* China allows banks to set OTC dollar/yuan rates
* A small step in China's gradual forex reform
* Interbank dollar/yuan rates still subject to controls (Adds background, fresh quotes)
BEIJING, July 2 China will permit banks to set their own exchange rates for the yuan against the dollar in deals with clients, in a further step to relax controls to make the currency more market-driven.
The world's second-largest economy seeks to widen the use of the yuan in global trade and freeing up its tightly-controlled currency is a pre-requisite for wider market liberalisation.
Beijing has pledged to free up interest rates and currency controls eventually to help put its economy on a more sustainable footing, but such changes have so far been gradual.
Effective Wednesday, banks can set the dollar/yuan exchange rate in their over-the-counter deals based on market demand, the foreign exchange regulator said in a statement.
Before the move, the spread in banks' dollar/yuan buying and selling prices had been subject to regulatory controls.
"This is a complete liberalisation of the over-the-counter exchange rate," said a currency trader who declined to be named.
The State Administration of Foreign Exchange (SAFE) has already scrapped controls on spreads for banks' retail exchange rates between yuan and non-dollar currencies.
Even after the change for dollar/yuan deals, the forex rates that banks offer will be guided by that in the interbank market, which is still subject to controls including the central bank setting a daily mid-point from which the spot rate may fluctuate in either direction by only 2 percent.
"This is a small step in China's foreign exchange reforms," said an analyst at state-owned Bank of China, the country's biggest foreign exchange bank, who asked not to be identified.
In March, China doubled the yuan's trading band with the dollar to 2 percent.
The latest reform step comes ahead of bilateral economic talks between the United States and China later this month, during which U.S. officials are expected to raise their concerns about Beijing's interventions in the currency market.
Critics say China artificially suppresses the value of the yuan to protect its exporters, an accusation China has always denied.
U.S. Treasury Secretary Jack Lew, who will attend the Strategic & Economic Dialogue in Beijing later this month, said on Tuesday the yuan's value is a "very big issue" for the United States and that the currency needs to appreciate more.
Chinese regulators have created pilot programmes and test zones to trial different aspects of yuan liberalisation, ranging from simple paperwork reduction measures to sophisticated programmes allowing cross border lending and intra-company payments. (Reporting by China economics team; Editing by Jacqueline Wong)