China's yuan jumped on Tuesday to its highest level since the currency was revalued in 2005 as the central bank signaled it would tolerate yet further gains to make good on its vow for more foreign exchange flexibility.

China is relaxing its control on the yuan ahead of this weekend's G20 summit of world leaders and breaking a two-year dollar peg that had been a lightning rod for critics who say the currency is under valued and gives Chinese exporters an unfair trade advantage.

Markets surged on Monday after Beijing's weekend vow to allow flexibility for the yuan, on optimism a stronger currency would boost the fast-growing economy's purchasing power. Some doubts crept in to market sentiment at the end of the global day on just how far China would go.

But on Tuesday, the People's Bank of China set the yuan's daily mid-point -- the reference rate for trading -- at 6.7980 per dollar, the highest level in five years.

I am not surprised they did this, said Edward Meir, commodities and energy analyst at MF Global in New York.

We had been looking for a revaluation for some months. It's an easy way out for Beijing -it helps their inflation numbers and will stem some of the criticism about the value of the yuan.

The market was worried that the weekend announcement was more political hot air than a real attempt to address the undervalued yuan.

This perhaps gives investors more confidence that we will see the yuan moving higher and as a result markets may have touched short-term bottoms and we expect a firmer tone in most commodities in the next.

Dollar/yuan offshore forwards fell, indicating a higher value for the yuan, on the view that the central bank would allow the currency to keep rising in spot trading.

Three-month dollar-yuan non-deliverable forwards fell to a low of 6.7100, implying expectations for the yuan to rise 1.3 percent over that period.

One-year NDFs fell to a low of 6.600, implying expectations for the yuan to rise 3 percent in a year.

In spot trading, the yuan rose as high as 6.79 per dollar, up 0.11 percent from Monday. The currency rose more than 0.4 percent on Monday, close to its 0.5 percent limit.

The central bank disappointed many early on Monday by fixing the yuan at a steady 6.8275, so much was riding on Tuesday's fixing.

Now, traders are waiting to see if the central bank refrains from currency 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 on Monday, eroding much of the stock market gains 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. It was trading at $1.2314 on Tuesday.

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.

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.

The proof will be in the pudding over time, Canadian Prime Minister Stephen Harper said in an interview with Reuters.

But I think it's fair to say this is a very positive announcement by China. More broadly it does show China not simply doing some positive things, but China assuming a more global view, he said.

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; editing by Neil Fullick)

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