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Markets and economics - The curious case of China's currency

2015-08-12 14:17:18

Aug 11th 2015, 9:00 by Buttonwood

THERE have been some dramatic devaluations in history think of sterling in 1967

and 1992, or Argentina in 2001/2. When currencies decline, they do so in a big

way. China's devaluation of the yuan today is less than 2%, but it is also

being treated as a major story. Robert Peston of the BBC says it is more

significant than either the Greek crisis or if the Federal Reserve raised

interest rates. The combination of falling commodity prices and weaker emerging

markets is certainly a worry.

Bears have predicted that a Chinese devaluation would send a new wave of

deflation* round the globe. It would force Asian competitors to respond with

their own devaluations, reducing import prices in the developed world. This

might lead to job losses in the west or reduced profit margins. Charles Dumas

of Lombard Street Research, a consultancy, recently wrote that it:

would export the deflationary impact to its trade competitors in the rest of

the world. In addition, countries that became notably overvalued, such as the

US and UK, could be weakened as cheap imports cut into margins. This is how the

current bullish cycle in stock markets could end.

But a 2% devaluation is neither here nor there. It will hardly be a massive

boost to Chinese exports, which fell 8.3% in July. The Bank for International

Settlements calculates real trade-weighted indices for different currencies; as

of June, China's index was 126, up from 111 a year earlier and 105 in September

2012. This shift is just a marginal retracement of that gain.

So this move looks more like a signal than anything else. In particular, it may

be a response to IMF concerns about whether to grant the yuan reserve currency

status and inclusion in the special drawing right (SDR) basket. China would

very much like to get that status, partly for prestige reasons and partly to

help its financial sector. So a little bit of currency flexibility might help,

yet the move is not big enough to really annoy the country's Asian neighbours

or the Americans.

But can China manage the process effectively? A limited devaluation may

encourage traders to expect more, whether the People's Bank of China (PBoC)

says so or not. And that will require the PBoC to use reserves to defend the

new rate. It has lots of reserves, of course, but still the recent $300 billion

reduction might give the authorities pause.

China is trying to juggle several balls at once; to move from an investment-led

economy to a consumption-led model without letting growth slip too far, to rein

in speculation in property and equities without damaging industry, to engage

with markets without being hit by volatility, and to expand its financial

sector without suffering the hot money flows that destabilised Asia in the late

1990s. It would be surprising if it didn't drop at least one ball. And its task

is so complicated that it is bound to send out confusing signals every now and

then.

accompanied by monetary easing. Even if all currencies end up where they

started (not everyone can devalue, of course), the world will have easier

monetary policy as a result. The big question here is whether monetary policy

has lost its effectiveness and the only positive result from quantitative

easing and other policies is the currency impact. In that case, it is a

zero-sum game.

China's yuan currency falls for a second day

China's Central Bank has again cut the guiding rate for the national currency,

the yuan, a day after Tuesday's record 1.9% devaluation.

The move sent fresh shockwaves through Asian markets, but the bank has sought

to calm fears, saying it was not the start of a sustained depreciation.

This is now the biggest two-day lowering of the yuan's rate against the dollar

in more than two decades.

The commerce ministry said the lower rate would boost struggling exports.

Figures released at the weekend showed Chinese exports fell more than 8% in

July, adding to concerns the world's second largest economy is heading for a

slowdown.

There were further signs of weakness on Wednesday, when figures showed

industrial production in July rose 6% from the previous year. The rise was

smaller than expected and was also below the 6.8% increase seen in June.

Fixed asset investment, a measure of state spending on infrastructure, expanded

11.2% for the first half of the year, also below estimates and at its lowest

since December 2000.

However, the action on the yuan has sparked fears of a global and destabilising

"currency war". There has been criticism from the US, where markets fell

sharply overnight.

Read more: Asian stocks down on lower yuan

Karishma Vaswani: Not why, but why now?

One-off?

On Wednesday, China's central bank fixed the "official midpoint" for the yuan

down 1.6% to 6.3306 against the dollar.

The midpoint is a guiding rate, from which trade can rise or fall 2% during the

day.

China has long kept tight control of their currency's value

Until Tuesday, that rate had been determined solely by the People's Bank of

China (PBOC) itself. But the rate will now be based on overnight global market

developments and how the currency finished the previous trading day.

The bank, which had called Tuesday's 1.9% cut a "one-off" adjustment, sought to

reassure financial markets on Wednesday.

"Looking at the international and domestic economic situation, currently there

is no basis for a sustained depreciation trend for the yuan," it said in a

statement.

Analysis: Karishma Vaswani, Asia Business Correspondent

But the question we should be asking isn't how much did China's devalue its

currency by - but why now?

China's been under international pressure to allow its currency to be driven by

market forces as opposed to by the government for years. The US has been its

biggest critic - saying that Beijing keeps the currency artificially low to

help boost exports.

So in theory, China says it is doing what the US and the international

community wants. According to the language of the Chinese central bank - China

will now allow the yuan's value to be more flexible.

Backing from IMF

The International Monetary Fund said the move to make the rate more

market-based "appears a welcome step".

"Greater exchange rate flexibility is important for China as it strives to give

market-forces a decisive role in the economy and is rapidly integrating into

global financial markets," the international lender said in a statement.

"We believe that China can, and should, aim to achieve an effectively floating

exchange rate system within two to three years."

The IMF added, though, that the decision would not affects its considerations

of Beijing's hopes for the yuan to be added to the "special drawing rights"

(SDR) reserve currencies.

These are currencies which IMF members can use to make payments between

themselves or to the Fund.

China has long been lobbying to have the yuan included alongside the dollar,

euro, yen and the British pound.