What China's surprise currency devaluation means for its economy and the world

The Chinese central bank said that the change was a one-time event to allow it to set exchange rates in line with free market practices. Photo / Getty Images

China surprised the world on Tuesday, announcing it would devalue its currency in a move likely to boost Chinese exports and support the country's flagging economic growth. The change to the currency's value was the most dramatic in two decades.

The move is likely to stir intense concern, as political leaders, especially in the United States, have long complained that China leaves its currency at a lower value to boost its domestic industries.

In recent years, China has worked to let the value of the currency, known as the yuan or renminbi, rise, but the announcement by China's central bank Tuesday is sure to reignite debate over whether the country is giving an unfair advantage to its businesses.

Stephen Roach, a fellow at Yale University who formerly served as a non-executive chairman for Morgan Stanley in Asia, told Bloomberg that the move raised the "possibility of a new and increasingly destabilizing skirmish in the ever-widening global currency war".

The Chinese economy slowed to 7 per cent year-over-year growth in the first quarter, the slowest pace in six years, while exports plummeted 8.3 per cent year-over-year in July, according to data released last weekend.

But the Chinese central bank argued on Tuesday that its goals were more mundane than spurring exports and growth. Rather, the bank said that the change was a one-time event to allow it to set exchange rates in line with free market practices. And in their initial responses, many analysts agreed.

Like many things in China's economy, the country's currency is controlled by a mix of market forces and government decree. Every morning, Beijing sets a target for the trading of its currency against the US dollar, then allows investors to buy and sell the currency for 2 per cent more or less. Tuesday's change relaxes the government's control over setting that rate. The midpoint will now be set at the market's closing rate for the previous day.

In some ways, the move follows what American officials have wanted. US politicians have been pushing for China to adopt a more market-oriented exchange rate for years, with the assumption that China's currency is undervalued. In April, the Treasury Department praised China's recent efforts to allow the renminbi to rise, but said the currency remained "significantly undervalued".

But not all economists agree that that is the case, and this is why China's decision could actually be a negative for the U.S. economic growth, at least in the short term. The International Monetary Fund said in May that China's currency was no longer undervalued.

Now, market forces could pressure the currency to depreciate rather than appreciate, making Chinese products comparatively cheaper. Analysts from Citi said in a note Tuesday that they expect the rule change to mark the beginning of a measured currency depreciation.

In China, the depreciation will be a boon for exporters and heavy industry, but bad news for companies that depend on imported goods. Shares of Chinese airlines plummeted on Tuesday, as analysts predicted that the higher cost of oil in U.S. dollars would weigh on their earnings.

The move could also mean increased competition for China's neighbours. A cheaper yuan would make Chinese goods more competitive with other exporting countries in the region, perhaps spurring them to devalue their currencies. Currencies in Thailand, the Philippines, Malaysia, Indonesia, South Korea, Singapore and Australia fell on Tuesday, as analysts questioned whether the move would spark a race to the bottom in currency wars.

In the US, a cheaper yuan could weaken American exports to China, widening the already-large trade deficit with China. And it will add fuel to the arguments of American politicians and businesses who claim the yuan is undervalued. It also might add pressure on the Federal Reserve to delay raising interest rates, as a rate hike would put upward pressure on the dollar and make US exports even less competitive.

Even so, some analysts argued that the move was not primarily directed at boosting Chinese export competitiveness. Michael Meidan of China Matters, a London-based consultancy, wrote in a note on Tuesday that weak trade data supported the central bank's decision "but was not the main driver".

According to GaveKal Dragonomics, the primary goal was longer-term reforms aimed at internationalizing the Chinese currency. The International Monetary Fund recently announced that it would delay a decision until the end of the year on whether the yuan would be included in its special drawing rights - a reserve asset that includes the dollar, euro, yen and pound.

The IMF has urged China to merge its government-controlled onshore market with the freely trading offshore market and make its currency more flexible, and Tuesday's move could be seen as addressing this.

Of course, there's also a chance that that explanation could just be political cover for weakening the value of the renminbi to boost exports. In 2013, Beijing intervened aggressively in the market to stop investors from pushing the value of the renminbi up. With the inscrutable Chinese leadership, it's always hard to tell.

• Ana Swanson is a reporter for Wonkblog specialising in business, economics, data visualisation and China.