* China allows banks to freely set OTC yuan/dollar rates
* Sign that Beijing is confident yuan is reaching equilibrium
* Retail demand will influence main interbank rates
* Corporate clients will have better choices to obtain FX (Repeats to fix formatting, adds details, quotes, analysis)
By Lu Jianxin and Pete Sweeney
SHANGHAI/BEIJING, July 3 (Reuters) - China has permitted banks to freely set their own exchange rates for the yuan against the dollar in over-the-counter transactions -- another step toward freeing the exchange rate from government control.
Banks were previously required to price the yuan/dollar rate they offered retail clients within 3 percent in either direction of the Chinese central bank's midpoint on a given day.
"The liberalisation of the retail market implies that the PBOC believes that the yuan has now reached equilibrium," said analyst Cao Yang at Shanghai Pudong Development Bank.
Such equilibrium permits the central bank to gradually free the yuan's exchange rate without worrying about excessive volatility, he said.
The new rules do not apply to the yuan/dollar's main rate in the interbank market, which is subject to controls including the central bank setting a daily midpoint from which the spot rate has been allowed to fluctuate in either direction by 2 percent since March.
Under the new policy, effective immediately, banks can price OTC yuan/dollar exchange rates "in line with market supply and demand and without any restrictions", the People's Bank of China (PBOC) said in a statement published late on Wednesday.
The move "is aimed at further perfecting the mechanisms to establish market-oriented exchange rate for the yuan," the central bank said in the statement.
However, the wholesale market that the banks trade in must still abide by the midpoint guidance rate. Because that primary market is an enormous source of forex supply and demand, posting around $15 billion in transactions every day, it will continue to exercise a strong influence on the retail market.
The world's second-largest economy is seeking to increase the use of the yuan in global trade and investment to diminish China's dependence on the U.S. dollar, and by extension its exposure to economic policy decisions made in Washington outside of its control.
Allowing the market to price the yuan against the dollar is a pre-requisite for wider liberalisation, and at the same time decreases the need for Beijing to accrue dollar reserves in the name of managing the exchange rate.
The PBOC has purposefully guided the yuan to stage more two-way trading over the past couple of years, letting the yuan appreciate 2.9 percent versus the dollar in 2013, only to push it down as much as 3.4 percent this year to convince the market not to consider the currency a one-way bet on appreciation.
With the first market-oriented yuan/dollar exchange rates in the OTC market, the central bank can collect data on dollar supply and demand from major state banks, traders said.
"Retailing is also an important indicator for yuan/dollar demand and supply and reflects sentiment towards these currencies," said a senior dealer at a major European bank in Shanghai.
"As such, the OTC exchange rates will have influence on the interbank rates and help banks discover market-oriented rates."
Chinese companies, which obtain foreign currencies both at the interbank market and with a less degree, via banks' OTC channels, welcomed the move.
"The opening will have a positive impact on corporate foreign exchange deals," said Wang Xinjiu, Securities Affairs Representative at China International Marine Containers (Group) Co , the world's top container producer.
"Companies, just like individuals, will have better channels to meet their foreign exchange demand with more reasonable exchange rates," he said.
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.
Robert Minikin, forex strategist at Standard Chartered in Hong Kong, said he believed that Beijing is also preparing to change the way it manages the market in general, and that the freeing of the retail market could be a step in this direction.
"There are some hints that the PBOC is changing the way it is managing the FX market, and in particular the way the daily fix is managed. We may be moving toward a more market-driven daily fix rather than one set by the authorities."
Minikin was referring to a common complaint by participants in China's forex market, namely that the central bank has used the daily midpoint fixing as a leash to control market movements instead of an indicator of consensus price.
Economists have pointed out that so long as Beijing continues to set an official midpoint rate, it retains a tool for controlling the exchange rate; and so long as the interbank market is restrained by a trading band, the market is not truly in charge. (Additional reporting by China economics team; Editing by Kim Coghill)