Expect further China speedbumps during transition to market-driven system

China’s recent moves to devalue its currency amid slowing economic growth sparked sharp declines in global markets. Some observers believe China took this action to spur its economy and exports and to improve its international competitiveness.

Over the past three years, the dollar – for which the Chinese yuan is loosely pegged – has strengthened against the Japanese yen, the euro, and many emerging markets currencies. While the US economy has strengthened, China’s economy has weakened on a relative basis, resulting in a steady erosion of its global competitiveness. China has been steadily losing ground to other exporters due to rising labour costs, so it makes sense that there has been growing pressure on the currency on a trade-weighted basis.

While boosting the economy appears to be part of China’ motivation to devalue, we believe China’s decision was also intended to move toward a more flexible, market-oriented exchange rate, with the ultimate goal of making the yuan a fully floating global reserve currency, such as the dollar, euro, pound, and yen are today.

China, however, faces some significant obstacles to achieving this goal. Because China is a command economy, allowing the exchange rate to be driven by market forces is a major step. In addition, the authorities have to manage the market’s expectations to stanch the capital outflows from China likely to result from the devaluation and market sell-off.

As China allows its currency to be more flexible, the market will expect the yuan to depreciate. Those expectations could create a self-fulfilling prophecy and lead to more capital outflows and even more pressure to depreciate. To avoid that undesirable scenario, the authorities are reassuring the market that they have plenty of foreign currency reserves to support the currency.

In the near term, given China’s slowing economy and the divergence in global central bank policy, we anticipate continued pressure for capital to flow out of China and further yuan weakness.

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