ON Tuesday, the People’s Bank of China (PBOC) sprung a surprise on the rest of the world by devaluing the yuan, allowing it to depreciate by nearly two percent, its biggest single-day change in almost 20 years.
This naturally threw global financial markets into a bit of a tizzy; here in the Philippines, the peso reacted by shedding 23 centavos from its opening to close at a new five-year low of P45.93 to $1, with trading volume more than doubling from Monday to reach $1.1 billion. Tuesday’s close was the lowest level for the peso since late July 2010, when it bottomed out at P45.97 to $1.
Under “ordinary” circumstances, the way in which the PBOC manages the value of the yuan is to set a daily reference rate against the US dollar, and then allow currency trading within a range of plus or minus 2 percent from that indicated rate. What the PBOC did on Tuesday was to, instead, set the reference rate at close to the market closing rate from the previous day, rather than resetting the rate to a more arbitrary target based on longer-term monetary policy strategy.
Since 2005, when China more or less officially unpegged the yuan from the dollar, that strategy has been to allow the yuan to gradually rise over time as the Chinese economy expanded. The strategy is driven partly by economic logic, and partly by politics: one of the biggest criticisms of Chinese monetary policy by the western world is that China artificially depresses the value of its currency to prop up domestic industries. China’s government, of course, has always denied this, but it has to bend at least a little, because the criticism raises a few hurdles to the bigger goal of internationalizing the yuan.
The recent deferral of a decision by the International Monetary Fund of whether to include the yuan in the currency basket that determines the value of the SDR (special drawing rights—the contrived currency unit used by the IMF, which at the moment has a value of about $0.72) may have encouraged the PBOC’s move on Tuesday, as well as the general cooling of the Chinese economy.
According to the Chinese, Tuesday’s devaluation was simply a bit of housekeeping, a one-off reset of the yuan to closer to market rates to make subsequent setting of the daily reference rate a little more accurate. Based on the huge volume of commentary and analysis about the move, the rest of the world seems genuinely confused about what China may be up to; opinions seem to be fairly evenly divided between accepting the PBOC’s explanation, or taking the devaluation as a sign that the Chinese government is more worried about the economic slowdown than they’re letting on.
The latter view gains a little bit of credence from the fact that August is the “ghost month,” when economic activity of all kinds tends to wane. Skepticism of China’s original explanation grew further when the devaluation happened again yesterday, shaving a further 1.62 percent off the yuan’s reference rate.
The biggest benefit to China from the devaluation is to make its exports relatively cheaper; conversely, it presents problems for import-dependent businesses.
For the rest of the world, the benefits are cheaper Chinese imports and lower commodity prices, but the length of time these advantages can actually be enjoyed is extremely short; in real terms, it may have lasted a couple hours on Tuesday afternoon, but was over by Wednesday morning. That is because other countries, particularly countries that rely on two-way trade with China (like the Philippines) have to allow their own currencies to depreciate in order to help their exports stay competitive with China’s, and to keep Chinese imports of Philippine goods from being priced out of that market. This raises fears of a currency war, in which everyone is “racing to the bottom” to try to maintain competitive equilibrium.
If that happens, the Philippines could be in for a rough ride. A strong dollar and flagging domestic economic conditions are already putting negative pressure on the peso, and the yuan devaluation—particularly if it turns out to be the start of a more volatile downward trend rather than the “one-off” housekeeping the PBOC said it was—simply amplifies that.
Further aggravating the problem is the very real possibility now, at least in the view of some analysts, that the US Federal Reserve may hold off a bit longer on its interest rate hike that was presumed to be in the pipeline for next month; monetary authorities and market watchers here have been counting on that to help ease the value of the dollar and slow or stop the peso’s slide, and without it, more aggressive action on the part of the BSP—which may or may not be a good idea in the long run—will be necessary to achieve the same result.