The People's Bank of China (PBOC) set the yuan's mid-point, its base from which the currency can fall or rise a maximum 1 percent in a day, at its second-weakest level this year in a clear sign it will permit the yuan to depreciate slightly.
But dealers said the Chinese central bank also appeared to have added dollar liquidity to the market in a move aimed at preventing the yuan from excessive depreciation.
Spot yuan closed at 6.3 674 per dollar, slightly stronger t han Wednesday's close of 6.3685. It was initially weaker against Wednesday's close at 6.3778 in the morning trade.
Traders said they expected the yuan to move between 6.35 and 6.40 per dollar in the near term, citing a rough balance of dollar supply and demand at these levels.
"Chinese companies have favoured keeping or accumulating dollar positions recently, given the prospect for the yuan to depreciate partly because of the dollar's strength in global markets," said a trader at a US bank in Shanghai.
"Still, there has been decent dollar liquidity in the (Chinese) market," he said. "While banks have limited dollars on hand, the PBOC is naturally the ultimate supplier to fill the dollar supply shortage."
Before trading began, the PBOC fixed the yuan's midpoint at 6.3392, weaker than Wednesday's 6.3305. On July 25 the bank set the midpoint at 6.3429.
MEASURED DEPRECIATION
The yuan has generally weakened so far this year, dropping 1 .1 5 percent a s of Thursday's close.
Traders said Chinese firms began keeping dollars on hand in the last quarter of 2011 amid signs that China's economic growth was slowing, putting depreciation pressure on the yuan.
Retaining dollars marked a reverse from the way banks and their corporate clients, after the yuan's 2005 landmark revaluation, tended to sell their dollar earnings as quickly as possible.
The PBOC has recently used the yuan's midpoint to signal the government's intention to let the currency depreciate slightly, but it has also fixed the midpoint slightly above the yuan's trading levels to prevent the currency from falling too sharply.
Traders say that the PBOC, in China's first major currency policy adjustment for years, is now also a seller of foreign exchange as well as a buyer. Previously, the central bank only bought dollars so as to curb the Chinese currency's appreciation, but now it must also prevent excessive deflation.
While the government has clearly stated that its focus for the rest of 2012 is to maintain decent economic growth, the yuan should have more room to depreciate in coming months, particularly if the dollar index continues its recent rally in global markets, traders said.
In the latest sign that the world's second-largest economy is still on a slowing track, China's official factory purchasing managers' index (PMI) fell to an eight-month low of 50.1 in July from 50.2 in June.
Offshore one-year dollar/yuan non-deliverable forwards were largely stable on Thursday, changing hands around 6. 4260 i n la te a f ternoon trade, implying the yuan would fall 0.9 1 pe r cent in 12 months from the midday spot yuan rate.
Offshore spot yuan in Hong Kong traded at 6.3 77 0, s lightly weaker than the onshore spot rate.