Fans of a more open China should welcome the devalued yuan

China wants to be an international player, and to be an international power it needs the Chinese yuan to be an international currency.

Tuesday morning’s announcement by the People’s Bank of China (PBC) that it was reforming its daily USD/CNY (Chinese yuan) mid-point fixing mechanism was simply another step along the path to yuan internationalisation. Of course, it was a reform that was also very cleverly timed to weaken the yuan when a weaker yuan is just what China needs to slow the decline in Chinese exports.

The first big step towards internationalising the yuan came in 1994, when as part of a break from Communist state planning, Beijing let the currency fall by one-third. For the next decade, the Chinese authorities held to a hard peg that valued the US dollar at 8.28 yuan.

Then on July 21 2005, the People’s Bank of China announced it had removed the hard peg – a move which initially served to push the dollar down to 8.11 yuan. Since then, the yuan has continued to rise against the dollar, so that by July 2015, the Chinese currency had risen about 33% against the dollar over the decade.

Before Tuesday, China’s central bank set a midpoint for the value of the yuan against the dollar, called the daily fixing. The yuan is allowed to move 2% above or below the daily fixing in daily trading. But the PBC has never been clear on what criteria it takes into account when setting the daily fixing.

In particular, the PBC has sometimes ignored daily moves so that, for example, when the market indicates the yuan should be weaker against the dollar, the daily fixing is set to make it stronger. So the strategy of fixing the yuan has, for quite a while now, actually allowed it to diverge considerably from the market rate.

With Tuesday’s announcement, the fixing will now be much more aligned to the market, in that it will be based on how the yuan closes in the previous trading session. The most immediate result of this new policy on Tuesday was that the yuan’s fixing was weakened by 1.9% from the previous day, leaving it at 6.2298 to the US dollar, compared with 6.1162 on Monday. Another 1.62% devaluation was applied on Wednesday.

Welcome to the free market

So while US Republicans and much of the media are yet again declaiming against the undervaluation of the yuan – a nasty Chinese strategy to sell its goods at artificially cheap rates on the world market – in fact the yuan’s midpoint has now become much more market based. In other words, the PBC has done what longtime critics of China’s currency policy have long been clamouring for – let the market play a bigger role in deciding the yuan’s value.

In May 2015 the IMF recognised that China’s yuan was no longer undervalued for the first time in more than a decade – a statement which contradicted the US Treasury Department’s assessment published just a month previously which said the currency remained “significantly undervalued”.

The overall impact of the recent alteration in rate-setting policy and consequent devaluation? First, it is another step towards a more open and international Chinese economy. As recognised by the IMF:

“The exact impact will depend on how the new mechanism is implemented in practice. Greater exchange rate flexibility is important for China as it strives to give market forces a decisive role in the economy and is rapidly integrating into global financial markets’.

How the new mechanism is implemented in practice will also influence the extent to which it will assist China’s desire to have the IMF declare the yuan an official reserve currency on par with the dollar, euro, the Yen and the Pound. According to the IMF:

“The announced change has no direct implications for the criteria used in determining the composition of the [IMF’s SDR] basket. Nevertheless, a more market-determined exchange rate would facilitate SDR operations in case the Renminbi were included in the currency basket going forward.”

The real fallout

In the short term, the change will give a shot in the arm to Chinese exports, especially to Europe. Chinese exports to Europe have suffered as the Chinese yuan has followed the US dollar in appreciating against the euro.

Another short-term impact will be the fluster that is caused in US politics. The devaluation of the yuan will pose a dilemma for the US Federal Reserve which is preparing to raise interest rates later this year, but is concerned by the continuing strength of the US dollar. Concern that is now deepened because the Chinese move puts further upward pressure on the dollar.

US politicians will also rail against what they see as another example of China’s broken promises to refrain from intervening in exchange markets. After high-level talks with Chinese officials in June, US Treasury Secretary Jacob Lew said China agreed only to intervene in foreign exchange markets if absolutely “necessitated by disorderly market conditions”.

Coming straight after a series of State interventions in Chinese stock markets, the recent PBC announcement is not going to inspire US confidence that China is serious about putting the word “free” (beloved of Americans everywhere) together with the words “market forces”. Xi Jinping’s forthcoming visit to Washington should be interesting.

In the longer term, it is too early to tell whether recent volatility in China’s stock markets will actually delay full yuan convertibility as many analysts predicted. The PBC announcement seems to be a message from China that it will not. And it should always be kept in mind that given the size of China’s economy, and the large size of its foreign exchange reserves, China can control its exchange rate more effectively than most countries can.

The main concern for the Chinese authorities is to retain control over hot money flows – speculative flows of money chasing interest and chasing currencies expected to appreciate. These cause greatest damage when they flow out of currencies expected to depreciate as occurred during the Asian Financial crisis of 1997, which China observed closely but was able to protect itself against.

Alice de Jonge does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond the academic appointment above.