In the currency markets, China's yuan is considered largely a one-way bet: Economic growth and pressure from trade partners make appreciation against the dollar a no-brainer, within the limits set by the government.
So when the yuan's appreciation actually slowed in February, the conventional wisdom may have been shocked to discover that market forces were largely to blame.
While China still keeps a tight rein on its currency, it has quietly been expanding the market's role, giving banks some room to diversify their holdings, hedge their positions and even do some speculating.
"Since the yuan's revaluation, China has done a lot to build up mechanisms that allow the market to play a role in pricing the yuan, possibly more than many critics have realised," said Wang Qing, economist at Bank of America.
Wang and others are quick to add that, despite the market's growth, expectations remain one-sided that China's currency will rise, and a freely traded yuan is still a long way off.
The central bank, aiming to keep the yuan stable, buys most of the dollars that flow in from overseas to buy Chinese goods and build Chinese factories, while capital controls limit banks' daily currency positions.
Before trading starts each day, the People's Bank of China, the central bank, also sets the yuan's daily mid-point - its kick-off rate for trade. The yuan-dollar rate cannot move more than 0.3 percent from the mid-point in either direction.
Despite all the restrictions, China has taken several steps, since the yuan was revalued by 2.1 percent against the dollar and depegged from it in July 2005, to construct a system dealers said would eventually make the yuan rate market-driven.
The China Foreign Exchange Trade System, an interbank market owned by the central bank, recruited major banks as market-makers who must stand ready to buy and sell at the prices they quote.
And while it is unclear how the central bank sets the yuan's mid-point, dealers said it appeared to be giving greater influence to banks' premarket quotes, which are based in part on overnight movements in the dollar and other currencies.
"Some of the yuan's recent mid-points have been very close to the banks' quotes," said a Shanghai dealer at a major US bank. In the past, banks almost invariably quoted the yuan - which has risen a further 5 percent per dollar since mid-2005 - above the central bank's mid-point, pushing for faster appreciation.
But since February the market has seen a reversal, with banks routinely willing to quote the yuan at rates below the mid-point. Rising inflation and a surprising dive in the March trade surplus have eroded the market's confidence about how far and how fast the yuan could rise, dealers said. Most have lowered their forecasts to 4 percent or less for 2007 from 5 percent.
The central bank has also been intervening less in trading since the second half of last year, allowing the market room to manoeuvre within the daily 0.3 percent limit, a Shanghai dealer at a European bank said.
Banks are also influencing the yuan rate via market-oriented currency swaps, which were launched a year ago and became active enough to affect spot yuan rates by late last year, dealers said. The swaps' daily turnover is now estimated at $500 million to $1 billion - up to one-fourth the volume of the cash market.
In early April, onshore one-year yuan/dollar swaps were indicating 2.47 percent appreciation in the yuan in a year's time, down from 2.69 percent in early February. Dealers said that helped to slow the yuan's gains on the spot market, where it has risen only 0.4 percent since February, for an annual rate of about 2 percent, compared with a rise of 0.6 percent in January, for an annual rate of 7 percent.
Regulators announced another key reform in June of last year, allowing banks to retain long positions in the dollar and other currencies overnight and longer, although within allotted quotas. Freed from worries about day-to-day balances, banks can diversify their positions into terms of three months, six months or even a year, and use those different terms to hedge positions in foreign currencies, or to speculate on how economic data or currency moves might affect the yuan.
As yuan dealers more aggressively adjust their portfolios, intraday volatility and trade volumes have risen, pushing daily average turnover in spot yuan trading to at least $4 billion, double the year-ago amount, according to dealers' estimates.
"An appropriate next step could be allowing banks to build short overnight foreign exchange positions, and adding more derivative products," said Bank of America's Wang.
As the yuan's market mechanisms steadily develop, however, economists and dealers stress that the days of a fully free yuan rate will have to wait until the removal of capital controls - perhaps during the next five-year economic plan from 2011.
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