In early trade, the offshore yuan traded in Hong Kong was at 6.56 per dollar, nearly a 0.2 yuan discount to the onshore rate -- its steepest since the Hong Kong market began trading last June.

Typically, the yuan in the offshore market trades at a premium to the onshore rate as the Chinese currency is freely convertible in Hong Kong and investors have purchased it aggressively betting on further gains.

With Asian local currency debt and currencies coming under severe selling pressure this week amid a worsening euro zone debt crisis and after the Federal Reserve painted a gloomy economic outlook, traders said some hedge funds and banks had been liquidating long yuan positions.

Jonathan Cavenagh, a senior FX strategist at Westpac Institutional Bank in Singapore, said with expectations of yuan appreciation being scaled back sharply, investors were now heading to the exits.

Benchmark one-year offshore dollar/yuan forwards jumped on Friday to imply more yuan depreciation in the next 12 months -- a sharp turnaround from earlier this week when they were indicating an appreciating bias.

Liquidity in the interbank markets has dropped sharply and price swings have magnified.

One senior trader at a European Bank in Hong Kong said only about $300 million has been traded so far, lower than Thursday and much lower than the daily average volume of more than $1.5 billion.

"With no signs of the usual Chinese names to buy the yuan, this selloff can get uglier," the trader said.

Copyright Reuters, 2011