China pulled back the veil on its new currency regime a little further on Tuesday, appearing to engineer a fall in the yuan to make clear its vow of flexibility did not include one-way bets for appreciation.
Big Chinese state-owned banks kept the yuan in check, a day after its biggest rise since the currency was revalued in 2005, indicating Beijing will allow its currency to appreciate at a far slower pace than demanded by its critics in the West.
The two-way movement in the yuan is not great by the standard of freely floated currencies but is unprecedented in China where until this week the central bank had squashed intraday volatility via intervention.
China is relaxing its control on the yuan ahead of this weekend's G20 summit of world leaders in Canada, breaking a two-year dollar peg that had been a lightning rod for critics who say the currency is undervalued and gives Chinese exporters an unfair trade advantage.
China has backed up all the talk with action, and President Hu (Jintao) will arrive in Toronto later this week with tangible evidence that China is serious about increasing the flexibility of its exchange rate, said Brian Jackson, strategist with Royal Bank of Canada in Hong Kong.
We still may see moves in either direction from day to day, but we think the trend in the weeks and months ahead will be for the yuan to make limited but meaningful gains against the dollar.
The yuan rose more than 0.4 percent on Monday, its biggest rise since the landmark revaluation in 2005, pushing up close to its trading limit of 0.5 percent either side of a reference point set each day by the central bank.
On Tuesday, the central bank set the reference rate at about the same level as Monday's close, leaving room in theory for the currency to rise another 0.5 percent.
The yuan immediately rose to a new five-year high before turning lower. State-owned banks also stepped in to the market and aggressively bought dollars, suggesting authorities want to control the pace of the yuan's appreciation.
The People's Bank of China, the central bank, made no secret that it would not allow the yuan to appreciate too fast in statements over the weekend announcing the currency reform.
By allowing for greater ups and downs, the central bank will move a step closer to its long-stated aim of developing a more mature market in which companies learn to hedge against foreign exchange risks, part of its overall efforts to develop Shanghai into a global financial center by 2020.
Still, markets and critics in the United States and other countries are unlikely to be easily convinced of the depth of the reforms unless they see significant appreciation of the yuan.
Markets surged on Monday after Beijing's weekend vow, on optimism a stronger currency would boost the fast-growing economy's purchasing power.
But doubts about the speed of yuan appreciation had already begun to surface in the United States on Monday. Asian stocks then reversed their gains on Tuesday as investors took profits from the rally on Monday.
Commodities also pared their gains, as did commodity-linked currencies like the Australian and Canadian dollars.
Many economists see China's currency strengthening further in coming days but at a very modest pace, further diluting hopes for big market gains.
A Reuters poll of 33 economists showed they expected the yuan to end the year at 6.67 per dollar, a rise of 2.4 percent from late last week before China's policy announcement and similar to the appreciation implied by offshore non-deliverable forwards.
The challenge for China going into this weekend's G20 summit will be to convince other countries, many of which are expected to seek further clarification from Beijing, that it has made a genuine move to a more flexible currency.
We're obviously encouraged, but we'll be monitoring the progress, White House spokesman Bill Burton said in Washington. Implementation here is going to be key, and so we're just going to be keeping an eye on that.
A senior U.S. official, briefing reporters on condition of anonymity, said China's gradual approach to yuan flexibility was a prudent step that could both manage expectations and deter massive speculative buying of Chinese assets.
The official said it was promising that China seemed ready to allow the exchange rate to respond to market forces, and that the test now was how far and how fast Beijing would permit the yuan to move.
The proof will be in the pudding over time, Canadian Prime Minister Stephen Harper said in an interview with Reuters.
But I think it's fair to say this is a very positive announcement by China. More broadly it does show China not simply doing some positive things, but China assuming a more global view, he said.
(Additional reporting by Koh Gui Qing and Karen Yeung; additional writing by Wayne Cole)