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.
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.