China Yuan Devaluations Could Spark Currency War

China yuan devaluation
A customer holds a 100 Yuan note at a market in Beijing, August 12, 2015. China shocked global markets on Tuesday by devaluing its currency after a run of poor economic data, a move it billed as a free-market reform but which some experts suspect could be the beginning of a longer-term slide in the exchange rate. Jason Lee/Reuters

China's dramatic devaluation of the yuan is threatening to spark a global currency war, where other countries also cut the value of their currencies in a bid to boost exports, according to economic analysts.

Beijing cut the guiding rate for the yuan—also known as the renminbi—on Wednesday, resulting in a fall in value of 1 percent. Combined with a 1.9 percent devaluation on Tuesday, this constitutes the biggest two-day lowering of the yuan's rate against the U.S. dollar in more than 20 years, according to the BBC. The second devaluation came as a surprise, as the People's Bank of China (PBOC) had described Tuesday's cut as a "one-off depreciation." However, the PBOC has tried to calm fears by saying that persistent currency devaluation is unlikely.

The move comes after figures revealed this weekend that Chinese exports fell by 8.3 percent in July compared with the same month in 2014, the biggest drop in four months. Other figures released on Wednesday and reported by the BBC showed that industrial production rose by 6 percent in July, slower than the 6.8 percent seen in June, while fixed asset investmentwhich measures state spending on infrastructureexpanded 11.2 percent in the first half of 2015, the lowest since December 2000.

The Wall Street Journal reported that Beijing had to intervene in the final moments of trading on Wednesday to prop up its currency after traders and businesses rushed to convert their yuan to dollars. The PBOC ordered state-owned banks to sell dollars in the last 15 minutes of trading, resulting in a 1 percent jump in value of the yuan against the dollar.

The successive devaluations have generated a range of reactions across the financial world. In Vietnam, the State Bank doubled the trading band of its currency on Wednesday in response to China's decision, in effect paving the way for the Vietnamese dong to depreciate in value. Other Asian currencies fell following the yuan's devaluation, with South Korea's won, Malaysia's ringgit and Indonesia's rupiah all declining by at least 1 percent against the dollar, according to Bloomberg. Meanwhile, the U.S. Treasury said that China's decision indicated its desire to "move to a more market-determined exchange rate," but U.S. Democrat Senator Chuck Schumer accused China of having "rigged the rules and played games with its currency."

Gabriel Stein, Director of Asset Management Services at global think-tank Oxford Economics, says he expects Taiwan, Malaysia and Singapore to follow suit by devaluing their currencies in an attempt to compete with Chinese exports. However, too many countries devaluing at the same time will lead to a global slowdown in growth, says Stein. "It's a bad thing because it means imports become more expensive for everyone that does this," he says. "The idea with devaluing your currency is you have less domestic demand and your exports gain competitiveness, but everyone cannot do it at the same time and, if they try to, that's demand deflationary for the global economy."

Rajeev De Mello, Head of Asian Fixed Income at global asset management company Schroders in Singapore, was quoted in the Guardian as saying that while it was too early to predict whether this was the start of a period of sustained devaluation, other central banks may also resort to devaluation which could "trigger a fresh round of currency weakening around the emerging world."

China said that yesterday's devaluation was the result of a change in policy as to how the country sets the reference rate of the yuan, which is loosely pegged to the U.S. dollar. Previously, the PBOC fixed the rate at a point of its own choosing, which often led to claims, particularly from the U.S., that Beijing was undervaluing the yuan in order to boost exports. As of yesterday, the PBOC begun setting the rate in accordance with the previous day's rate and overnight changes in the market, making the yuan more accurately reflect the state of the market.

The decision was welcomed by the International Monetary Fund (IMF), which China is lobbying to include the yuan in its basket of reserve currencies known as Special Drawing Rights. These are currencies used by the IMF to lend to sovereign borrowers, and currently include the U.S. dollar, the British pound, the euro and the Japanese yen. The IMF said that China's decision "appears as a welcome step" toward a more market-based economy.

Chang Liu, China economist at macroeconomic research company Capital Economics, says that the devaluation is the result of market forces rather than a deliberate decision to spark a currency war by Beijing. "This is just part of the financial reforms that they have promised for a long time. Weak export data may have played a part but if they honestly were trying to depreciate the yuan, they could have done so in a much more quiet manner than this high-profile way."