting on any big moves this year. Trading in the dollar/yuan non-deliverable forwards market shows investors pricing in about a 0.4 percent depreciation in 12 months. That has fluctuated over the past several quarters, but never strayed too far from the spot market.
In a move seen aimed at testing waters for the yuan to trade in a wider range, the PBOC has been allowing the mid-point to move by a few hundred pips in selected days since the start of March.
In the first half of March, the PBOC let the yuan weaken by 0.70 percent to the dollar in its mid-point, its biggest 11-session loss in the fixing since the set-up of the CFETS.
Over the next eight sessions, the central bank allowed the yuan to appreciate 0.82 percent in the mid-point, the biggest eight-session gain in the fixing since October 2010.
If China wants to further develop its currency market, it would need to do more work, including introducing a wider range of hedging options, traders say. China now has only a handful of financial derivative to hedge currency risk.
For example, forwards, swaps and options traded on the CFETS are occasionally used by Chinese banks and companies but the financial derivative market, China Financial Futures Exchange, does not have a single foreign exchange derivative product.
The latest currency reform, however, is likely to have a limited impact on the country's fixed income and stock markets in the short-term, although a freer yuan will permit more foreign capital inflows into China and will thus benefit its capital markets in the long term.
"The widening of the yuan's trading band points to a direction for the government to allow more foreign capital to flow into China," said bond market analyst Liu Junyu at China Merchants Bank in Shenzhen.
"That will be a long term positive factor for China's fixed income market, although short-term impact will be limited."
Ren Chengde, a senior stock analyst at Galaxy Securities in Shanghai, echoed, adding that the widening of the yuan's trading band was among a slew of recent government moves to free capital flows.
Earlier this month, China announced an expansion of quotas for foreign investment in its capital markets, raising the total quota for its qualified foreign institutional investor scheme (QFII), a main channel for foreign investment in Chinese securities, by $50 billion to $80 billion.
(Editing by Emily Kaiser)