China's decision to devalue its currency has taken international markets by storm, raising concerns over a protracted currency war among the world's leading economies.

Reflecting its growing anxieties over the country's economic prospects, Beijing has decided to go for the jugular by making Chinese exports more affordable in international markets.

Recent months have been particularly unsettling for the world's second largest economy.


Q&A: China's yuan and a potential global currency war


Between June and July, China's stock markets fell by more than 30 percent (evaporating $3.4 trillion in financial assets), exports suffered an 8.3 percent year-on-year decline in July, and there are growing indications that China will miss its growth target of 7 percent for this year.

Though China still has one of the world's most dynamic economies, recent trends are, to say the least, particularly disconcerting for an authoritarian regime, which stakes its legitimacy on providing unbridled prosperity.

Counting the Cost - China's currency wars

Gradually, China is beginning to lose its economic lustre, as investors and policy-makers shift their attention to mitigating and hedging against the vulnerabilities of the Asian economic powerhouse.

More fundamentally, China's economic woes could significantly undermine its regional and global soft power bid, which is primarily anchored by Beijing's financial prowess and largely successful growth model in the past three decades.

The government's erratic responses to economic fluctuations also underline the ruling Communist Party's ambivalence vis-a-vis fee market principles.

Beggar-thy-neighbour

As leading economists have noted, one of the factors behind the 2008 Great Recession was the neomercantilist strategyof locomotive economies, which engaged in "manipulative recycling" of their export-earnings into less productive economies.

The timing of the [devaluation] decision shows that China is more likely driven by short-term concerns over reflating its flagging economy, as the country tries to recover from slowing exports and a stock market crash.

 

Manufacturing powerhouses like China and Germany constantly propped up their current account balance, discouraging domestic consumption in favour of massive credit lending to consumerist trading partners.

This unnatural and large-scale infusion of foreign credit into countries like the United States created a precarious spending spree among less productive economies.

The result was staggering debt levels and unsustainable trade deficits going hand in hand with unsafe lending practices and massive financial speculation by Wall Street, which culminated in the crash of the American sub-prime property market in 2007.

Eager to redress the imbalances in the global economy, the US, the UK as well as Japan, among other countries, engaged in a sustained campaign to make their currencies more competitive, implementing expansionary monetary policies - quantitative easing - which, by extension, also made their exports more affordable.

The rebalance

In the eurozone, Germany ended up subsidising peripheral economies, which suffered from a sovereign debt crisis after years of unsustainable borrowing and weak exports.

Interestingly, the post-recession period actually saw a steady appreciation in Chinese currency (renminbi), as Western countries and international financial institutions called on China to revalue its currency, liberalise its capital markets, and shift into a more consumption-driven economy.

Over the years, the US trade balance improved as its exports became more competitive, while China saw a steady growth in wages and domestic credit, which allowed for greater consumption and spending at home.


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To express its commitment to the transformation of China's economy, the Xi Jinping administration went so far as to declare that the market forces will begin to play a more "decisive role" as the state decreases its intervention in economic affairs.

Meanwhile, China also stepped up its efforts in creating alternative international financial institutions that provide affordable loans and focus on strategic sectors, such as infrastructure development.

It didn't take long, however, before the Chinese economy's vulnerabilities were exposed, as regulators failed to prevent a massive stock market crash that disproportionately affected aspiring middle classes, while growth numbers tanked and raised fears of political backlash.

Back to reality

China's days-long decision to devalue its currency, knocking off more than three percent of its value, sent shockwaves across the region, leading to a decline in the currencies of neighbouring countries, such as South Korea (two percent), Australia (1.75 percent), and Japan (0.3 percent), while German car giant, BMW, also suffered a decline in its stock value.

The US Federal Reserve is also revisiting its initial plan of raising its interest rates later this year.

To be fair, China's currency devaluation came on the heels of its decision to actually let market forces determine its value, a crucial step towards making renminbi a genuine global currency alongside the US dollar, euro, and yen.

In fact, for years the International Monetary Fund and Western countries have been calling on China to allow its currency to float along market dynamics.

However, the timing of the decision shows that China is more likely driven by short-term concerns over reflating its flagging economy, as the country tries to recover from slowing exports and a stock market crash.

Indeed, the draconian response of the Chinese government to the recent stock market crash - large-scale temporary suspension of public offerings, caps on short-selling, and cuts in interest rates - exposes its reluctance to allow market forces dictate economic developments.

But as China grapples with domestic economic woes, it will inevitably have to also re-evaluate its massive international spending spree, which is partly aimed at challenging the Western and Japanese-dominated Bretton Woods institutions, such as the World Bank and the Asian Development Bank.

In the past year or so, China has pledged more than $150bn to various initiatives, such as the Asian Infrastructure Investment Bank, the "One Belt, One Road" strategy, and the New Development Bank, with plans of spending as much as $1.25 trillion globally by 2025.

Though China's massive $4 trillion currency reserves provide it with significant room for manoeuvre, there are serious signs that it will have to be more cost-efficient (rather than politically-motivated) in deploying its financial prowess.

China is gradually entering a new normal as it descends from the economic heaven.

Richard Javad Heydarian is a specialist in Asian geopolitical/economic affairs and author of "How Capitalism Failed the Arab World: The Economic Roots and Precarious Future of the Middle East Uprisings."

The views expressed in this article are the author's own and do not necessarily reflect Al Jazeera's editorial policy.

Source: Al Jazeera