SETTING the yuan free to float with supply and demand on semi-official swap centres is seen by analysts as a drastic, high-risk move leading to a sharp fall of the currency in both swap and black markets. A People's Bank of China official says the move seeks to preserve foreign exchange reserves, used by the Chinese government to support the yuan in swap centres before March. Hongkong Baptist College senior lecturer in economics Tsang Shu-ki says it may be a desperate attempt to resolve the yuan's depreciation: ''They may try to let the value currency to reach an equilibrium itself. ''But I think it's dangerous. Nobody knows where the equilibrium is. ''The right equilibrium should not be inflationary. If it is, it is just like a breather and the yuan will fall again shortly.'' In the context of an overheated economy, it is poorly timed, he says: ''Inflation and the yuan devaluation together form a spiral - a vicious circle.'' He says devaluation will lead to imported inflation, which in turn will bring about further devaluation and apparent stability of the past few months has proven artificial. ''Thus any equilibrium will be fragile. There is not a level that it can sit for long,'' Mr Tsang says. Peregrine Brokerage senior economist Vincent Chan Cheong-wa says downward pressure will be particularly high while China has a trade deficit. ''The currency would have great support from trade surplus. But the mainland is suffering from a trade deficit now,'' Mr Chan says. Once confidence in the yuan is lost, overseas subsidiaries of mainland companies will buy overseas assets instead of converting their foreign currencies to yuan. He says black markets in Hongkong also will be dragged down. Swap centres are high-volume trading pits for Chinese importers, exporters and investors needing to balance their foreign exchange. Importers will obviously suffer from a yuan fall in swap centres but Mr Tsang warns it will also hit exporters. ''Their overseas sales volume may not rise enough to catch up with the yuan depreciation rate. It is especially worrying when markets such as the United States and Western Europe are weak at the moment,'' Mr Tsang says. Joint ventures, which depend on the swap market for forex, will also be hit. Impact will not be limited to swap centres but magnified the loss of confidence in the yuan. ''People will doubt whether the yuan is stable when the swap market is not doing well,'' Mr Tsang says. ''It can generate pessimism and panic buying as well.'' Loss of confidence in the yuan will accelerate the flight into other currencies. Analysts also attribute yesterday's plummet in the Hang Seng Index partly to the new measure. Retail stocks with investment on the mainland are expected to be the worst hit. They are also concerned this will widen the gap between the official rate and lower swap rate, which officials previously hinted would converge through swap-rate controls and a slide in the official rate. ''But the latest move is now causing a lot of confusion in its policy. This sends a wave of panic through investors,'' one analyst says. Mr Tsang says the move may be a reaction to the failure of attempts to stabilise the yuan in March and April when authorities strictly limited participation in the swap market to curb speculation. At the same time, the Chinese government sold US dollars. In the fourth quarter of last year, China tightened credit in a vain bid to halt the devaluation. Mr Tsang suggests the move may have been triggered by lessons from 1990 to 1992 when price liberation proved successful. ''But the economy then was not overheated. The situation is different now,'' Mr Tsang says. He speculates the move may be complemented by credit tightening and a big rise in interest rates but adds a re-evaluation is likely if problems develop. Beijing university economics professor Li Yining agrees that other monetary policies have to be in place to order to resolve the yuan's problems but any drastic measures will do more harm than good in a developing economy. Raising interest rates would be a more acceptable method to control the over-heated economy, he says. Professor Li says that issuing more B stocks and opening up markets to local investors would be an effective means of releasing the foreign currency surplus on the mainland. Overall he endorses the move to a free-floating yuan: ''Sooner or later the government will have to allow the foreign currency market to be governed by demand and supply.'' The latest move is another step towards the ultimate aim of liberalising the currency. However, Mr Tsang argues currency liberalisation should come after trade liberalisation, which has yet to be achieved.