3 reasons why China’s historic currency move is deflationary to the world

Markets received a seismic jolt from China on Tuesday as it devalued its currency, the Yuan, by the most in two decades, cutting its daily reference rate by 1.9 percent.

China’s shock move is scorching through every asset class – commodities, currencies and exporters are all tumbling on fears the world’s second-biggest economy is headed for a deep slowdown.

“The cut definitely helps exports”, said Yu Mingliang, the director of business development at Zhejiang Lianda Forging & Pressing Co., a manufacturer of mechanical parts and other goods in the eastern city of Wenzhou.

While a weaker yuan will not cure all the ills of China’s exporters, which suffer from rising labor costs and quality problems, it would help relieve deflationary pressure, a far bigger economic concern in the view of some economists. China’s decision to devalue its currency could further complicate the Fed’s decision on when to raise rates. The yuan had strengthened in tandem with the dollar, hurting Chinese exporters and imperiling jobs in key manufacturing industries. Exports in July plummeted by an unexpectedly steep 8.3 percent from a year earlier.

The United States and other governments complained for years that Beijing suppressed the yuan’s exchange rate, giving its exporters an unfair price advantage and hurting foreign competitors.

Analysts said the strength of the dollar against the yuan and the New Zealand and Australian dollars in the wake of the devaluation move could keep the Fed from hiking rates in September.

In the past, the central bank set the midpoint by a formula based on a basket of currencies, but the methodology was never publicized and many believed the midpoint was frequently used as a way to bend the market to policy goals. By making Chinese goods comparatively cheaper in the United States, a lower-valued yuan would contribute further to already-low U.S. inflation.

Beijing is likely to move cautiously, but market expectations of further weakening “could quickly become entrenched” and cause the yuan to “depreciate quite quickly and significantly”, said Wang.

The yuan, also known as the renminbi, is allowed to fluctuate in a band 2 percent above or below a rate set by the People’s Bank of China based on the previous day’s trading.

The PBOC called the change a one-time adjustment and said its fixing will become more aligned with supply and demand.

“This complex situation is posing new challenges”, said a central bank statement.

Following the change, the central parity rate of the RMB, or the yuan, weakened sharply by 1,136 basis points to 6.2298 against the U.S. dollar on Tuesday. They note that China’s currency, left to market forces alone, would have declined in value in recent months.

The latest move doesn’t appear to be aimed at helping Chinese exporters even though it follows last weekend’s announcement of dismal July trade, said Mizuho Bank economist Vishu Varathan in a report.

A sustained decline “risks abrasive global trade dynamics”, said Varathan.

“In a weak global economy, it will take a lot more than a 1.9 per cent devaluation to jump-start Chinese exports”, said Stephen Roach, a senior fellow at Yale University and former Morgan Stanley non-executive chairman in Asia told Bloomberg.