What’s behind the China’s yuan devaluation

Exchange rates are among many issues likely to be on the agenda for September’s planned visit to Washington by China’s President Xi Jinping.

“After a two-day adjustment, the [yuan] has gradually returned to a more market-oriented level”, PBOC official Zhang Xiaohui said during a rare press conference.

But in a surprise announcement on Tuesday, the central bank cut its daily reference rate by 1.9%, triggering the yuan’s biggest drop in over two decades. Shares in exporters such as Caterpillar and General Electric fell in the market rout this week, though many economists say the yuan’s drop so far isn’t significant enough to do much damage.

The devaluation sparked fears of a global “currency war” and accusations that Beijing was unfairly supporting its exporters, but the central bank on Wednesday sought to reassure financial markets that it was not embarking on a steady depreciation.

China becomes the third major trader to take actions that lower the value of its currency. They can hedge, or insure against unfavorable changes, by signing contracts to buy them at fixed prices on future dates. They keep devaluing their currency until they get it right.

On a larger scale, however, more flexibility could end the yuan’s status as a stable anchor among currencies of developing countries, said Rajiv Biswas, chief Asia economist for IHS.

He said such currencies must be driven by market forces.

In this Tuesday, August 11, 2015 photo, a bank clerk counts Chinese currency notes at a bank outlet in Huaibei in central China’s Anhui province.

“This is sheer nonsense”.

In the past, the central bank set the midpoint using formula based on a basket of currencies, but the methodology has never been publicised and many believed that in practice the midpoint was frequently used as a way to bend the market to policy goals.

Spot silver dropped 0.3 per cent to $15.23 an ounce after hitting a one-month high on Tuesday.

Another drop in China’s currency shook markets around the world for a second straight day amid rising concerns about the world’s second-largest economy. That replaced a strategy under which the rate was based on a basket of currencies.

If there is a “prolonged period of recession” in China, the company will make moves to balance supply with demand, he said, adding, “we don’t see anything like that at this point”. It hurts earnings, too: The revenue that foreign companies collect in yuan from China sales are worth less when converted back into their home currencies.

Beijing’s move could complicate the U.S. Federal Reserve’s decision about when to raise interest rates that have been near zero since the 2008 global financial crisis.

The U.S. dollar rose to 125.28 yen, its highest level since June 8, before weakening to Y125.24 around 0450 GMT.

“But the administration has no economic basis for criticizing China’s move”, said Prasad. U.S. stocks were poised to open higher with Dow futures and the broader S&P 500 future set for gains of 0.3 percent at the bell.

An extended slide in the value of the yuan risks triggering a series of competitive devaluations and threatens a global deflation shock as prices of exports and commodities fall. That would mean allowing market forces free rein might push it down even further.