China should allow an immediate one-off appreciation in the yuan's value and widen the currency's trading band to stem inflows of speculative capital that might fuel inflation, said UBS AG economist Wang Tao.

"China's economic fundamentals mean that the yuan should strengthen," Beijing-based Wang told Bloomberg. "The central bank will find it harder to manage liquidity and inflation when a flood of speculative funds returns, betting on the yuan's appreciation."

The Chinese economy grew at the fastest pace in a year in the second quarter and export declines slowed in September, fueling speculation that policy makers will let the yuan resume appreciation against the dollar.

China's cabinet, the State Council, said last month that managing liquidity is increasingly difficult and signaled that inflation concerns will play a greater role in setting policy.

Policy makers should do "the unexpected", countering perceptions that the currency is a one-way bet, before expectations for gains strengthen, Wang said. She didn't say how much the currency should immediately appreciate.

Yuan forwards, which rose to a 14-month high late last month, suggest the currency will gain 2.3 percent against the dollar in the coming year. The yuan climbed 21 percent over three years after the government scrapped a fixed exchange rate in July 2005.

Yuan convertibility

Stephen Roach, chairman of Morgan Stanley Asia, recently predicted that China will "ultimately" allow the yuan to be freely convertible to other currencies.

While Chinese officials, including Central Bank Governor Zhou Xiaochuan, have called this year for an alternative to the dollar as the world's main reserve currency, they maintain controls on the yuan that prevent it for now from becoming a competitor.

In an interview with Bloomberg Television in Hong Kong, Roach added that the Hong Kong dollar's peg to the US currency "will relax" after China makes the yuan convertible. The un-pegging of the Hong Kong dollar is out of the question for now, he said.

Russian Finance Minister Alexei Kudrin said last month that the yuan could become a global reserve currency in about 10 years should China make it convertible. A change in Chinese policy would make the yuan a "notable and weighty" reserve unit, Kudrin said in an interview on the state-run Vesti television channel.

China will likely seek to slow capital inflows by convincing speculators they don't stand to make large returns, rather than allowing a one-off appreciation, said Mitul Kotecha, head of global foreign exchange strategies at Calyon in Hong Kong.

"China will need to be very careful," he said. "It needs to communicate to the market that yuan appreciation will be limited to about 5 percent to 6 percent a year. The danger in the past was that expectations of appreciation attracted hot money."

China's financial system is already flooded with cash from a record $1.27 trillion in new lending this year, the trade surplus, foreign direct investment, and inflows of speculative capital, or so-called hot money, adding to the risk of bubbles in stocks and property.

The nation's foreign exchange reserves rose $141 billion in the third quarter to a record $2.273 trillion, following an unprecedented $178 billion increase in the previous three months.