China’s decision to change the method of setting its currency exchange rate caused global shock waves last week. ‘Biggest devaluation in two decades!’ was a typical headline.
Is this a real story? Is the world about to experience even more deflation risk as a result of a 4 percent drop in China’s yuan over a two-day period? Does the addition of a new uncertainty–possible further yuan depreciation–usher in another leg down for already challenged emerging market (EM) assets? Or is this a storm in a Chinese teapot?
Let’s first inject some perspective into this debate: a 4 percent drop is not big. Consider:
1. The currency is one of the few to have appreciated against the US dollar over the past five years (up 6 percent as of last Thursday), Thomson Reuters data show. The yuan is up about a quarter on a trade-weighted basis and has trounced every EM currency over the same period, the data show.
2. A real depreciation, say 10 percent or more, would stimulate exports and add to global deflation. This simply hasn’t happened–yet.
3. The small move modestly helps net trade, in itself a modest contributor to China’s economic growth. (It does help at the margin–and it has the potential to boost asset prices against a backdrop of slowly declining GDP growth.)
What matters more is whether this change ushers in a period of sustained currency depreciation. The yuan’s slow and substantial appreciation over the past decade indicated Beijing had abandoned the use of foreign exchange (FX) policy to stimulate the economy. Dusting off this tool and re-applying it would constitute a threat to EM stability in particular.
If we take the People’s Bank of China (PBC) at its word, the change toward a market-determined exchange rate is part and parcel of financial liberalization – and nothing more. The jury is still out. Do take into account that the world’s second-largest economy faces material challenges. Among them: a currency that was dragged higher by a strengthening U.S. dollar at a time when the economy is slowing. Asian and commodity-producing economies in particular depend on China, and catch a cold when it sneezes.