Don’t Fear the Yuan’s Devaluation

The Peoples Bank of China caught financial markets off guard with Tuesday’s surprise announcement that it will devalue the Yuan, prompting sell-offs in stock markets across Europe and the US.  Some US lawmakers condemned the move, calling into question China’s motives, that its move escalates a “currency war.”  For years, China has been accused of artificially manipulating the Yuan’s value lower to make its exports more competitive but China maintains a soft peg against the US Dollar and the recent appreciation of the dollar caused the Yuan to appreciate in tow.

Yuan and Dollar Overvalued                                                       The Real Effective Exchange Rate (REER) is a weighted average of a country’s currency relative to basket of other major currencies, adjusted for inflation.                                      

The consequence of this peg is that Chinese exports grew less attractive, highlighted by a report released Monday showing Chinese exports dropped 8.3% year-over-year.  China has essentially been importing tighter monetary policy from the US Federal Reserve and its economic growth has been worsening as a result.

Market forces have been pressuring the Yuan downward and China has actually been intervening to keep its value higher.  The IMF went so far as to praise the move as a step towards a more free market approach in determining exchange rates.  The Peterson Institute for International Economics views China’s move as primarily market driven:

“The action taken by China, far from being a step to manipulate its currency, is actually an effort to let the RMB fluctuate according to the dynamics of the exchange markets.”

While the move certainly hurts US firms that export products to China, causing their products to be more expensive to the Chinese people, the devaluation is a fair move.

A possible silver lining for investors is that US inflation could slow down as the Yuan falls and, with inflation already below its 2% target, this may give the Fed pause before raising interest rates.  Like always, staying cool and not reacting will prove the best policy in the end.

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