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Why another China devaluation could be coming

After a few sessions of relative stability, risk aversion returned in a big way to China's stocks Tuesday with the Shanghai and the Shenzhen Composite both down 6 percent by the end of the session.

Local media put the sudden return of volatility down to Chinese brokerages increasing margin lending and short-selling. Traders and analysts in Europe and the U.S., meanwhile, spoke of concerns over another devaluation of the yuan, fuelling another rout in its stock market.

"We think there is a reason to believe that the Chinese renminbi (yuan) devaluation isn't over. There could be more moves there," Ben Gutteridge, the head of fund research at Brewin Dolphin, told CNBC Tuesday.

China's Central Bank
ChinaFotoPress | Getty Images
China's Central Bank

Kamakshya Trivedi, chief emerging market macro strategist at Goldman Sachs, agreed, telling CNBC Tuesday that another devaluation is likely in the "medium term."

A near 4 percent devaluation of the yuan last week sent Chinese - and emerging market - stocks - into freefall, with investors pulling out money from an economy that is still coming to terms with slowing growth.

China has enjoyed a debt-fueled boom in the last decade but the People's Bank of China (PBoC) is now trying to manage a transition to a more consumer- and services-focused economy.

Rate cuts and devaluations are usually seen as stimulatory but Trivedi explained to CNBC that investors are now pricing in a premium for Chinese assets because of the chance that the central bank will make a "policy mistake." Trivedi, however, added that the pace of any future devaluation is likely to be slow.

The policy - despite getting a warm reception from the International Monetary Fund and potentially boosting exports - is flawed, according to Gutteridge. He believes that a "managed" devaluation is giving a "free pass" for investors to get out of the currency and thus damaging the country's balance of payments.

"Slow translation creates capital flight and puts challenges on the balance of payments," he said.

"By defending your currency, by taking yuan out of the economy, you are tightening liquidity. So they may have to, I think, take another devaluation from here."

The dollar is now worth 6.3928 against the yuan after trading at a level of 6.2085 before last week's market movements. The move has also sparked fears of a currency war across Asia with other central banks joining the fray and devaluing their currencies to defend their own economies.

Larry McDonald, the head of U.S. strategy at Société Générale, told CNBC Tuesday that the PBoC had lost some credibility after the deprecation, adding that investors were right to be concerned with markets "getting a lot of mixed signals" from Chinese policymakers.

Commodity traders have also grown wary after last week's developments, with a lower yuan potentially making metals more expensive for China, thus hitting demand.

Nonetheless, Caroline Bain, senior commodities economist at Capital Economics, is fairly resolute on the outlook for the sector, suggesting this was only a worse-case scenario.

"Unless the yuan was to go into freefall, which we don't think is likely....then this sort of scale of devaluation is not really going to deter commodities buying," she told CNBC Monday.