Asia FX

China's reform drive threatens to derail yuan

Chinese one-hundred yuan banknotes.
Tomohiro Ohsumi | Bloomberg | Getty Images

After a positive year for the yuan, Beijing's reform drive may knock the off its path of appreciation over the coming 12-18 months, according to Lombard Street Research.

"Beijing has firmly set off on the route of reform, planning to widen the exchange rate band and liberalize capital flows. But contrary to the expectations of many, this is most likely going to push the yuan down rather than up," Diana Choyleva, head of macroeconomic research at Lombard Street Research wrote in a report.

"Opening the capital account will fundamentally change the direction of causation between the current account and the yuan. Capital flows will become the key driver," she added.

(Read more: China unveils boldest reforms in decades, shows Xi in command)

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During the Third Plenum earlier this month, policymakers pledged to speed up the opening of the country's capital account and further financial liberalization. While no timeline has been outlined for such reform, the firm expects the pace of reform to be much swifter than in previous episodes of change.

According to Choyleva, allowing capital to flow more freely into and out of China may lead to an exodus of funds out of the mainland, as domestic investors seek to diversify through buying foreign assets in search of yield.

(Read more: China's economic reforms: What you need to know)

This will result in capital outflows outstripping capital inflows, driving the yuan down, she said. The tightly-controlled Chinese currency has appreciated 2.2 percent against the U.S. dollar so far this year.

"China's national savings are around $4.2 trillion - a huge 'wall of money' which will be unleashed on the rest of the world," she said. This compares to national savings of $2.7 trillion in the U.S., and $1.3 trillion in Japan.

"Once the capital account is fully open there is little limit to the extent that [Chinese] residents can sell their own currency for foreign," she added.

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On top of this, foreign investors will be discouraged from piling into Chinese assets as the economy's adjustment over the next couple of years is likely to be accompanied by weak growth, corporate defaults and financial instability, she added.

Mitul Kotecha, head of global foreign-exchange strategy at Credit Agricole says that liberalization of foreign exchange policy is likely to be negative for the currency in the near-term.

(Read more: China pledges 'decisive' role for markets in reform push)

"This is because a widening of the daily trading band, which we expect in fourth quarter of 2013 or slightly later, will imply a higher value at risk for players holding positions in the currency," he said.

Currently, the yuan can only trade 1 percent above or below the midpoint set by the central bank each day.

"Risk departments will therefore reduce exposure limits for traders. Most in the market seem to be long the CNY [yuan], as indicated by the fact that spot has been trading close to the stronger end of the band, so a reduction of limits would suggest a need to cut CNY [yuan] longs," he added.

While Kotecha sees the yuan weakening slightly against the greenback into the year end to 6.10, from 6.09 percent currently, he forecasts the currency will be at 6.00 by end-2014.

—By CNBC's Ansuya Harjani; Follow her on Twitter:@Ansuya_H