Why is the world so exercised over a 4% "devaluation" of the Chinese yuan? The Euro recently suffered a 25% "devaluation" vis a vis the dollar, but that did nothing to ruffle the feathers of global financial markets.
While the two currencies are not strictly comparable, it's important to understand how they are different, and why a lowering of the yuan's peg against the dollar is appropriate and not a threat to global financial stability.
As the chart above shows, since its inception in 1999 the Euro has been quite volatile vis a vis the dollar. Most notably, between early last year and March of this year, the Euro was "devalued" by about 25% relative to the dollar, falling from 1.4 to 1.05. While this had a significant impact on global balance sheets, it was not a destabilizing event. Most importantly, the decline in the Euro's value was driven not by the ECB's decision to devalue the euro, but rather by market forces. The Euro became less attractive relative to the dollar for a variety of reasons: the U.S. economy looked stronger than the Eurozone economy, the Fed seemed likely to raise interest rates sooner than the ECB, and the Eurozone was saddled with lingering debt default problems and currency stability issues (e.g., Greece and possible Grexit). The decline of the Euro was not the result of anything the ECB did, and thus it did not impact the Eurozone money supply, nor did it greatly impact the Eurozone economy. 10-20% moves in major currencies relative to each other happen quite frequently, but they do destabilize global financial markets, because they are mostly the result of changing desires to hold one currency relative to another.
The situation in China is much different. The Chinese central bank is following a "managed peg" monetary policy, whereas the ECB is following a managed interest rate policy. Very different animals. China's central bank establishes a currency peg (which has quite often been changed, usually upwards, but recently downwards) and then watches to see how this impacts capital flows. If the market decides to withdraw capital from China at a given peg, then that creates net capital outflows which the central bank must accommodate. This typically takes the form of selling securities (e.g., Treasuries). which in turn reduces the Chinese money supply. Money decides to exit China, and that results in less money in China. A reduced supply of yuan helps restore equilibrium, by offsetting reduced demand for yuan.
In the case of the Euro, a reduced demand for Euros will simply and automatically lower the value of the Euro; it will not impact the supply of Euros. The task of the ECB is to find the interest rate that results in a balance between the supply and demand for Euros, regardless of where the currency happens to be trading.
The Chinese central bank only has to sell Treasuries if the peg it has set proves too high to balance the supply and demand for yuan. Capital outflows effectively signal the bank to reduce its peg. Sooner or later, a lower peg will allow the restoration of a market equilibrium in China. There is a value of the yuan which will balance the supply and demand for yuan, and that peg is probably somewhat lower than the current peg. But a further decline in the yuan's value will not necessarily result in higher Chinese inflation, because a lower peg will restore the balance of money supply and demand. A weaker yuan will have an impact on China's trade and its economy, but mainly because a weaker yuan reflects reduced investment demand for yuan and that in turn will result in a slower-growing economy.
The Chinese central bank was content to accumulate reserves for almost 20 years (see second chart above), even as they periodically increased the yuan's dollar peg. That's probably because they wanted to build a substantial balance of foreign exchange reserves. By sitting on a mountain of reserves, the central bank could defend the yuan's value almost without limit, and that was an important step in establishing the yuan as a reserve currency that might one day rival the dollar. But things changed about a year ago, as capital inflows were replaced by capital outflows. My guess is that the central bank does not want to squander its reserves, nor let them decline much further. They can avoid the further loss of reserves by lowering the yuan's peg, and that is what they are doing. A cheaper yuan will at some point increase the attractiveness of investing in China by enough to restore a balance between capital inflows and outflows.
UPDATE: David Beckworth very nicely summarizes here the dilemma that China is facing with its currency peg. The thing to worry about is that it is going to be difficult for China to get itself out of the corner it has painted itself in. Trying to manage the yuan's peg is complicated by the rise of the dollar and China's desire to liberalize capital flows, all at a time when growth is slowing. If I'm being too optimistic about the central bank's ability to manage the peg without losing too much of its forex reserves, Beckworth lays out the bear case convincingly. I've been thinking the yuan has more downside, and he would agree; the problem I've perhaps underestimated is that the market is figuring this out and that is making the central bank's task more difficult.
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