But first, let's put things in perspective.
The chart above shows the inflation-adjusted value of the dollar against two baskets of currencies: one, the "Broad" dollar basket, containing over 100 currencies, and the other containing a dozen or so major currencies. Since the early 1970s, the inflation adjusted value of the dollar has averaged almost exactly the same as its current value when measured against most of the planet's currencies. Relative to just major currencies, the dollar today is about 10% above its long-term average. So it's fair to say the dollar is somewhat "strong" relative to major currencies, while being simply "fair" relative to all currencies.
Over the past 20 years, China has strengthened its peg vis a vis the dollar considerably, from 8.4 yuan to the dollar to now 6.3. As the chart above shows, the real value of the yuan against all other currencies has doubled in the past 20 years. So it's fair to say the yuan has been an incredibly strong currency for the past two decades. That it should drop 2% against the dollar is hardly noteworthy. Maybe it was just too strong, and now it's a little bit less than "too strong."
The chart above is arguably the best way to appreciate what's going on with the yuan. With the central bank's decision to peg the yuan to the dollar (a peg which has been adjusted, mostly upwards, many times over the past two decades) comes the obligation to purchase any net inflow of foreign currency, and to be a seller of foreign currency in the event of net outflows. Even though the yuan has been getting stronger and stronger for years, China experienced an almost constant net inflow of foreign capital; the economy was booming and everyone wanted to get a piece of the action. China's foreign exchange reserves increased from almost nothing in 1995 to about $3.5 trillion today. But over the past year, China's forex reserves have dropped from $4 trillion to $3.5 trillion, which means China is now experiencing net outflows of capital.
As long as China's reserves were rising, it made sense for the central bank to allow the currency to appreciate. But now that reserves are falling, it makes sense to allow the currency to depreciate. Capital outflows are the world's way of saying that the yuan is "too strong." China is no longer booming, it's merely growing more rapidly than most other economies. The yuan will probably continue to fall against the dollar until it reaches a level that equilibrates capital inflows with outflows. And there's nothing wrong with that. That's how currencies compensate for differences in the economic performance and relative attractiveness of economies.
The yuan is not suddenly collapsing or being devalued, it's simply adjusting to the new reality of slower Chinese growth.
A somewhat weaker yuan will make Chinese goods a bit cheaper for U.S. consumers, and there's nothing wrong with that either.
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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