China has surprised the currency markets by devaluing the yuan (otherwise known as renminbi) by 1.9% last night. It’s an apparent policy u-turn by the People’s Bank of China, which maintains a daily fix, or 4% price range, against the US dollar by the force of its vast foreign currency reserves.
The repercussions of this decision could be significant, hitting already suffering American exporters and heaping yet more deflationary pressure on Europe as Chinese imports get cheaper. It won’t exactly be great news for mining firms either, as it will further cool demand for dollar-denominated commodities in the massive Chinese market.
It’s not all gloom of course. Thomas Cook will no doubt be pleased as the cost of holidays in China drops.
The People’s Bank said it made the move in an effort to listen to the markets more than it has done when setting the fix. There’s been downward pressure for some time on the yuan, so in a sense China is just letting it fall from an artificially high level.
This in turn would help China gain IMF recognition of the yuan as a reserve currency in its own right, which fits with the country’s long held ambition to join the top table in global affairs. Developed, mature economies don’t have to peg their currency rigidly to the dollar, after all.
Politics may not be the only reason though. In hard economic terms, the main beneficiary of the currency fall will be Chinese exporters, whose trade took an 8.3% hit in July compared to the year before. The devaluation may be a sign of panic about the country’s economic slowdown, which some believe is more severe than reported by the Chinese authorities.
Economists at Fathom Consulting, for instance, believes that GDP growth was actually less than half the most recent official figure of 7%, pointing to the commodity price drop as evidence of a slump in demand. At the same time, China's battle to calm its volatile equity markets doesn't exactly inspire much confidence in either its economic health or the state's management thereof.
In the context of a faltering economy, devaluing the currency could be a way of fighting the tide of capital flight without having to raise interest rates, which would otherwise be counterproductive.
‘Until yesterday, China had acted to prevent the depreciation of the renminbi, with its foreign exchange reserve slipping from a peak of nearly $4tn, to $3.7tn. With a US interest rate hike just around the corner... the pressure on Chinese policymakers to throw in the towel and abandon the peg would rise still further,’ Fathom said.
Whether China is in a hard or soft landing from its high growth heyday is difficult to know for certain, but either way it does need to stimulate the economy and it is facing pressure to devalue. Just how far the currency falls over the next months will be telling. If the People’s Republic continues to devalue the yuan significantly, it could bode very badly for the global recovery.