What comes after a more flexible yuan?

China loosened its grip on the yuan-dollar exchange rate on Saturday, widening the daily trading band to two percent from one, effective starting next Monday.

The move, a major step forward in the country's exchange rate regime reform, did not surprise analysts as the central bank had made it clear it would widen the band this year.

China's currency, the yuan, started to fall against the U.S. dollar early this year after a string of appreciations in 2013. The yuan-dollar central parity rate nosedived 111 basis points on Monday, the sharpest daily decline since July 2012.

"The recent depreciations guided by the central bank have tested the resilience in the market, and in a sense prepared investors for the band widening," said Ting Lu, an economist with Bank of America Merrill Lynch.

The central bank said in the announcement that two-way yuan fluctuation will become the norm.

"The announcement strengthens its signal that the one-way bet on a gaining yuan is over," Lu said.

In the second half of last year, a significant rise in domestic interest rates coupled with one-way growth of the yuan attracted a large inflow of hot money.

New funds outstanding for foreign exchange stood at 437.4 billion yuan in January, hitting a three-month record, and all the monitored financial institutions reported rises in such funds over the past six months.

A more volatile yuan-dollar exchange rate without an appreciation trend will deter hot money inflow and perhaps result in some unwinding of previous inflow, Lu predicted.

Zhu Haibin, J.P. Morgan's chief China economist, also said a capital outflow will help drain domestic liquidity and that possible yuan depreciation could support exports.

Chinese exporters, who may need time to adapt to a more volatile yuan, will overall benefit from the band widening, which sends a strong signal for the end of one-way appreciation, they said.

To dismiss worries over risks of large-scale money outflow, Lu noted that China has a massive four-trillion-dollar foreign exchange reserve and a 20-percent reserve requirement ratio (RRR).

If there is a money crunch in the interbank market, the central bank has a lot of room to inject liquidity, including cutting the RRR, according to Lu.

RISE OR FALL?

"It is widely perceived that the yuan-dollar rate is very close to its equilibrium level," said Lu, adding that neither trend appreciation nor trend depreciation will appear in the near term.

Wang Tao, chief China economist at UBS, agreed with Lu, saying China's current account surplus-GDP ratio is below two percent, already lower than a widely-recognized standard that says a currency is at equilibrium when the ratio is between 2.5 and 3.5 percent.

"In this perspective, the yuan is to some extent overvalued, rather than undervalued," Wang said.

J.P. Morgan's Zhu said although the band widening gives the yuan more room to fall, the currency is not shifting toward a depreciation trend due to China's stable current account surplus, the efforts in yuan internationalization and political pressure from major trading partners.

"We forecast that the yuan-dollar rate will remain stable in the near term, or experience small appreciations," Zhu said.

Whether the yuan rises or falls, analysts believe further band widening is highly possible as China has put financial reform on its priority agenda.

In addition to discussions about how a more flexible yuan will influence the Chinese economy, Lu advised China to reconsider ways to set the daily central parity rate.

As an intermediate step toward a market-based regime, China could peg the yuan to a basket of currencies weighed by the importance of its trading partners, he said.

Reform toward a real managed float requires a group of more confident and pragmatic political leaders who are truly believers in markets, Lu said.

"The current Chinese leaders are market-oriented," he said.