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

After China pushed down the value of its yuan (CNY) on Tuesday, the government assuaged fears of an ensuing currency war by saying that the drop was a “one-off”. Yet the value of the yuan dipped twice more on Thursday, sending shudders through global stock markets. 

Later on Thursday, as the yuan’s third slide revealed itself to be more subdued than previous devaluations, Asian stock markets scrambled back to stability. 

China does not allow its yuan to trade freely in the global market; instead, the yuan’s value is tied to the US dollar. Because the dollar has recently risen in value, so too has the yuan.

---

RELATED: China stock market plunges despite government measures

---

But by depreciating its currency, China will now allow its exports to be distributed at cheaper, more competitive prices. As a senior official at China’s Ministry of Commerce said on Wednesday, the adjustment “will have some stimulative impact on exports”, which dropped 8.3 percent in July due to weak global demand.

In the US, where politicians have long accused China of manipulating its currency unfairly, senior lawmakers from both parties are positioning the devaluations as China grappling for an advantage in its exports. Yet the International Monetary Fund (IMF) called the depreciations “a welcome step”, arguing that they allow the yuan’s value to be better determined by the market, and not by its relationship to the dollar.

In September, the US Federal Reserve (the Fed) is expected to raise its interest rates – its first increase in nine years. The new rates could pose “disruptive” implications for the global economy, according to the New York Federal Reserve President William Dudley, in addition to strengthening the dollar. 

A lower yuan also means a higher dollar, leading economists to speculate whether the devaluation will affect the US’ inclination to lift rates and, consequently, the US dollar’s climbing value. With the huge gap in export trade between the US and China, the fear is that a strong dollar could make US exports expensive and less competitive in the global market. 

Before China’s third devaluation of the yuan, Al Jazeera spoke with Rajiv Biswas, the Asia-Pacific chief economist at IHS. He believes that, if China is to further devalue its currency, the depreciation and possible US interest hikes could introduce turmoil to global currency markets. 

---

RELATED: China to prop up stock market after record fail

---

Al Jazeera: Why is China choosing now, in particular, to devalue its currency? 

Rajiv Biswas: China’s decision to devalue the yuan against the US dollar reflects concerns about the weak performance of the Chinese export sector this year… The sector has faced a perfect storm of sluggish global demand for its exports and eroding competitiveness due to rising Chinese manufacturing wages, as well as the depreciation of the euro, yen, and many other emerging markets’ currencies against the US dollar this year. 

With the US Federal Reserve expected to begin lifting its policy interest rate soon, which would have put further downwards pressure on the euro, yen and emerging markets’ currencies, pressure had built up for the Chinese government to allow the yuan to move lower against the US dollar before the Fed rate hike.

Al Jazeera: What does this move mean for China’s efforts to move away from an export economy?

Biswas: Although President Xi and Premier Li Keqiang have made economic reforms and a transition to domestic demand-led growth policy priorities, the sharp economic slowdown and stock market crash have forced them to take measures to stabilise the Chinese economy. The export sector has been a key growth engine for the economy…

While China will continue to make a gradual transition from an economy driven by investment and exports towards an economy driven by domestic consumption, this transition will take many years. Meanwhile during the current cyclical slowdown, the government is again having to resort to boosting its traditional growth engines of investment and exports to try to stabilise the economy, using its toolbox of currency devaluation to improve export competitiveness, and fiscal and monetary stimulus to boost domestic demand.

Al Jazeera: How valid are fears that China’s move will trigger “a global currency war”, and what could such a war look like?

Biswas: The Chinese yuan devaluations have created turmoil in currency markets, with many other emerging markets’ currencies also depreciating against the US dollar following the yuan devaluations.

The stability of the CNY against the US dollar in recent years has helped to mitigate risks of competitive depreciation among emerging markets’ currencies, with the CNY acting as an anchor of stability in currency markets.

However, if the CNY devaluations this week herald further such devaluation steps by the Chinese central bank, it could increase uncertainty and turmoil in global currency markets, particularly if the Fed also begins hiking interest rates.

Such a combination of Fed tightening rates as well as the Chinese growth slowdown and yuan devaluations would likely result in increased global asset allocation towards the US dollar and US Treasuries, and away from emerging markets’ currencies, equities and debt.

In the Asia Pacific region, some of the most vulnerable emerging markets’ currencies are the Malaysian ringgit and Indonesian rupiah, both of which have already depreciated significantly against the US dollar this year. It is possible that some emerging markets central banks could use macro-prudential measures to stabilise their currencies if their currencies depreciate too sharply.

Biswas: The depreciation of the euro, yen and many emerging markets’ currencies against the US dollar over the last year had put pressure of China to also devalue its currency against the US dollar. However, in an environment of sluggish global growth … the Chinese devaluation has triggered a shock wave of further depreciation among many emerging markets’ currencies. The net effect is that China’s relative competitiveness against many other emerging markets has not changed significantly after its devaluations.

Al Jazeera: To what extent will US and EU economies be affected by the devaluation, especially given the expected interest hike in September in the US?

Biswas: The US dollar has already appreciated significantly against many of the currencies of its key trading partners, including the euro and the yen, as well as many emerging markets’ currencies. Consequently, US export competitiveness has been gradually eroded by the strengthening US dollar as prices get higher.

The Chinese yuan devaluation will further erode US export competitiveness, not only in the Chinese market, but also in other emerging markets as a result of the latest round of emerging market currency depreciation. However, many US multinationals will be resilient despite the strong US dollar, as they have extensive production facilities and supply chains in the EU and emerging markets that act as a hedge against US dollar appreciation.

For the eurozone economies, the significant depreciation of the euro against the US dollar over the last year has improved the competitiveness of EU exports into the key US market. As the Fed begins raising interest rates, this is likely to result in further appreciation of the US dollar against the euro, helping to improve eurozone export competitiveness in the US market.