Why did China devalue the yuan? 

(And what comes into play next?)

I’m not a big fundamental trader. I much prefer to follow the technical picture on the charts instead.  But I was intrigued by potential long-term effects of those yuan devaluations by China last week. I’ve been doing a bit of digging around, so I thought I’d share my findings with you today.

What did China actually do?

For the last two decades the People’s Bank of China (PBOC) kept their currency pegged to the US dollar. They set the price on a daily basis and kept the exchange rate fluctuating 2% either side of that pegged rate.

Last Tuesday they moved the fixed price by 1.9%. They moved it a further 1.6% on Wednesday. And they’ll now take a fix from the previous day’s market rate as their ongoing policy.

I see this as a positive step. It hands power to market forces of supply and demand and removes the artificial conditions created by someone’s opinion of what the rate should be.

So on Tuesday the Chinese yuan instantly fell 1.9% against the US dollar (or the dollar increased 1.9% against the yuan).

On Wednesday the yuan fell a further 1.6% against the US dollar (or the dollar increased 1.6% against the yuan).

And we now have a situation where the exchange rate between the yuan and the dollar will float much more freely than it has before.

What was the immediate impact?

Jitters were seen across the Forex markets. The major pairs showed a reaction as you might have expected, but emerging market currencies like the Malaysian ringgit and the Indonesian rupiah were hit harder. They slumped to lows last seen in the late 1990s.

Global stock markets also fell – it was a bit of a poke in the eye for Western brands that rely largely on Chinese custom for their volume. And commodity prices took a slide on prospects of fewer imports into China too.

We’ll move onto the longer-term effects in a moment. But first, let’s look at the two main reasons China might have made their move.

Did China devalue the yuan to boost their economy?

The obvious motivation for China to have taken these steps would be to give their economy a leg-up.

Allowing the value of the yuan to move lower helps make Chinese goods cheaper for overseas buyers.

And you can see why they might apply this strategy. The strong US dollar has taken the yuan along for the ride recently (because of the pegged price) and it’s created a situation where Chinese goods have become much more expensive for overseas buyers.

Euro-based customers have found Chinese prices 20% more expensive since last summer and Japanese yen buyers have found Chinese goods 17% more expensive since early 2014. This has put China at a disadvantage to its local trading partners in Asia.

So yes, boosting exports is certainly one big benefit of devaluing their currency.

But is there a bigger agenda on China’s table?

Is this China’s first step to securing ‘reserve’ status for the yuan?

The other theory is that China just made its first move easing the yuan into the position of a credible global reserve currency.

Obviously it couldn’t really claim to be a serious alternative to the US dollar when the market price of the yuan was actually pegged to the dollar anyway!

So this now raises some interesting possibilities. They’ve distanced the yuan from the dollar and sent a message to the market that China may not be willing to step in and hoover up US treasury bonds, as they have in the past.

(They did this to counterbalance the effect US dollar prices had on their own currency via the peg, but now this situation has now changed why would they bother?)

They actually have a vested interest in not stepping in. Allowing the dollar to suffer on its own may position the yuan as a potentially stronger alternative to the greenback.

And the yuan can now float more freely against currencies like the yen, the Aussie dollar, the euro, the Canadian dollar, and other emerging market currencies.

So what happens next?

I’ve read a number of forecasts and theories of what comes next, but as always, the proof will be in the pudding.

Take what you read here as idea fodder, but watch events unroll with your own eyes and react accordingly. That’s the best way to take advantage of any opportunities this situation may present.

1) Could it trigger a period of global recession?

A global recession could be one possible outcome created by countries making competing devaluations to their own currencies. The risk is a ‘race to the bottom’, as countries try to out-do each other with cuts as they try to keep their own economies intact.

And these recent ‘aggressive’ actions by China could be the perfect cover story for a struggling US economy in coming months too. Watch for the media rolling out the Chinese devaluation as an excuse for flagging western economies, and remember that the US stock market had actually been selling off for weeks in advance of China making any announcement!

2) Will tension escalate between China and the US?

It made me smile when I read how the US could be upset by China’s actions, poor things.

We know too well just how (insert your own sarcastic tone here) the United States have a god-given right to manipulate exchange rates. (And police global markets like they own the entire world!)

But China’s actions may well have an impact on the widely anticipated decision for the US to raise interest rates this coming September so keep an eye out for that.

3) And where do the US dollar and Chinese yuan go from here?

There are two diametrically opposed opinions currently doing the rounds. (Nothing’s ever straightforward is it!?)

Many traders expect the dollar to soon resume its long-term bearish move to the downside. And if that’s the case, the yuan could rise strongly against it. So would the Chinese be better to have left the peg in place?

Alternatively, if the US economy goes into a proper nosedive at the end of the year, as many expect, the dollar could be left to zoom skywards untethered by Chinese intervention.

Is that what China are preparing for?

And if so, what significance does the timing of their recent actions hold?

I’m sure we’ll find out soon enough. And I’m sure things are only just getting warmed up!

Be Prepared: Market Moving Data Coming This Week (London Time)

Wednesday 19th August:

13:30    USD    Core Consumer Price Index

19:00    USD    FOMC Minutes

Thursday 20th August:

09:30    GBP    Retail Sales

15:00    USD    Existing Home Sales

15:00    USD    Philly Fed

Friday 21st August:

08:30    EUR    German Manufacturing PMI

Monday 24th August:

– no big reports

Tuesday 25th August:

07:00    EUR    German Gross Domestic Product

09:00    EUR    German IFO Business Climate

15:00    USD    CB Consumer Confidence

15:00    USD    New Home Sales

There’s not a great deal of activity on the economic calendar for the week ahead, but Wednesday will be a day to watch – CPI report from the US early afternoon and then the Fed’s minutes early evening here in the UK.

Until next time, happy trading!

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