Download What`s Really Behind Yuan`s Devaluation?

What's Really Behind Yuan's Devaluation?
By Craig Phillips, CFP, AIF
August 19, 2015
Markets across the globe were sent into a tailspin
recently with the news about the Chinese
government's surprise decision to devalue its
currency, known as the yuan. This led to a 2
percent drop in the yuan's trading value earlier this
month, the largest one-day decline in history.
The ripple effect from China’s announcement was
seen across the world. The U.S. market lost more
than 1% of its total value, oil prices fell and global shares plummeted on
news that China decided to make its currency two percent cheaper than it
was before.
Yes, the news hit big. The press touted the prospect of a global currency
war, and some headlines even hinted that nations may resort to trade
barriers, which would slow down global trade in all directions. But, what
did not make the big headlines was that even after the devaluation, the
yuan is still actually more valuable against global currencies than it was a
year ago in trade-weighted terms. Nor did most press detail the fact that
China actually intervened in the global markets to make sure the
devaluation didn’t go any further in open market trading.
So, why did China announce decide to devalue the yuan?
Basically, the core reasons for China’s devaluation is its slowing economic
growth coupled with its recent stock market volatility. It is anticipated that
China will experience a 7% growth rate this year. Although that is three
times the U.S. growth rate, it is considered sluggish by Chinese standards,
and likely unacceptable to the country’s leaders. You may have read that
the Chinese stock market climbed to impossibly high levels earlier this year
and then fell just as far in a matter of weeks. True to form, the Chinese
government charged in with a heavy hand to outlaw short sales, banish
hedge funds to the sidelines, suspend margin calls and even buy stocks
directly in an effort to put a floor on prices. The theory was that the
devaluation was part of this intervention, since it would make exports
cheaper and boost sales, raising profit margins of those companies whose
stocks were recently free-falling.
But, let’s keep in mind, China’s percentage of world exports has been
steadily growing for this entire century, without any need to add the
stimulus of a weaker currency. So, perhaps China’s strategy to devalue the
yuan is a small step to keep the yuan’s value in line with those of its peers,
not a dramatic shift in exchange-rate policy or a part of the Great Shanghai
Market Panic.
But, what’s China’s long-term strategy? One unnerving scenario could be
that China’s ultimate goal is to make the yuan the reserve currency for
global trade—replacing the U.S. dollar. China has been pushing hard to
make the yuan the fifth currency recognized by the International Monetary
Fund as an international reserve currency. To achieve this status, China
has to demonstrate that its currency is "freely usable," a conclusion the IMF
has refused to draw as recently as 2010.
With China being a hybrid of state and market control, it’s in a unique
position. Because its new exchange rate is more in line with basic economic
fundamentals, it strengthens China’s argument that the yuan is not under
government control. But until China stops attempting to manipulate its
own stock market and impose limits over its currency flow, that argument
doesn’t seem very convincing.