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A flexible yuan: The last thing China needs?

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A move to widen the yuan's trading band is Beijing's latest step towards financial liberalization but analysts warn that it may trigger renewed volatility and further damage market sentiment.

In a document released late Friday, China's State Council announced its intention to widen the currency trading band to 3 percent against the dollar, from 2 percent currently. That means the tightly controlled yuan—also known as the renminbi—will be allowed to rise or fall 3 percent from a daily midpoint rate set by the People's Bank of China (PBoC) every morning.

"The data in China has been weak so if they widen the trading band now, there will be more depreciation pressure and volatility pressure," Johanna Chua, head of Asia economics and market analysis at Citi, told CNBC on Monday, pointing to a report last week showing June factory activity slumping to a 15-month low.

There is a present bias towards capital outflows amid weakening economic growth and broad U.S. dollar strength, which could trigger a build-up of expectations that the yuan will fall in value, Citi warned.

That view was also echoed by Mizuho Bank in a note on Monday. The lender pointed out that the renminbi is already trading on the weaker side of the current band, down 1 percent in the past six months, suggesting more downward pressure is in store if the band is widened.

Read MoreChina turmoil grows: 10% renminbi drop predicted

Ordinarily, wider trading bands are theoretically neutral on a currency. But in China's case, history reveals that wider bands do lead to a weaker currency, Mizuho explained. It pointed to 2012 and 2014, when the central bank last widened the trading band that sparked broad depreciation; 2014 for example saw the currency end the year with a more than 2 percent loss.

In regard to timing, Citi expects the band widening to happen after November, but warns it may be fast-tracked if the dollar spikes following a September U.S. interest rate hike.

Hit to sentiment

While the move does signify Beijing's commitment to reforms, "the near-term prospects for currency volatility in light of the recent equity market plunge and interventionist measures does not augur well for confidence and accordingly, near-term SDR consideration," Mizuho explained, referring to the International Monetary Fund's decision to include the renminbi in its Special Drawing Rights basket.

Indeed, Citi's Chua said Friday's announcement took her by surprise: "There was an expectation the PBoC would keep the exchange rate stable this year ahead of November's SDR decision and after the government showed an aversion to financial market volatility."

A protracted rout in Shanghai and Shenzhen stock markets that started in June saw government officials aggressively intervene to quash panic-selling, taking extreme steps like ordering share buybacks and halting new share offerings. Such measures have greatly hurt Beijing's credibility as a mature financial market and risked its acceptance into MSCI's Emerging Markets Index.

On the bright side

Enhanced trade growth will be a clear positive for China when the band is widened, according to Reorient Group.

"China's exports have suffered greatly from the relentless appreciation of its real effective exchange rate (REER) resulting from the tight peg of the yuan to the greenback," the firm said. The world's second-largest economy saw exports contract for four straight months before picking up an annual 2.8 percent in June.

"Our strongly held view is that band widening accompanied by central bank permission for the yuan to depreciate should come now [instead of later this year]. It would immediately help exports and at the same time release added liquidity into the financial system," Reorient warned.

This is more crucial for reform

Instead of a wider trading band, China's exchange rate reform could benefit more from a change to setting the daily fixing rate, Singaporean lender DBS suggested in a report.

"The fixing is currently viewed as a policy signal rather than a reflection of the underlying foreign exchange supply and demand. An implementation of a more market-oriented fixing would bring the yuan closer to becoming a market-determined currency and narrow the current spot-fix spread."

But there is a chance the daily fixing formation could be reformed after the IMF's SDR decision, noted Citi.