The yuan fell to a new 10-month low on Wednesday after the Chinese central bank set its weakest fixing in eight months, in step with the euro hitting a fresh two-year low.
The dollar/yuan rate has closely tracked the ailing euro in recent months, with the yuan weakening versus the safe haven greenback in line with the euro weakening in global markets.
But in recent weeks many traders have questioned whether the People's Bank of China would allow the yuan to follow the euro lower as the region's debt crisis worsens.
Before the market opened, the central bank set its midpoint at 6.3429, the weakest fixing since November 2011 and the first midpoint this year above the 6.34 mark.
Traders interpreted the fixing as a signal that the central bank is now prepared to accept further depreciation.
"It looks like (the central bank) will continue to maintain a strong link to the dollar index," said a trader at a major state-owned bank in Beijing.
The yuan weighed on its emerging Asian peers, and traders said it could drive regional currencies lower in the near term.
Traders had earlier told Reuters that they believed the central bank would keep the midpoint stronger than 6.34 in order to signal that it would not allow the spot rate to weaken beyond about 6.40.
The midpoint fixing is the base rate that the central bank uses to flag the government's intentions for the yuan's value, and from which the yuan is allowed to rise or fall 1 per cent in a single day.
"The psychological impact of fixing at its lowest this year will be strong," Dariusz Kowalczyk, economist at Credit Agricole CIB in Hong Kong, said in a note to clients.
"It creates an impression that Beijing is so focused on minimizing risks to growth ahead of the CPC Congress that it is ignoring any U.S. pressure," he said referring to the Communist Party Congress due to occur later this year, when the Party will conduct a once-in-a-decade leadership transition.
The willingness to set weaker fixings could allow the yuan to depreciate further, since it has already been trading near the weak side limit of its daily band, he said.
But traders said that the magnitude of the midpoint's fall against the dollar will continue to be less than the euro's corresponding weakness against the U.S. currency.
Closing at 7.7387 per euro on Wednesday, the yuan has now strengthened by 5.2 per cent against the euro this year, compared to the yuan's 1.5 per cent fall versus the dollar.
Traders widely believe the PBOC uses the dollar index – which tracks the greenback's value against a basket of currencies dominated by the euro – as a reference for setting its daily midpoint.
The yuan closed at 6.3885 per U.S. dollar, 27 pips weaker than Tuesday's close and its weakest finish since late September last year.
While the yuan is weak against the U.S. dollar, it is at its strongest level against the euro since 2002, making Chinese goods more expensive in China's largest export market.
Traders believe the central bank is increasingly allowing the yuan to respond to the market rather than using the midpoint to push back against such forces.
The International Monetary Fund appears to concur. It softened its stance on the Chinese yuan to "moderately undervalued" against a basket of currencies, and lowered its medium-term forecast for the current account surplus to between 4 per cent and 4.5 per cent of GDP, in an annual review released on Wednesday.
Offshore, one-year non-deliverable forwards were bid at 6.4355 in late afternoon, implying 0.7 per cent depreciation over the next 12 months, little changed from Tuesday's close.