Explainer: why is China devaluing its currency?

China has shocked global financial markets by devaluing its currency for two days running. August 11 saw a record 1.9% fall in value, followed by another 1% decline on August 12. The move by the Chinese central bank marks the yuan’s largest devaluation in two decades, sending a ripple effect across the regional Asian market and global financial markets.

Stocks, currencies and commodities came under heavy pressure as money managers feared it could ignite a currency war that would destabilise the global economy. Both the Nikkei stock market index in Japan and Hang Seng in Hong Kong were down more than 1%. Meanwhile the Singapore and Taiwan dollar both hit five-year lows on the news. It was a similar story for Indonesia’s rupiah, the Philippine peso, South Korean won and Malaysian ringgit.

The Australian dollar, which is often seen as a proxy for China’s currency, fell to a fresh six-year low of US$72.25, having been sold off heavily on Tuesday. Oil was hit, too, as well as key industrial and construction materials including nickel, copper and aluminium.

Why the devaluation

The move comes as a bit of an about turn, as it follows a long period of strengthening. The People’s Bank of China had been keeping the yuan strong to support the government’s goal of shifting economic growth from being export-driven to increasing domestic demand. But a run of poor economic data in the last few months clearly has the Chinese government worried.

The abrupt devaluation is a clear indication of mounting concern in Beijing that the country could fall short of its goal of roughly 7% economic growth for 2015. In the past few months, dwindling growth has put heavy pressure on state-owned banks to lend money readily to companies willing to invest in new factories and equipment. A rout of the Shanghai and Shenzhen stock markets in late June and early July (which took aggressive government action to stem) appears to have further dented consumer demand within China and investor confidence across the globe.

Calculated drop in the yuan.xe.com

The People’s Bank of China defended its move to devalue the yuan as a way of making the country’s financial system more market-oriented. The central bank guides the market daily by setting a reference rate for the yuan, from which trade may vary only 2%. But on August 11 the bank said it will set this rate based on market forces, which have been willing the yuan lower. This seems logical, as over the past few months the yuan-dollar spot price had been lower than the exchange rate, and it became clear the central bank was supporting a stronger yuan.

Thus, the Chinese government may well have the IMF in mind, whom it has been lobbying to include the yuan among freely traded benchmarks like the dollar, euro and yen, so that other countries can include it as an official reserve currency. A market-driven exchange rate is something the IMF has welcomed, saying it would facilitate the operations of its basket of reserve currencies, should the renminbi be included in the future.

Multiple currencies at play

Whether or not the Chinese government is reversing its policy and trying to boost exports, as some have claimed, is hard to say. It is important to see the devaluation in the context of how the currencies of China’s competitors have been performing.

The yuan is strongly tied to the dollar because China manages the exchange rate within a range against the dollar. Thus, the rise of the US dollar against other currencies over the past year (pulling almost even with the euro), means the yuan has also risen against its trading partners' currencies thus raising the relative price of Chinese exports worldwide.

Meanwhile, the Japanese yen has been falling in value, as a result of Bank of Japan market intervention. It hit a 13-year low in June this year, losing 16% of its value since the last quarter of 2014. So, arguably China is responding to this competition.

In South Korea, Malaysia, Indonesia and Thailand – China’s competitors – central banks have initiated interest rate cuts due to gradual slides against the US dollar. This has allowed a slow depreciation of their currencies, making their exports more attractive.

Ultimately, China wants a stronger currency and to move toward a domestic demand-driven economy. In the meantime, however, the determination to stay on course for 7% growth this year and need to compete with its neighbours means we have the makings of a currency battle on our hands.

Nafis Alam does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond the academic appointment above.