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The return of the currency wars – now China’s joined in

The devaluation of the renminbi could mean more countries joining the 'race to the bottom'. John Stepek looks at what's behind the yuan's fall, and what it means for investors.

150811-china-yuan

China has just launched another salvo in the global currency wars.

The country has devalued its currency the yuan renminbi by nearly 2%. That's the biggest such devaluation under the current currency regime, which started in 1994.

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The era of yuan appreciation is over, said one former adviser to China's central bank.

So what does the shift mean for the rest of us?

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Why has China weakened the yuan?

China had been willing to maintain the relatively high yuan. That's partly to protect companies who have borrowed money in foreign currencies (a weaker yuan will make it harder for them to repay their debts). However, it looks as though something has cracked.

It's possible that the 8.3% slide in exports last month has rattled the authorities. The People's Bank of China (the Chinese central bank) noted that the strong yuan is putting pressure on exports.

Also, China would like the yuan to be made an official reserve currency by the International Monetary Fund (IMF). The IMF delayed a decision on whether to do so or not earlier this month. Basically, the IMF wants the yuan to have a more flexible exchange rate. Now it seems to be getting what it wants.

Until now, China's central bank has managed the currency tightly, setting the exchange rate each morning and then allowing it to trade within a 2% band of that point.

But today, the currency was devalued by nearly 2%. And now the new exchange rate regime will have to take account of supply and demand, the previous day's spot price, and various other factors that were not considered before. In short, it's "a new currency regime", noted one analyst on Bloomberg.

Given that the market pressure is now for the yuan to fall rather than rise, this looks like a good way to kill two birds with one stone. Keeping the IMF happy provides political cover for the move, which allows China to get a weaker currency to help boost growth and imports.

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Why we're likely to see more yuan weakness

Already this morning, currencies throughout Asia slid as markets bet on rival exports such as South Korea looking to weaken their own exchange rates.

"That raises the distinct possibility of a new and increasingly destabilising skirmish in the ever-widening global currency war. The race to the bottom just became a good deal more treacherous," notes Roach.

Charles Dumas of Lombard Street Research notes that a devaluation of the yuan will make China's internal rebalancing less painful. But it will "export the deflationary impact to its trade competitors in the rest of the world." If China starts to export deflation, then competition from cheap imports could hurt US corporate profits.

However, that doesn't mean a crash would come right away. Because at the same time, says Dumas, if money leaves China looking for a home elsewhere, then "real foreign assets, no doubt concentrated in North America" could be the beneficiaries. As a result, "Chinese capital inflows and a buoyant US economy could lift the stockmarket substantially before the erosion of profits kicked in."

Meanwhile, in the short term, it's bad news for commodities in that China won't be able to afford to import as much. But given that Chinese demand has clearly already dropped off, I suspect this isn't especially significant in the context of a sector that has already crashed badly. Moreover, if a weaker currency helps to boost Chinese growth, then overall, that would boost demand for commodities.

For now, no one can really complain about China devaluing the yuan has been one of the stronger currencies for a long time, and China's economy is clearly suffering. But an ongoing slide in the yuan could well result in retaliation from other countries aiming to keep their own export share high.

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For now, we'd stick with China. A weaker currency is generally good news for a country's stockmarket as we've seen elsewhere in the world. We looked at some of the best ways to invest in China in a recent issue of MoneyWeek magazine.

If you're not already a subscriber, you can get your first four issues free here.

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