China’s Currency Devaluation: A Butterfly Effect?

On 11 August, the People’s Bank of China (PBoC) announced a sudden devaluation of the Chinese renminbi, reducing its value by almost two percent against the US dollar, the largest such drop in twenty years. The following day another devaluation of nearly two percent took place. The rationale behind these events was to allow for market forces to play a greater role in determining the country’s currency value, and to make Chinese products more attractive overseas in light of softening demand.

The degree of the overall devaluation has been minor, yet the decision created many ripple effects in other markets, especially in Asia but also in the US and Europe.

Fragile state

The move also demonstrated the still fragile state of the overall Chinese economy as it seeks to continue reforming while having to contend with a sluggish global economy with less money for buying Chinese exports. It remains to be seen, however, whether the devaluation will have its desired effects, and what the regional and global impact of the decision will be in the near future.

There had been much evidence since the start of the year that China’s economy was facing a rough period ahead. The recent turmoil in the Chinese stock markets, which required a high degree of government intervention (and capital) to address, was another sign of ongoing economic uncertainty.

'Currency war'

As well, government figures released in July suggested that Chinese exports had fallen by 8.3 percent that month as China’s leaders sought to rework the country’s economy to place a greater emphasis on domestic development and consumption.

Outside of China, the decision to devalue had a negative effect on the worth of several Asian currencies, and once again raised the spectre of a ‘currency war’, meaning a series of competing devaluations culminating in a ‘race to bottom’, in the region.

The news was also poorly received in the United States, which had long accused Beijing for keeping its currency artificially low in order to better promote its exports. One early effect of the renminbi’s devaluation was a spike in the value of the dollar.

International pressures

Since the 1990s, China had maintained an informal ‘peg’ on its currency, set at about 8.3 yuan to the American dollar. However, by the turn of the century, critics in the United States and Europe argued that the Chinese economy had matured to the point where the policy was increasingly unnecessary and called for the renminbi to ‘float’, meaning to rise and fall in value more in keeping with global market conditions.

In July 2005 under international pressure, Beijing agreed to a change in foreign exchange policy and instead pegged the renminbi to a group of currencies including the US dollar and the euro, and also indicated that the value of the RMB would better reflect market conditions. The value of the renminbi slowly increased after that decision was made, but as the global recession began to take hold after 2008, resulting in the swift passage in Beijing of a US$586 billion stimulus plan in November of that year, the Chinese government became more wary of allowing the yuan to appreciate too quickly.

Again, Beijing opted to keep its value restrained with a set trading band despite international pressures.

As the American presidential campaign intensifies, Beijing’s devaluation decision and the overall renminbi issue could again ignite debate within the US over Chinese economic policy, especially as China’s President Xi Jinping prepares to meet with US President Barack Obama in September.

History repeating?

Although it has been almost twenty years since the Asian Financial Crisis which set off a wave of currency devaluations across East and Southeast Asia, the memories of those events remain fresh and there will added caution as a result of the PBoC’s recent decision to prevent history repeating itself. However, in the longer term Beijing has made it clear that it wishes to see the renminbi be more fully accepted as an international currency along with the US dollar, the euro, the pound and the yen.

For example, since 2010 several countries, including Australia, Canada, France, Germany, Singapore and Switzerland, along with the UK, have agreed to house trading hubs for renminbi as part of that policy. Yet in order for the Chinese currency to become fully globalised, it has been generally agreed that it will be necessary to allow its value to be further influenced by the market.

This transition process will nonetheless be far from smooth, and has been demonstrated this week the economic decisions made by China are now having more of an international influence than ever before.