* Yuan daily moves bigger in new system, imply possible fall
* State banks used to curb dollar gains, promote volatility
* China does not promise yuan appreciation via depegging
* Yuan likely to rise medium term, but no straight line
By Lu Jianxin and Koh Gui Qing
SHANGHAI, July 2 (Reuters) - Now that China is staying true to its word and letting the yuan trade a bit more freely, analysts and investors outside the mainland may not be prepared for one potential outcome: a yuan drop.
China is showing a determination to let the yuan be more volatile against the dollar within its daily 0.5 percent trading band and go with the market flow, contrary to some expectations for another steady rise as happened between 2005 and 2008.
That means there are no guarantees that the yuan will appreciate against the dollar over time, and Beijing is set to stick firmly to its position on yuan flexibility no matter how much it disappoints critics -- most prominently U.S. lawmakers.
The fundamentals arguing for substantial yuan appreciation have changed since the financial crisis: China is running smaller trade surpluses, and economists see the potential for the shrinking current account surpluses to turn into deficits in coming years.
As a result, the basis for steady but slow yuan appreciation versus the dollar is not as strong as five years ago -- one reason why Beijing keeps emphasising flexibility in its pushing forward the reform of its currency system.
"China's new yuan policy lays emphasis on a quick response to changes in economic and market conditions, with no preset levels for yuan appreciation either in the short term or long term," said Chen Lu, chief economist at Haitong Securities in Shanghai.
The People's Bank of China has matched its words with deeds by allowing greater yuan volatility since the June 19 announcement and subsequent clarification that flexibility still means that yuan moves must be gradual and controllable.
The yuan has moved in an average daily range of more than 100 pips since its depegging, far above the 50 pips that dealers say would allow banks to engage in proprietary trading intraday.
This compared with a daily movement of only a few pips during the two years when the currency was pegged to the dollar.
Banks are just starting to do more day-to-day speculation, adding to liquidity in the local spot market.
Before the depegging, the limited daily swings meant all trading was almost a pure reflection of supply and demand, with the PBOC keeping the market in check.
Realised volatility in dollar/yuan has jumped as spot has started swinging more sharply within the daily trading band on the official CFETS platform.
WATCH THE STATE-OWNED BANKS
The PBOC is apparently fostering two-way trade within the daily trading band for the spot yuan rate, trying to get banks and companies accustomed to greater volatility and to hedging currency risks.
But during the peak of speculation on yuan gains early last week, the PBOC used state banks to buy dollars in hefty chunks, effectively limiting the market's ability to short dollar/yuan -- especially since banks are not allowed to hold short positions overnight.
"Some big Chinese banks bought dollars in such large amounts that they could not have been acting on demand from clients or doing their own trading. They apparently did that on the PBOC's behalf," said a European bank dealer.
"Instead of being complacent about the latest yuan rise, investors may need to prepare for rainy days when the PBOC actually permits the yuan to depreciate against the dollar."
Dealers said the state banks scooped up dollars at a wide variety of levels, suggesting the authorities were not trying to defend the yuan at a certain level.
These mechanisms are a step back from direct intervention by the PBOC in trading, often employed in the post-revaluation phase of yuan appreciation from 2005 to 2008 and during the de facto dollar peg of the past two years.
Dealers also believe the PBOC may have also adopted a new formula for setting the mid-point, or its reference rate, for the daily trading band.
It appears it sets the mid-point using the yuan's close on the previous day plus overnight moves in the dollar index, making the mid-point market-oriented rather than an expression of the central bank's desires as before.
But traders expect the PBOC to keep the mid-point as a ready weapon for the PBOC for limiting any yuan moves during times of market volatility. The PBOC consults with banks but keeps the market in the dark as to how it sets the rate.
During the peg, the PBOC tweaked the mid-point by only one or two pips each day. Any trades happened far from the reference rate on a given day would have to be covered around the mid-point in subsequent days, discouraging moves far from the mid-point.
Since the depegging, the yuan has risen as much as 0.83 percent as the PBOC tolerated a rise to a post-revaluation high of 6.7700 against the dollar on Friday.
While the new regime has still disappointed critics in the United States, Chinese market players believe that Beijing will not make any further concessions and that new pressure from U.S. lawmakers -- some of whom believe the yuan is undervalued by as much as 40 percent -- would likely backfire.
The euro zone debt woes have cast doubt on the pace of China's recovery, the latest reminder how vulnerable the world's third-largest economy is to a global slowdown.
China's still low per person income also argues against sharp yuan appreciation, economists say, arguing that it is inappropriate to apply Western standards to the currency of a country whose GDP per person was only 8 percent of that of the United States last year.
"What China can do is to show that it's friendly, it's cooperative and it's willing to change in line with economic and market conditions," said a senior Chinese bank dealer in Beijing. "As China will adjust the yuan's value on a floating basis, yuan appreciation forecasts will become more or less a guessing game." (Editing by Eric Burroughs)