Why has China devalued its currency and what impact will it have?

Beijing devalues yuan against US dollar, which will make Chinese goods cheaper after 8.3% fall in exports in July

What has China done?

China’s central bank has devalued the yuan by nearly 2% against the US dollar for the second time in two days to boost exports and take it a step nearer to becoming an official reserve currency.

Why has Beijing acted now?

Industrial production, investment and retail sales data for July were weaker than expected, while at the weekend figures showed Chinese exports tumbled 8.3% in July, their biggest drop in four months. After a string of weakening output growth figures going back to last year, the authorities have come intense pressure internally to address the slowdown with a dramatic policy shift.

Why focus on the currency’s value?

The dollar has appreciated over the past year in anticipation of the US raising interest rates for the first time since the financial crisis. Since the yuan loosely tracks the dollar, it has been dragged higher – keeping its differential with the greenback roughly the same, but at the expense of making the country’s goods dearer compared to regional rivals, especially South Korea and Japan. That has hit Chinese exports badly. Now the US Federal Reserve is close to its first rate rise in seven years, potentially pushing the dollar to new highs, the situation is set to worsen from China’s point of view.

What has the central bank done exactly?

On Monday, the People’s Bank of China set its daily “reference rate” for the yuan at 6.2298 to $1, compared with 6.1162 yuan – in effect 1.86% lower. That triggered a further fall in the currency markets. As the authorities pick the mid-point from the previous day as the basis for the next day’s reference rate, they were forced to devalue again or risk ignoring market forces. Choosing the former, it set the rate at 6.3306, fractionally weaker than Monday’s market close. The spot rate has responded by falling another 1.6% on Tuesday, likely forcing a further devaluation.

The currency moves are the biggest one-day falls in 20 years, and in particular, since China reformed its currency system in 2005. Back then, it unpegged the yuan, also known as the renminbi (RMB), from a strict tie with the dollar in favour of a looser tracking policy.

The successive devaluations follow a further shift in policy that means the bank will now expand the criteria used to calculate the daily fix – the rate at which it determines the currency’s value each morning and from which it is in theory allowed to move 2 percentage points in either direction, although in practice the moves are much smaller.

How can it help the Chinese economy?

Chinese businesses compete with regional rivals to supply the world with everything from raw steel to fridges, and a cheaper yuan will make Chinese exports less expensive, potentially boosting the overseas sales that have been among the main drivers of growth during the nation’s remarkable rise over the past three decades. However, controls on the currency have given Chinese businesses a high degree of predictability when they plan investments in industries heavily dependent on exports.

How can this move help the yuan become a reserve currency?

China is seeking to build on its 2005 reforms in an effort to have the yuan included in the International Monetary Fund (IMF) basket of special drawing rights (SDR) reserve currencies. Its remaining controls have been a stumbling block in gaining admittance to the select group of the US dollar, the euro, the pound and the yen. The bank’s move to include more information when setting its daily fix can be seen as a relaxation of controls, moving the currency a step closer to satisfying the IMF’s entry requirements. The organisation said this month that significant work still needed to be done for the yuan to be considered before its next review in November.

Will it do the trick?

Liu Dongmin, director of the international finance research office at the Chinese Academy of Social Sciences, said: “A reasonable adjustment of the RMB’s value is good for China’s exports and also good for the RMB to be admitted to the SDR. But most importantly, this marks key progress for RMB exchange rate reform since 2005 and a major step for RMB marketisation.” Despite this, Beijing’s long-promised goal of free currency convertibility probably remains distant.

How will the US react?

The devaluation could prompt an angry reaction from the US, which has consistently argued that the yuan is undervalued, damaging US exports. It could also force other Asian countries to devalue, making exports to the US cheaper and increasing Washington’s trade deficit further.

Will China export more than just cheaper goods and services?

Central banks in the US and the UK are toying with raising interest rates to combat the prospect of higher inflation. But cheaper Chinese goods will reduce inflationary pressures and keep interest rates lower for longer. Less welcome will be the export of unemployment, as Beijing effectively prices western workers out of a job to protect its own economy.

Why does the Chinese currency have two names?

It is similar to referring to the pound and sterling. Renminbi is the official name of the currency and means the people’s currency. Yuan, like the pound, is the name of a unit of the currency.

Source: The Guardian 11th August 2015

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