Asian markets waited with bated breath Tuesday to see how far Beijing would go in allowing its currency to strengthen, a litmus test of just how flexible the Chinese authorities are prepared to be to meet U.S. demands.

The yuan surged almost 0.5 percent on Monday in spot trading to reach 6.7976 per dollar, its highest since the last major revaluation in 2005. However, the People's Bank of China (PBOC) has to confirm the market's move at its morning fixing, due at 115 GMT (9:15 p.m. Monday EDT).

The central bank disappointed many early Monday by fixing the yuan at a steady 6.8275, so much is riding on whether it allows its currency to follow the market's lead. A limited rise would tend to hurt risk appetite and so equities, the euro and higher-yielding currencies.

The focus is on the USD/CNY reference fixing today, as key to the outlook lies on the extent to which USD/CNY may be fixed lower today, said analysts at JPMorgan.

Since the mid-rate is set as yuan per dollar, a lower fixing actually implies a higher yuan.

A decline in the reference fixing is a necessary condition for USD/CNY to trend lower from here.

Traders said if the mid-point was set around 6.8100 that could be taken as a green light for further gains.

They were also keen to see if the PBOC would refrain from intervention, as it did on Monday, thus suggesting it was happier to let the market move the currency. The yuan is allowed to trade 0.5 percent either side of the set mid-point.

Doubts about the speed of yuan appreciation had already begun to surface in the United States overnight, eroding much of the gains markets made in the Asian session.

After starting higher, Wall Street stocks faded through the day and the S&P 500 ended 0.39 percent down.

The euro was a notable victim of the caution, falling back to $1.2325, from a Monday high of $.1249. Commodities also pared their gains, as did commodity-linked currencies like the Australian and Canadian dollars.

HOW FLEXIBLE?

China's surprise move to relax currency controls ahead of this weekend's G20 summit had initially buoyed global markets and sent the yuan to a five-year peak on Monday, but caution returned as analysts questioned how far Beijing's flexibility would go.

Stock markets surged after China's new currency policy, which is aimed at steadying its economy during the global downturn and paving the way for the yuan to appreciate over the long-term as demanded by the United States and other major trade partners.

But initial optimism was quickly tempered with caution as officials, analysts and investors sought to determine the extent of China's willingness to rethink policies which have turned it into a global export powerhouse.

We're obviously encouraged, but we'll be monitoring the progress, White House spokesman Bill Burton said in Washington. Implementation here is going to be key, and so we're just going to be keeping an eye on that.

A senior U.S. official, briefing reporters on condition of anonymity, said China's gradual approach to yuan flexibility was a prudent step that could both manage expectations and deter massive speculative buying of Chinese assets.

The official said it was promising that China seemed ready to allow the exchange rate to respond to market forces, and that the test now was how far and how fast Beijing would permit the yuan to move.

Markets were unable to sustain that euphoria as they looked into the details, said John Brady, senior vice president at MF Global in Chicago.

The currency issue is likely to feature at the summit of the Group of 20 nations in Canada on June 26-27, with many expected to seek further clarification from Beijing.

Many economists see China's currency strengthening further in coming days but at a very modest pace, further diluting hopes for big market gains.

A Reuters poll of 33 economists showed they expected the yuan to end the year at 6.67 per dollar, a rise of 2.4 percent from late last week before China's policy announcement and similar to the appreciation implied by offshore non-deliverable forwards.

(Additional reporting by Koh Gui Qing, Edmund Klamann, Karen Yeung, Saikat Chatterjee, Simon Rabinovitch, Pedro da Costa, Ben Blanchard, Brian Love and Sui-Lee Wee; writing by Andrew Quinn; editing by Simon Denyer and Todd Eastham; Editing by Mark Bendeich)

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