(c) 2013, Bloomberg News.

(c) 2013, Bloomberg News.

HONG KONG Smaller swings in the yuan, this year's best-performing emerging-market currency, are providing scope for China to widen the trading band for the first time since April 2012.

The yuan's one-month implied volatility fell to 1.148 percent Friday, the lowest level since Oct. 4 and the most stable of 23 emerging-market currencies after the pegged Hong Kong dollar, according to data compiled by Bloomberg. Analysts have cut appreciation forecasts for the yuan as growth in the world's second-largest economy slows. The currency will end the year at 6.12 per dollar, the median estimate in a Bloomberg survey shows, weaker than the 6.10 projected on June 30 and the 19-year high of 6.1090 reached Friday in Shanghai.

"It's definitely a good time now or before September to get a wider trading band," Banny Lam, co-head of research at Agricultural Bank of China International Securities Ltd. in Hong Kong, said in an Aug. 12 phone interview. "Lesser bets on yuan gains and low volatility are instrumental as that means there won't be too much one-sided speculation even if you have a broader range."

Expanding the yuan's trading range would lend weight to China's pledge to pursue a more flexible exchange rate as policy makers shift the economy away from exports to focus more on household demand. The People's Bank of China widened the band to 1 percent from 0.5 percent last year, at a time when mounting concerns over the debt crisis in Europe, China's biggest trading partner, damped speculation for yuan gains.

The yuan has climbed 1.96 percent against the dollar this year, almost twice the appreciation of the next-best performing developing-nation currency, Bulgaria's lev.

The People's Bank of China sets a daily reference rate for the yuan against the dollar in Shanghai that limits the currency movement to a maximum 1 percent on either side. The limit is 3 percent for fixings versus the euro, the British pound, the yen and the Hong Kong dollar, while there is a 5 percent cap against the Malaysian ringgit and the Russian ruble.

The currency has touched both ends of its current trading range versus the dollar. It fell to a 0.99 percent discount to the official fixing on July 20, 2012, testing the weak end for the first time. The yuan traded within 0.1 percent of the upper end of the band on most days between October and May, reaching the limit often during the period. The spot rate has been at an average 0.7 percent premium to the reference rate since May.

China will improve the yuan's exchange-rate regime by letting market forces play a larger role and increasing the currency's two-way volatility, the PBOC said in a quarterly report released on Aug. 2. The central bank also said it would keep the currency basically stable at a reasonable level.

Appetite for yuan assets is cooling as China targets economic growth of 7.5 percent, marking the slowest pace in more than two decades. Yuan positions at Chinese financial institutions accumulated from sales of foreign exchange, a measure of capital flows, declined 41.2 billion yuan ($6.7 billion) in June, the first drop in seven months, central bank data show.

Speculation that the Federal Reserve will scale back its monthly $85 billion bond-buying is also driving funds away from emerging markets, including China. The nation's capital and financial account showed a $1.6 billion deficit for the second quarter as the Bloomberg U.S. Dollar Index, which tracks the greenback against 10 major currencies, climbed 2 percent.

"We see that the economy is slowing down and the dollar will be strong on the back that the Fed may start tapering as soon as next month," Irene Cheung, a currency strategist in Singapore at Australia & New Zealand Banking Group Ltd., said in an Aug. 13 phone interview. "It's no harm if they really want to do it now. It's ok because it's not at the bottom of the band. It's very clear they want to have more flexibility."

The trend of one-way moves in the yuan has ended and the exchange rate will stabilize at an "equilibrium level" in the medium term, Wang Ren, a Shenzhen-based chief strategist at Ping An Securities Co., wrote in an Aug. 14 report.

"Given the government has quickened financial reforms this year, changes to the exchange-rate mechanism will also be significantly faster," Wang wrote. "That'd include widening the trading band, adjusting the basket of currencies that the yuan is referencing, as well as the fixing mechanism."

Li Keqiang took over as China's premier in March and has pledged to rein in the role of the state. He extended PBOC Governor Zhou Xiaochuan's record tenure in March, a sign he backs the central bank's relaxation of yuan controls.

The State Council, or the cabinet led by Li, signaled in May that the government will propose a plan for yuan capital- account convertibility in 2013. Policy makers scrapped a floor on banks' lending rates in July and engineered a cash crunch in June to rein in credit growth and address risks in the banking system.

Twelve-month non-deliverable forwards for the yuan have traded more than 2 percent weaker than the spot rate in the past two months, a trend last seen in the first quarter of 2009 during the global financial crisis. The contracts have been 0.4 percent stronger on average in the past five years.

"The conditions are there for a band widening as yuan appreciation pressure has greatly reduced," Bruce Yam, a currency strategist at Sun Hung Kai Financial Ltd. in Hong Kong, said by telephone on Aug. 14. "There's an urgent need for China to accelerate reforms to maintain the country's competitiveness. The leaders know that and a more flexible yuan should be part of the package."

After keeping the exchange rate stable for a decade, China allowed its currency to strengthen 21 percent against the dollar between July 2005 and July 2008, including an initial, single- day gain of 2 percent. Appreciation was then halted for almost two years to help exporters weather a global recession. The currency has advanced 12 percent since restrictions were loosened on June 19, 2010.

China has amassed a record $3.5 trillion in foreign- exchange reserves, partly by intervening in currency markets to limit yuan gains.

"The yuan's exchange rate is now more balanced," Raymond Gui, a Hong Kong-based senior portfolio manager at Income Partners Asset Management, said in a phone interview on Aug. 12. "In the base case, as long as China's economy continues to grow much stronger than that of the U.S., funds are likely to be attracted to China. That'd support a neutral to gradual yuan appreciation."

The U.S. Treasury Department declined to label China a currency manipulator in a semi-annual report to Congress published on April 12. The yuan "remains significantly undervalued" and needs to rise further, it said. PBOC Deputy Governor Yi Gang said the following week in Washington that China would push ahead with opening its capital account and a widening of the yuan's band was likely "in the near future."

China may expand the band before October, when the U.S. Treasury is scheduled to publish its next report on currency manipulation, according to ANZ's Cheung.

"The remarks from the PBOC came out saying they want to have a more flexible exchange-rate," she said. "I'd expect something to happen before the report comes out, otherwise there is not much point of saying anything."