China rattles markets with yuan devaluation

Bloomberg

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China devalued the yuan by the most in two decades, a move that rippled through global markets as policy makers stepped up efforts to support exporters and boost the role of market pricing in Asia’s largest economy.
The central bank cut its daily reference rate by 1.9 percent, triggering the yuan’s biggest one-day drop since China unified official and market exchange rates in January 1994. The People’s Bank of China called the change a one-time adjustment and said it will strengthen the market’s ability to determine the daily fixing.
 
Chinese authorities had been propping up the yuan to deter capital outflows, protect foreign-currency borrowers and make a case for official reserve status at the International Monetary Fund. Tuesday’s announcement suggests policy makers are now placing a greater emphasis on efforts to combat the deepest economic slowdown since 1990 and reduce the government's grip on the financial system.
“It looks like this is the end of the fixing as we know it,” said Khoon Goh, a Singapore-based strategist at Australia & New Zealand Banking Group Ltd. “The one-off devaluation of the fix and allowing more market-based determination takes us into a new currency regime.”
Global impact
The yuan dropped 1.8 percent to 6.32 per dollar as of 1:34 p.m. in Shanghai. It slid 2.3 percent in Hong Kong’s offshore trading. The onshore spot rate was 1.4 percent weaker than the reference rate of 6.2298, within the 2 percent limit allowed by the central bank.
The devaluation jolted global markets, with the currencies of South Korea, Australia and Singapore falling more than 1 percent amid bets other countries may seek weaker exchange rates to keep exports competitive. Shares of Chinese airlines sank on concern their dollar debt costs will rise, while commodities retreated amid speculation yuan weakness will erode the buying power of Chinese consumers. U.S. Treasuries gained on growing demand for dollar assets.
Today’s sudden policy move is a reaction to a significant weakening of China’s export numbers in July and rising deflation risk”
China’s intervention in the currency market had contributed to a $300 billion slide in the nation’s foreign-exchange reserves over the last four quarters. It made the yuan the best performer in emerging markets, fueling an 8.3 percent slide in exports last month.
The yuan’s real effective exchange rate -- a measure that’s adjusted for inflation and trade with other nations -- climbed 14 percent over the last four quarters and was the highest among 32 major currencies tracked by Bank for International Settlements indexes.
Market forces
Effective immediately, market-makers who submit prices for the PBOC’s reference rate will have to consider the previous day’s closing spot rate, foreign-exchange demand and supply, as well as changes in major currency rates, the central bank said. Previous guidelines had no mention of these criteria.
“The new fixing will be quoted based on the previous day’s closing, which is a real market level,” said Becky Liu, a Hong Kong-based senior strategist at Standard Chartered Plc. “The band will become the real band. This is a big step, and bolder than we expected.”
China has to balance the need to boost exports with the risk of capital outflows, Tom Orlik, chief Asia economist at Bloomberg Intelligence, wrote in a research note. He estimates that a 1 percent depreciation in the real effective exchange rate boosts export growth by 1 percentage point with a lag of three months. At the same time, a 1 percent drop against the dollar triggers about $40 billion in outflows.
Monetary policy
“The risk is that depreciation triggers capital flight, dealing a blow to the stability of China’s financial system,” Orlik said. The calculation from China’s leaders is that with their $3.69 trillion of currency reserves “they can manage any risks,” he said.
The PBOC said Tuesday that a strong yuan puts pressure on exports and cited a high effective exchange rate as a factor behind the devaluation. July’s export slump was deeper than economists predicted, while the nation’s index of producer prices declined 5.4 percent.
 A tourist holds 100 yuan bank notes in Beijing, China.
“Today’s sudden policy move is a reaction to a significant weakening of China’s export numbers in July and rising deflation risk,” said Liu Li-Gang, the chief Greater China economist at ANZ in Hong Kong.
While the devaluation will help support growth, Liu is predicting that the PBOC will lower lenders’ reserve requirements in August and cut benchmark interest rates this quarter for the fifth time in a year.
Volatility surges
IMF requirements that reserve currencies must be freely usable may have also played a role in the PBOC’s move, according to Commerzbank AG. The fund has said in recent months that the yuan needs to be more flexible.
“The yuan exchange rate will be more market-oriented going forward,” Zhou Hao, an economist at Commerzbank in Singapore, wrote in a report. “Volatility of both the onshore and offshore rates will pick up significantly.”
The yuan’s one-month implied volatility, a measure of swings used to price options, surged 3.9 percentage points, the most since 2004, to 5.075 percent. The gauge had fallen to a one-year low of 0.993 percent on July 24.
China’s move has raised the risk of a “currency war” as export rivals seek a weaker exchange rate to stay competitive, according to Stephen Roach, a senior fellow at Yale University and former non-executive chairman for Morgan Stanley in Asia.
“It’s hard to believe this will be a one-off adjustment,” Roach said. “In a weak global economy, it will take a lot more than a 1.9 percent devaluation to jump-start sagging Chinese exports. That raises the distinct possibility of a new and increasingly destabilizing skirmish in the ever-widening global currency war. The race to the bottom just became a good deal more treacherous.”

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