Why has China devalued its currency?

China’s central bank weakened the renminbi by its most in two decades on Tuesday. The unexpected move fuelled talk of “currency wars”, although some interpreted it as a welcome gesture towards market reform and financial liberalisation.

What happened?

The People’s Bank of China devalued its currency by setting the daily “fix” for the renminbi 1.9 per cent lower — the sharpest shift on record. The move caused investors to push the currency to its lowest level in nearly three years.

What’s the daily fix?

Each day at 9.15am in Beijing the PBoC sets a midpoint for its tightly controlled currency. When the market opens 15 minutes later investors are allowed to trade the currency 2 per cent either way from this midpoint.

Why now?

An obvious catalyst is the slowing economy: in the first and second quarters China’s economy grew at an annual rate of 7 per cent, the slowest pace in six years. Data at the weekend showed exports tumbled 8.3 per cent year-on-year in July, far worse than expectations for a 1.5 per cent decline. A weaker currency should help make Chinese exports competitive.

So China is trying to spur exports? Isn’t that a currency war?

Not necessarily. The stated purpose for the move was market reform. The central bank said this was a one-time move to enhance “the market-orientation and benchmark status” of the renminbi. Previously, the PBoC would set the currency wherever it liked. Now it will give markets a voice: the daily fix will “refer to the closing rate of the interbank foreign exchange market on the previous day”.

Is there pressure for market reform?

Before the end of the year the International Monetary Fund will decide whether to include the renminbi in its special drawing rights, a global reserve asset comprising the dollar, euro, pound and yen. Inclusion would mean endorsing the renminbi as a formal reserve currency.

Last week the IMF hailed China’s progress on financial reform but called on authorities to take further steps to increase foreign access to its onshore stock and bond markets. The IMF only conducts a review of the SDR once every five years, so the PBoC could be stepping up its efforts to liberalise the currency as part of its quest to internationalise use of the renminbi.

So this is a triumph for market reform?

Perhaps, but it is hard to say. The renminbi had been under pressure to weaken for months because of capital outflows but the PBoC restrained any depreciation by setting the fix higher and selling forex reserves. Today’s one-off depreciation eases some of that pressure.

Many economists were optimistic about the action. Those at Barclays called the new mechanism “a revolutionary move”. But we will not know if China is truly letting the market have a say in the currency’s value until we have seen it move in a direction that would not be supportive to its own goals.

The Chinese currency has a soft peg to the US dollar, which has surged this year and contributed to the decline in Chinese exports. A weaker renminbi could support the economy, so Beijing could simply be allowing the currency to slide and use the talk of “market reform” as political cover; otherwise it would be controversial for the currency to be devalued.

Does this matter outside of China?

Yes. China is a huge consumer of commodities and if the move is interpreted as a sign of economic weakness, there will be ripple effects. On Tuesday every currency in the region weakened against the US dollar — those of New Zealand, Taiwan, South Korea, Singapore and Australia fell 1 per cent or more.

Dollar strength could make the Federal Reserve reluctant to lift interest rates, as that would cause further upward pressure on the US currency.

Within China, the nation’s airlines lost 9 per cent of their market value, on average, as a weaker renminbi will inflate the cost of oil, priced in US dollars. The same effect forced shares of Qantas, Australia’s flagship carrier, to fall as much as 4.1 per cent.

What are the risks?

Investors have been pushing for the renminbi to weaken and if they are allowed to determine where the fix is, it is possible the currency could depreciate quickly. Stuart Allsopp, head of country risk at BMI Research, a unit of Fitch, warns that investors could now see the renminbi as a one-way bet “and start to position against the currency, raising the prospect of more substantial [renminbi] weakness and more economic uncertainty”.

What now?

The key question is whether Beijing really does allow the currency to trade more freely. Last year the PBoC moved to stamp out one-way speculation, when the renminbi was continually appreciating, resulting in the currency’s first annual loss in two decades. If investors begin to push the renminbi lower, Beijing may feel the need to act again. If it does not, neighbouring countries that compete for exports may complain.

The US could be in a tough position: it has asked for market reform for years but if China allows the daily fix to be determined by market forces and the currency depreciates, hurting US manufacturers, it is not obvious how Washington should respond.

This article is published in collaboration with The Financial Times. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Patrick McGee is a Hong Kong based reporter for fastFT, a new service from the Financial Times that provides market-moving news and views, 24-hours a day.