Last week the Chinese government shocked the world when it instigated the country's biggest currency devaluation in two decades. Its move left the yuan around three per cent weaker against the US dollar and sparked fears of a global currency war.
So far that hasn't happened, but there are concerns about some of the other impacts the devaluation could have for countries around the world, both directly and indirectly. Here we take a look at what prompted the government's action and what the ripple effects could be.
Why was the yuan devalued?
Beijing's decision came as a big surprise for two reasons. Firstly, it was made without clear warning and secondly, economists had expected Beijing to support the yuan in order to strengthen its reputation as a global reserve currency.
That's why the move is being seen by many as a sign that China's economy – the world's second largest – is in trouble. Growth is slowing, inflation remains very low and the country is facing a huge fiscal deficit. China's stock market has also taken a hammering after a year-long boom.
In addition, recent figures have shown that the country's exports are falling. In June they dropped by 8.3 per cent. For a country that relies so heavily on manufacturing and exported goods, this is concerning, and it is seen as the main reason why the yuan has been devalued.
A weaker local currency will give Chinese exporters a competitive edge on the global market as their goods will be cheaper for foreign buyers. Similarly, imports from other countries will be more expensive for Chinese consumers, giving domestic manufacturers a further boost.
Of course, the Chinese government did not mention the impact on exports when the devaluation was announced. It simply said it wanted to switch to a more market-orientated method of calculating the daily reference rate by which the value of the yuan is set.
In other words, the value will be more closely determined by supply and demand – something critics of China's exchange rate policy have been advocating for some time now. Indeed, it may help China move closer to satisfying the International Monetary Fund's reserve currency entry requirements.
What are the impacts?
The impact of the yuan devaluation will be felt not only within China, but right around the world by everyone from governments and central banks to ordinary consumers. Below are just a few examples of the kind of changes and challenges Beijing's move could bring about.
For manufacturers in China the devaluation is a positive development, as it means their goods and services will become cheaper for foreign buyers and therefore more attractive. It is not such good news for exporters in other countries, particularly those that compete with China.
For example, nations such as Taiwan and South Korea export similar products to similar markets, and if China's goods are preferred their manufacturers could suffer. On the other side the devaluation could spell trouble for countries that export heavily to China, as their goods will be more expensive.
The exporters that may struggle the most as a result of a cheaper yuan are the major commodity producing nations for whom China is a major customer. Since most commodities are priced in US dollars, a weaker yuan will raise the cost of imports and further weaken demand.
The world's appetite for natural resources has been falling for a while now and this has already put tremendous downward pressure on prices. Beijing's move will only add to that, creating further problems for nations such as Australia, Russia and Brazil.
There is a concern that cheaper Chinese imports could result in a new wave of price weakness in developed economies like the UK and the US. Here, inflation is already at zero, and the worry is that Beijing's devaluation could push it into negative territory.
Societe Generale economist Albert Edwards voiced his unease in an interview with the Guardian newspaper. He warned that a cheaper yuan could cause a "tidal wave of deflation" to hit the global economy, which leads us onto the next challenge.
- Interest rates
In recent months central governments in the UK and the US have been warning that higher interest rates are just around the corner. Here, increases are expected to come in early 2016, while across the pond the consensus is that they will occur before the end of the year.
However, the cheaper yuan may delay any fiscal tightening if, as economists are anticipating, cheaper Chinese exports act as a drag on inflation. Increasing interest rates could also push up the value of the pound and the dollar, which is undesirable at a time when the yuan is falling.
China's currency devaluation and the concern this has unleashed over the true state of the country's economy has unnerved the financial markets. Chinese stocks were already in decline and the yuan's downward movement has only exacerbated the situation because markets hate uncertainty.
The move has also hit equity markets across the rest of Asia and in Western nations, with shares in companies that export heavily to China experiencing the worst of the declines. With this in mind, investors will be on the lookout for signs that Beijing's yuan devaluation was not just a one-off.
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