The People's Bank of China (PBOC) set the yuan's midpoint against the dollar sharply lower on Monday, the second biggest single-day fall on record and the latest signal that China is willing to let its currency move within a wider range.
The central bank allowed the yuan to fluctuate last week after PBOC governor Zhou Xiaochuan said conditions were ripe for the exchange rate to float in a wider range.
Last week, the midpoint dropped 0.41 percent from Monday to Thursday, the biggest four-day fall since August 2010, and then on Friday, it posted the biggest single-day rise in four months.
Traders and analysts said the PBOC appears to be preparing the domestic and global markets for sharper fluctuations to eventually widen the yuan's daily trading band.
But they said the greater volatility will not automatically lead the yuan to depreciate against the U.S. dollar, adding they expect it to firm over the year.
The yuan appears to be ending its years-long trend of one-way appreciation and is set to fluctuate in either direction from now on, said Liu Dongliang, currency analyst at China Merchants Bank in Shenzhen.
This will force Chinese companies to gradually get used to rising exchange rate risk, he said. But the trend for the yuan to continue to appreciate slowly will continue this year.
The central bank set the yuan midpoint at 6.3282 to the dollar on Monday, making the Chinese currency fall 209 pips or 0.33 percent from the previous day's fixing.
It was the second biggest daily fall in the midpoint since China established its modern foreign exchange market in 1994. The biggest single-day fall occurred on August 12, 2010, when the yuan dropped 247 pips or 0.36 percent.
The yuan closed at 6.3265 against the dollar, down from Friday's close of 6.3107.
Analysts said the drop did not appear to be linked to monthly trade data released at the weekend which showed China posted its largest monthly trade deficit in a decade in February.
It's simply a reflection of the fact that the authorities want two-way variability, and they're prepared to adjust the fix to reflect that, said Robert Minikin, senior foreign exchange strategist at Standard Chartered in Hong Kong.
China has long stated its intention to promote greater two-way flexibility in the tightly controlled yuan, which has appreciated more than 30 percent since July 2005, when Beijing conducted a landmark revaluation of the currency.
The current trading band for the dollar/yuan is 0.5 percent. The central bank has kept the yuan stable within a tight range this year, in line with the government's policy of avoiding any negative impact from a volatile exchange rate on the economy.
But analysts said weaker exports in the first half of the year, combined with smaller cross-border capital flows compared to last year, meant that widening the band would not trigger excessive volatility.
The yuan generally moves less than 0.2 percent a day, so the immediate impact of a wider band on the spot market would be limited, analysts said.
In the offshore non-deliverable forwards (NDF) market, the benchmark one-year NDFs implied yuan appreciation of 0.19 percent in afternoon trade, down from 0.27 percent appreciation implied at Friday's close.
(Editing by Jason Subler and Miral Fahmy)