Your guide to China’s devaluation of its currency

Renminbi Photo by Thomas Ruecker/Getty Images

Global stock markets have been on a roller coaster ride since Tuesday, when China’s central bank abruptly devalued the yuan. Photo by Thomas Ruecker/Getty Images

What’s happening to China’s yuan?

The yuan usually changes in value a fraction of a percentage point in a day. But on Tuesday, China’s central bank abruptly devalued the yuan by nearly 2 percent — the largest single-day drop since 1994. On Wednesday, China’s central bank devalued it by another 1.6 percent and on Thursday, 1.1 percent. Since Friday, when the yuan took a turn and appreciated .1 percent, the yuan has stabilized.

Global stock markets have been on a roller coaster ride since Tuesday, as the world tries to understand what the currency move means.

Why would China weaken its currency?

First, a bit of background.

China’s economy, the world’s second largest after the U.S., has been slowing down. For decades, the country had what many said was an unsustainable growth rate. In 2014, investments made up 48 percent of economic activity; in most countries that number is between 15 and 30 percent. Recently, there has been a slowdown in property investment, construction has lagged, and consumer spending is down. Then in June, China’s stock market crashed, and the government stepped in to reign in selling. In less than a month, shares fell by nearly a third.

China’s growth rate has dropped to 7 percent, a high number almost anywhere in the world, but low in a country that averaged 10.6 percent growth in 2010… and some economists wonder if the real number is actually lower.

Unlike most countries that allow the value of their currency to be determined in world markets, China’s government uses the U.S. dollar as a benchmark against which they manage their currency’s value — a policy dating back to the mid 90s. However, in the past two years, as the U.S. dollar appreciated in value, China’s economy slowed, making it increasingly difficult for the government to justify pegging the yuan to the dollar.

The move to depreciate the yuan was twofold. First, with exports slumping, officials were under pressure to try to boost them. Chinese products are cheaper as a result of the depreciation, making it more appealing for other countries to import Chinese products.

Second, China has been under a lot of pressure by the United States and the International Monetary Fund to allow their currency to be valued by the market. It’s part of broader financial market reforms by China to rebalance its growth and generate more consumption-driven growth. “Having China grow in a balanced and sustained manner is good for China and the world,” said Eswar Prasad, professor of trade policy at Cornell University and a former IMF official. And that’s in America’s interest: if China increases domestic consumption, they will import more from the U.S.

Hold on, I don’t understand. Is China manipulating its currency, or is it allowing it to fall according to the market?

“The 2 percent move was something that was orchestrated by the Chinese central bank,” said Prasad, referring to the Tuesday’s devaluation. “Then they allowed the market to decide from there. The depreciation was something that the market wanted.”

A slowing economy would normally depreciate a country’s currency. The nearly 2 percent drop orchestrated by the People’s Bank of China jumpstarted a move in the direction the market had been trying to pull it. The central bank might allow the currency to depreciate further, but they have also said that they won’t allow it to go too much further. On Thursday, in an attempt to quell growing concerns, Chinese officials said that their currency is not in free fall and that the bank maintains the power and authority to intervene and stabilize the yuan if need be. On Friday, the People’s Bank of China appeared to do just that, stabilizing the yuan in order to quell concerns from global markets as well as to smooth things out in their own financial markets, said Prasad.

In other words, the People’s Bank of China has adopted a “managed float” regime.

OK, so how is this affecting the global economy?

Well, China’s timing doesn’t exactly suit the rest of the world. Stock markets fell globally initially, rebounding a bit on Thursday and again on Friday following China’s assurance that the yuan isn’t in a free fall. Businesses that compete with China for exports or that have significant sales in China saw their share prices take a hit. Last week European stocks had their “worst week in six” but bounced back on Monday.

“[China is] doing exactly what the U.S. wanted at a time that is convenient for them and not for the global economy,” Prasad said. And when you have an economy as big as China’s, it affects the rest of the world.

“So you have the world’s second largest economy, which has been this big tailwind for global growth… suddenly sputtering,” Mike McDonough, chief global economist at Bloomberg Intelligence, told Judy Woodruff on the PBS NewsHour Wednesday. “So this tailwind is becoming a headwind. That’s the real concern. It’s not the devaluation.”

The devaluation signals that something is wrong, and that’s what sent stock markets on their roller coaster ride, Prasad said.

First, by devaluing their currency, people thought “China was throwing in the towel.” That is, the Chinese central bank must know something that rest of the world does not — that the Chinese economy must be worse than we think.

Second, countries fear a currency war. “There’s a lot of volatility in stock markets around the world, because they fear that other countries will depreciate their currency,” says Prasad. The cheaper a country’s currency, the more competitive its exports. With such a weakened yuan, China is a “fierce competitor” — more so than ever.

It’s possible that countries will depreciate their own currencies in order to compete with China, but the likelihood of a currency war depends on whether or not the yuan continues to depreciate.

Who’s taking the biggest hit?

Canada, New Zealand, Australia, Korea, Thailand, and Malaysia are likely to be hardest hit. They export a lot to China, but with a weakened Chinese economy, there is less demand for their goods. Korea, Thailand and Malaysia are facing a double whammy in that they often compete with China to export cheap goods to the rest of the world.

What does this all mean for U.S. markets?

Caught off guard, stock markets opened lower on Tuesday and dropped even more Wednesday, with the Dow Jones Industrial Average dropping 277 points before heading back to its original standing. On Thursday, likely in response to China’s government saying they will not allow a free fall of the yuan, the market steadied. And since Friday, with the stabilization of the yuan, it appears that markets have gotten off the roller coaster ride — for now at least — and are returning their attention to other matters.

Still, there are lingering concerns that the devaluation of the yuan could hurt the recovery for U.S. companies that export to China, because their products will be more expensive for Chinese consumers to buy. Additionally, exports from China are going to be cheaper for U.S. consumers, which is going to hurt U.S. manufacturers.

Not only that, China has been the biggest driver of global growth since the Great Recession, so if China is slowing down, the world may be as well.

That sounds scary! What does this mean for me?

“At this stage it’s way too early to tell,” Prasad said, “Short term is a little dicey, long term looks a little better.”

If a currency war does begin, it might not necessarily hurt U.S. consumers. If everyone depreciates the value of their currencies, the U.S. dollar will grow stronger. A stronger dollar means cheap imports, less expensive vacations abroad and lower interest rates. So even if the Fed raises interest rates in the fall, Prasad predicts that they will stay low in the long term, which would be good for mortgages and auto loans.

“Cheap imports and low interest rates are going to be a big benefit to the average American household,” Prasad explained. “So the benefits are going to be widespread, but the pain is going to be very concentrated in some sectors that could face very significant job losses and loss of economic momentum.”