The yuan closed sharply lower against the dollar on Friday, posting its second-biggest two-day drop since its revaluation in July 2005, as the central bank tested the market's ability to cope with volatility while curbing the yuan's gains.
The yuan finished at 7.6550 to the dollar, down from Thursday's 7.6487 and falling 0.25 percent since Wednesday's close. The biggest two-day fall on a closing basis was 0.32 percent on August 14 and 15 last year.
The central bank set the stage for the fall by fixing the yuan's mid-point at 7.6656 to the dollar before trading started on Friday, much weaker than Thursday's 7.6502 and Wednesday's 7.6398.
Friday's mid-point fell an unusually steep 0.34 percent from Wednesday's, for the biggest two-day drop since Beijing revalued the Chinese currency and abolished its peg against the dollar. The previous record was 0.30 percent, also hit last August.
"The central bank is testing the waters for more volatility in the yuan," said a Shanghai dealer at a European bank. "At the same time, the yuan's gains in the first half of this year appeared to have reached the central bank's goal, and the central bank may feel it's time for it to consolidate for a while."
Dealers still expect that the central bank will only allow the yuan to appreciate up to 5 percent this year, to preserve stability in the economy and particularly to curb risks for exporters and protect jobs in labour-intensive exporting sectors such as textiles.
At its post-revaluation intraday high of 7.6338 on Wednesday, the yuan had risen 2.24 percent since the start of 2007, for an annual rate of 4.5 percent - likely a hint from Beijing on how much it will allow the yuan to rise this year, dealers said.
The bulk of this year's gains were recorded since late April, with the yuan rising 1.33 percent from April 26 to Wednesday's peak, as China prepared for key trade talks with the United States in Washington in late May.
China also widened the yuan's daily trading band to 0.5 percent in either direction from 0.3 percent just ahead of the talks, another goodwill gesture that dealers believe was linked to the talks.
"The central bank has stressed that it will first build mechanisms for the yuan to move sharply in either direction before it will allow the yuan to appreciate at a quicker pace," said a dealer at a Chinese commercial bank.
"The yuan's sharp correction over the past two days fits the central bank's intentions, and it doesn't mean the yuan will slow its gains for the rest of this year," he said.
Traders said they maintained their forecast for the yuan to appreciate 4 to 5 percent for all of 2007, compared with 3.4 percent last year, and expected the currency to rebound and test the psychologically important barrier at 7.63 next week.
Dealers said the meeting of leaders of the Group of Eight (G8) leading industrial countries in Germany from June 6 to 8 had no impact on yuan trading, mainly because the summit was focusing on political issues. China is not a G8 member but Chinese President Hu Jintao attended the summit.
One-year NDFs quoted the yuan at 7.2940/7.3010, indicating appreciation of 4.99 to 5.09 percent in one year's time from Friday's mid-point. That was up from 4.95 to 5.02 one week ago, but well below 6.55 to 6.62 percent in late March.