The Chinese yuan, also known as the renminbi, is already convertible under the current account - the broadest measure of trade in goods and services. However, the capital account, which covers portfolio investment and borrowing, is still closely managed by Beijing because of worries about abrupt capital flows.
Yuan to trade directly with UK pound
Today's change replaces system of referencing the two currencies' rates against US dollar
While Premier Li Keqiang tours Britain, the yuan took another major step on its global journey yesterday as Beijing said the currency will start trading directly with the British pound from today.
The central parity rate of yuan against pound - or the midpoint exchange rate around which the daily rate will hover - will be calculated based on the direct quotations from the appointed market markers. Previously, traders would have to reference the two currencies' exchange rates against the US dollar if they wanted to convert yuan to pound or vice versa.
The transaction volume of London's yuan exchange market, which includes trading of spots, forwards, swaps and options, is expected to take off following the move.
Market watchers expect overall investor interest in yuan to pick up and help create a huge "Euroyuan" market the way the US dollar was boosted in its early years as a global currency.
Euroyuan refers to yuan deposits at foreign banks or foreign branches of Chinese banks. London is the largest depository for the Eurodollar, or US dollars outside the United States.
"Given London's dominant position in the global forex market and the UK's sizeable banking sector, the potential for financial products would be enormous," said ANZ economist Liu Ligang. "Direct conversion and the clearing facility will lay the foundation for London to nurture a Euroyuan market."
London currently has only around 15 billion yuan (HK$18.86 billion) of deposits, lagging far behind its major competitors such as Hong Kong and Singapore, or even Luxembourg.
Robert Minikin, senior foreign exchange strategist at Standard Chartered, said he expects the yuan option market, in particular, to grow rapidly.
"The market potential of the option market should be highlighted thanks to the increasing volatility of the renminbi, which would prompt corporates to hedge their yuan exposure," he said.
London is the second-biggest yuan foreign exchange centre with nearly 20 per cent of the market, while Hong Kong accounts for 61 per cent of the worldwide total.
The daily average yuan spot trading in London in the first half of last year stood at US$5 billion, representing a nearly seven-fold increase from less than US$1 billion in 2011, according to the City of London.
"The direct link of these two currencies unlocks a great deal of potential for the investment community, providing quick, transparent pricing that will facilitate the adoption of the renminbi for investment purposes," said Evan Goldstein, Deutsche Bank global head of renminbi services.
Britain is China's 12th largest trading partner, with bilateral trade crossing US$70 billion last year. Bilateral trade growth increased by 11 per cent last year, outperforming China's total trade growth of 7.6 per cent during the period.
Another significant currency move yesterday came from South Korea. A senior Korean official said that direct trading between the yuan and the Korean won is expected this year.
The currencies which are allowed to trade directly with the yuan include the US dollar, Japanese yen, Australian dollar, New Zealand dollar, Russian rouble and Malaysian ringgit.
"It is a surprise that the Korean won hasn't yet been allowed direct trading against China given its position as one of the biggest trading partners of China," said Minikin.