Global Report

Why China’s devaluation of the yuan isn’t the first shot of a currency war

Beijing said it would take a more market-based approach to its monetary policy, and that’s what it’s doing

Chinese 100-yuan note under magnifying glass

(Zhang Peng/LightRocket/Getty)

The global financial establishment reacts poorly to surprises. Traders flee for havens. Investors overreact. The business press takes it all in and then amplifies the sexiest bits.

China’s decision on Tuesday to devalue its currency, the yuan, by 1.9% resulted in chaos. The exchange rates of other Asian countries tumbled, but no one was sure exactly why. Some analysts said it was because the policy shift by the People’s Bank of China showed the Chinese economy was weaker than had been assumed. Others characterized the move as the official beginning of the “currency war.” In other words, traders rushed to sell the Australian dollar, the Korean won and other currencies to get ahead of inevitable countermeasures by the region’s other central banks.

I got caught up in the rush to explain what just happened. Now that a couple of days have passed, it is time to revisit those knee-jerk conclusions. The abruptness of the move remains a reason for pause. That is so because China’s intentions can’t be trusted. For years, Beijing unabashedly tethered the yuan’s value at an advantageous rate against the U.S. dollar. It had behaved better lately, but still lacked a track record of trusting market prices over government fiat. This week’s intervention broke an uneasy trust between President Xi Jinping and global financial markets.

But it’s possible Chinese authorities were clumsy, not malicious. The timing was bad, coming soon after new data showed exports plunged by more than 8% in July. Beijing’s handling of this summer’s stock-market collapse already had prompted questions about China’s willingness to suffer through the rough patches. The devaluation caused some observers to see a trend.

Yet Chinese authorities had shown remarkable restraint in allowing the yuan to rise along with the dollar. The euro and the yen both fell more than 20% against the U.S. currency over the past year. At the same time, People’s Bank of China was spending from the country’s foreign-exchange reserves to buoy the yuan’s value against the dollar. The country’s real effective exchange rate rose considerably, even as the the economy slowed to annual growth rates of 7% from the double-digit pace to which the world was accustomed:

Chart showing effective exchange rates for various countries

China insisted its intentions were pure. The central bank said the devaluation was simply an attempt to realign the yuan’s value with weaker economic fundamentals. Policy makers paired the announcement with a promise to implement a more transparent, market-based approach to setting the currency’s daily peg to the dollar. Arthur Kroeber, head of research at Gavekal Dragonomics, says Beijing deserves the benefit of the doubt. “My suspicion is that in a few months’ time all these anxieties will prove to have been overblown,” he wrote in a commentary published August 13 by the Business Standard. Attitudes about China’s penchant for managing the value of its currency were formed a decade ago, when the the country’s gross domestic product was expanding at annual rates in excess of 10%. That is no longer the case. Whereas international investors were desperate to buy into the China’s growth before the Great Recession, foreign capital now wants out because the heady days are over. Consider the buying intentions of Chinese companies, as measured by the purchasing managers index, or PMI. Economists at RBC Capital Markets this week contrasted PMIs of the U.S. and China to show the Chinese economy has been in relative decline for a while now:

Chart comparing China and US PMI

The Chinese currency now has slipped about 3% this week, and would have fallen more if the People’s Bank of China hadn’t resumed selling dollars to buy yuan. That’s not the action of a country seeking to beggar its neighbours. Some will use the intervention as evidence of Beijing’s weak commitment to markets. Those who make that argument will be on shaky ground. If there is one thing executives detest more than mispriced exchange rates, it is volatility. Any central bank faced with the conditions that confronted the People’s Bank of China this week would have responded the same way.

It remains too soon to know for sure what Beijing intends. Chinese policy makers are learning that their words don’t count for much and that they will be judged on what they do. So far this week, authorities have followed through on commitments to move toward a market-determined exchange rate and stepped in when things got out of hand. Those aren’t the actions of a central bank out to start a currency war.