Chinese authorities took a significant step Tuesday to weaken their tightly controlled currency, a move that we believe is aimed at helping jumpstart China’s slowing economy.
China devalued its currency by about 2% against the US Dollar, the biggest single-day depreciation since 1994, [1]when China’s current exchange rate system took hold. The move represents a permanent alteration to the daily fixing mechanism, in favor of a more market-based approach in deciding the Yuan’s value. It comes after China’s economy grew 7% in the second quarter, the slowest pace in six years.
A devalued Chinese Yuan could give the country’s struggling exports a boost, as it would make Chinese goods cheaper for international buyers. In July, China’s exports fell 8.3% from a year ago. A risk, however, is the move could cause ripples with the country’s prominent trading partners, such as the US.
In our view, here’s a look at potentially why China made the move, and what might be next.
Why Did China act now?
We believe there are three competing motivations as to why the Chinese authorities have taken these steps now, but all point in a similar direction:
(i) The Chinese economy is undergoing both a cyclical and a more secular (structural) slowdown. Against that backdrop, the US Dollar-driven strengthening of the Yuan has contributed to weaker export growth. Hence, the immediate currency depreciation by the People’s Bank of China (PBoC)—China’s central bank—may give the Chinese currency some protection from further USD strength as the Federal Reserve (Fed) prepares to raise interest rates. We believe the currency depreciation also potentially aligns the Yuan more closely to Chinese economic fundamentals.
(ii) In a quinquennial review of the Special Drawing Rights (SDR) currency basket—a value based on key international currencies—the International Monetary Fund (IMF) later this year[1] is expected to make a final decision on whether the Yuan should be included. In an IMF staff report published last week, the sticking point appeared not to be the so-called “gateway criterion” (pertaining to the value of exports, which China patently fulfils) but the question of whether the Yuan can be considered “freely usable” (meaning the elimination of curbs on outbound and inbound investments). We believe China’s announcement represents an incremental step along the path toward greater exchange rate flexibility (and, indeed, toward liberalization of the capital account), and will thus go some way to assuaging those concerns. Crucially, we believe the announcements made by the Chinese authorities will still leave the PBoC with significant control over the Yuan fixing, but may also be seen by the IMF as a significant concession. Put simply, we believe this move may increase the likelihood of the IMF deciding in China’s favor.
(iii) We believe the Chinese authorities also anticipate that the moves will foster a convergence in the onshore and offshore (meaning within and outside of national boundaries, respectively) Yuan exchange rates.
What are the potential implications?
We believe the ramifications and significance of the changes will become more apparent in the coming days and weeks, with the key variable to watch being the evolution of the fixings announced by the PBoC. If the greater emphasis on “supply/demand” (i.e. market forces) leads to a rapid and sizeable depreciation of the Yuan, then it may have positive implications for China output growth, albeit at the potential cost of more capital leaving the country.
More likely, in our view, is that the Chinese Yuan may depreciate modestly, thus keeping the IMF happy but also maintaining consistency with China’s pro-growth policy priorities.
