The People's Bank of China jarred international markets on Tuesday when it lowered the yuan's daily fix against the dollar by 1.9 percent, leading to the biggest plunge in the currency's value since the mid-1990s. Beijing's decision comes at a time when the country's economy is showing signs of weakening and in the wake of export data for July that showed a decline of 8.3 percent. The move is certain to stir up political concerns in Washington, Tokyo and Brussels about China protecting its export competitiveness. However, Beijing is in the midst of the slow process of liberalizing the yuan's exchange rate and loosening its ties to the dollar in hopes of establishing it as a global reserve currency. Thus, China is trying to spin Tuesday's currency change as a one-off move and place it in the context of exchange rate policy liberalization.
In March 2014, Beijing increased the daily amount that it allows the yuan to deviate from the daily fix from 1 percent to 2 percent. At the end of July 2015, the Chinese State Council announced that it intended to widen that trading band to 3 percent. This underlines perhaps the most important part of Tuesday's People's Bank of China statement: that effective immediately, its daily fix will be based on the previous day's spot market (or cash market), supply and demand, and the price movement of major currencies. The inclusion of the spot market is the aspect that Beijing is emphasizing because, in theory, it could allow the yuan's value to be more responsive to spot market tendencies. For example, so far in 2015, the yuan's spot market has been near the bottom of its trading band (the daily fix has been consistently higher than the spot market) and has at times tested the 2 percent trading band.
Of course, while Beijing's intention may be to liberalize the yuan's value and allow it to float more freely against the dollar in the long run, currency traders and market watchers are still concerned that Beijing's political influence on the daily fix will remain and interventions will occur — the question is how often Beijing will intervene. Regardless, the currency move is signaling a policy change in Beijing, even if it is one we already knew would happen eventually.
Beijing's policy of having the yuan track close to the dollar has had several important side effects over the past year. In Europe and Japan — home of the other two paramount global currencies — quantitative easing and other forces have resulted in a depreciation of the euro and yen against the dollar. The yen has fallen by about a third since the last half of 2012, and the euro has fallen by a fifth since early 2014. Meanwhile, the yuan has essentially remained stable against the dollar. This means that the yuan's real effective exchange rate, or its exchange rate weighted against its trading partners, has appreciated dramatically over the past year. In fact, since June 2014 the yuan's real effective exchange rate has been the world's strongest, increasing by 13.5 percent — more than that of the U.S. dollar (12.8 percent) and the Swiss franc (11.4 percent).
From Beijing's perspective, maintaining the strong link with the U.S. dollar has, in a sense, undermined China's competitiveness with its major trading partners — Japan and Europe. July's poor export figures and a 47.8 manufacturing purchasing managers index — the lowest in several years — is a consequence of this strong link and of China's overall economic slowdown. The devaluation of the yuan's fix to the dollar merely puts it in line with the spot market for the past few months. It will not bring any relief to China's export sector. Moreover, a 2 percent devaluation pales in comparison to the 10-20 percent appreciation the yuan has experienced over the past year relative to many of China's trading partners.
The important point is the market's perception of the move and Beijing's clear choice to break with the strong U.S. dollar. Countries around the world have been weakening their currencies while Beijing has attempted to maintain a strong currency. However, with July's U.S. job report being somewhat encouraging and all signs pointing to the U.S. Federal Reserve increasing interest rates in either September or December, China is clearly signaling that it will not move in step with the United States and will allow its currency to trade lower if need be.
Beijing must change its exchange rate policy in order to achieve its broader objective of increasing China's stature in the global financial system. Internationalizing the yuan and establishing it as a global reserve currency requires a more transparent and hands-off exchange rate policy. The next step in that process is for the International Monetary Fund to place the yuan into its Special Drawing Rights currency basket, and just last week an IMF review recommended delaying including the yuan in the basket until September 2016, saying that the yuan does not meet the definition of a "freely usable" currency. Making the daily fix more responsive to spot market forces would certainly begin easing those concerns.
However, the Chinese economy is at a crossroads. Clearly China's export-oriented economic model is shifting toward a consumption-oriented model, but that transition is not an easy one, and some companies will shut down as the country makes the transition. A consistent reduction in the yuan's value will make imports more expensive, making the transition more painful while heightening concerns about Beijing's currency policy and whether its Aug. 11 move is a one-off. The only way that Beijing can assuage these fears is by simply doing what it says — allowing the market forces to act on the yuan. Either way, Beijing is continuing to show a substantive change in its foreign exchange policy, and that alone is worth keeping a keen eye on.