The renminbi—one of the world's most tightly controlled currencies—may be hit by significant weakness, with predictions that Beijing will stand down from its traditional interventionist stance.
"We're looking for about 5-10 percent depreciation over the next one year even though it might be stable over the next few months," Adarsh Sinha, head of Asia Pacific G10 FX strategy at Bank of America Merril Lynch (BofAML) Global Research, told CNBC.
"History tells us that whenever China is facing any economic volatility, they always keep the currency as flat as a pancake. However, the tricky thing for China is that their capital account is gradually opening up, which makes it difficult for them to credibly stabilize the renminbi now."
Further monetary easing is widely expected as part of Beijing's toolkit to halt the panic-selling in mainland stocks, and economists widely agree that will place severe downward pressure on the onshore renminbi (CNY). But if China wishes to gain MSCI status and internationalize the yuan, it cannot continue intervening in currency markets as it's done in the past, experts say.
"Government intervention steps contradict intentions to allow market forces to determine the allocation of resources. Herein was the first major test of embracing market discipline," said Jeremy Stevens, international economist at Standard Bank in a note, referring to the impact of intervention on Beijing's international ambitions.
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The CNY has traded in a narrow range around 6.2 per dollar in recent sessions but the offshore yuan (CNH), traded outside the mainland, has hit fresh three-month lows against the greenback this week. That said, the CNH is a more freely floating currency so it's much harder for the PBoC to intervene compared to the onshore yuan.
"Beijing is indeed minimizing foreign exchange intervention as part of the internationalization plan," said Bernard Aw, market strategist at IG, via e-mail, adding that there are rumors about a widening of the currency band to -/+3 percent from 2 percent currently. IG believes MSCI was right to reject the A-50's bid to enter its emerging markets index last month, calling Chinese markets "immature" due to Beijing's inability to control market declines through regulation and the PBoC's blatant support.
Indeed, the negative impact of any currency interventions on domestic liquidity could offset monetary easing, BofAML explained, referring to the recent flood of criticism towards Beijing's heavy-handed actions in markets.
Fresh measures to shore up confidence were announced on Thursday, with the banking regulator saying it would allow financial institutions to renegotiate terms regarding lending using stock as collateral. The move follows news on Wednesday that holders of more than 5 percent of any China-listed company have been banned from selling any of their stake for six months.
Actions like these have shocked traders and hurt China's financial liberalization program, especially ahead of the International Monetary Fund's decision on whether to include the renminbi in its basket of reserve currencies. Indeed, market liberalization will likely be delayed by at least one or two years as a result, according to Eric Liu, head of research at Vanda Research.
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"We argued recently that China will increasingly struggle to defy the so called Impossible Trinity: the notion that no country can have a fixed exchange rate, enjoy independent monetary policy, and have an open capital account at the same time," BofAML stated in a report this week.
A looming 'financial crisis’
Aside from monetary stimulus, further renminbi weakness is also expected on a potential contagion effect from the bloodbath in A-shares.
BofAML believes damage could spread far beyond the stock market to assets like the currency, debt and even property, expecting these to get re-priced lower going forward.
"If the market continues to fall sharply, stock lending related losses could run into trillions of renminbi, of which, banks and brokers may have to bear a meaningful share. These potential losses can be especially dangerous to brokers whose capital base is less than 1 trillion renminbi. Even more important, the opaqueness of China's financial system and the lack of clear definition of risk responsibility mean that contagion risk is high, similar to the subprime crisis."
To be sure, not all currency experts agree. Nizam Idris, head of fixed income and currencies at Macquarie, still expects Beijing to continue maintaining control over both the CNY and CNH going forward despite any impact it could have on its international reputation.