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BEIJING (Reuters) - China's policymakers might just have the wiggle room they need to deliver the more flexible currency they say they want.
The trade surplus is narrowing and an influx of hot money is on the retreat as the economy slows, easing fears among Chinese policymakers that the yuan could "overshoot," rising too fast or falling prey to speculators once they relax their grip on the currency.
The latest soundings from the central bank signal that conditions for flexibility might be ripening, with a long-anticipated widening of the yuan's current 0.5 percent daily trading band a possible first step.
"In the future, conditions for expanding the trading band will be relatively mature as capital inflows and outflows become more balanced," People's Bank of China Governor, Zhou Xiaochuan, told the official Xinhua news agency.
"The exchange rate floating band could be further expanded and this will be decided by the relationship between market supply and demand and transactions among market participants."
Zhou's comments are some of the clearest yet about current policy thinking and came late on Sunday after China's National Financial Work Conference, a once in five-year event that has previously reformed the central bank, created new regulators and set up the China Investment Corporation sovereign wealth fund.
"I reckon this is a signal," said Gao Shanwen, chief economist at China Essence Securities in Beijing, who believes the window for band widening is the first half of 2012.
"Easing pressures on the yuan will be favorable for widening the band. If the exchange rate is under one-way pressure to rise, it's difficult to widen the band," Gao told Reuters.
Chinese leaders have said they wanted more currency flexibility ever since they unshackled the yuan from its peg to the dollar in a landmark revaluation in July 2005.
Widening the yuan's trading band would allow China to say in the face of foreign critics of its currency policy that it is indeed moving ahead with reform to loosen its grip on the currency. Some U.S. politicians have argued that China has gained an unfair competitive edge in global markets by keeping the yuan artificially low to boost exports.
Ironically, the ambition of exchange rate reforms has fuelled market expectations of currency appreciation that have prevented Beijing from delivering a cleaner currency float -- hefty speculative flows would only serve drive up the currency and hurt exporters.
Beijing's sensitivity to external conditions was clear in mid-2008 when it effectively re-tied the yuan to the dollar as the global financial crisis menaced China's economy.
But as once rampant speculation about a move to widen the yuan's trading band has cooled, Beijing might have the leeway to steer a shift without triggering too much volatility.
Chinese officials have recently argued that the country's shrinking trade surplus as a proportion of its economic output and the yuan's recent market performance indicate the currency is near an equilibrium level.
Analysts say recent market swings showed China needs a more flexible regime.
The yuan traded limit-down nearly every day in the first half of December as global demand for dollar liquidity soared ahead of the New Year, forcing the central bank into the market to keep the currency within the band.
And that's despite there being little real risk of a sharp depreciation given the country's still sizable trade surplus and
inflows from foreign direct investment.
"The existing trading band is too tight," said Wang Jun, an economist at CCIEE, a top government think-tank in Beijing.
"Obviously, it's not favorable for creating two-way yuan trade in line with market forces, which could help reduce strong expectations on one-way yuan appreciation," he said.
Investors have long expected the yuan's daily trading band against the dollar to be widened to 1 percent. Wang reckons it should be 1-2 percent.
The central bank last widened the yuan's trading band to 0.5 percent from 0.3 percent in May 2007, nearly two years after its landmark revaluation of the yuan.
To be sure, the central bank will likely keep its grip on the yuan even if it widens the band, as exports are still a key growth engine for the world's second-largest economy even though Beijing is trying to spur domestic consumption.
Some analysts suspect change could be driven by Beijing's desire to see the yuan's inclusion in the International Monetary Fund's Special Drawing Right (SDR), the reference rate the captures the world's most important trading currencies.
The next review of SDR components is due to take place by 2015 and Beijing has certainly been stepping up efforts to internationalize the yuan in recent years, establishing a 1.3 trillion yuan system of international currency swaps and promoting direct settlement of trade in yuan.
Still, some analysts don't expect any imminent move.
For sure, China is likely to hold off any big shift on the yuan if Europe's debt crisis worsens and the U.S. economy slips into a recession, analysts say.
Major changes such as a yuan band widening are a political decision that needs the green-light from President Hu Jintao and Premier Wen Jiabao. Analysts say the government will probably tread cautiously on the currency ahead of a leadership reshuffle.
"The existing band is quite enough," said Kevin Lai, an economist at Daiwa Capital Markets in Hong Kong.
"The parity rate (mid-point) set by the central bank each day is more important than the daily trading. They can allow the faster appreciation without touching the trading band," he said.
The yuan is widely seen rising about 3 percent against the dollar in 2012, slowing from last year's pace of 4.7 percent.
Editing by Nick Edwards