Why is China devaluing the yuan?

Why is China devaluing the yuan?

China has rattled the financial markets by cutting the value of its currency - called the yuan or the renminbi – by almost 4% in two days.

The move ignited fears that the world’s second largest economy may start a global currency war, which would see nations trying to protect their exports by artificially managing their currencies.

The move saw the FTSE 100 fall by more than 100 points this morning, with Germany’s Dax and France’s Cac 40 each down by more than 2%.

China first cut the value of the yuan on Tuesday, by 1.9%. That marked the biggest one-day drop in the currency’s valuation since January 1994, and saw New York’s Dow Jones Industrial Average fall by more than 200 points. It followed this up with a second 1.6% cut on Wednesday.

:: Why is China doing this?

China is battling slowing growth. Over the weekend official Chinese data showed that its exports tumbled by 8.3% year-on-year, much worse than expected.

The economy is expected to grow by less than 7% this year, its slowest rate since 1990. Its stock market has been falling since June.

Economists say the move to cut the value of the yuan is designed to make its goods, the costs of which have been rising, cheaper across world markets.

Chinese factories provide work for millions of villagers. The cuts by The People’s Bank of China (PBoC), may be designed to try to avoid losses at these factories.

When the PBoC made its first cut on Tuesday it described the move as a “one-off” measure.

World markets were surprised by the second devaluation a day later.

:: Are there political factors behind China’s decision?

China has been lobbying to join the International Monetary Fund’s (IMF) Special Drawing Rights (SDR) basket of elite currencies – which comprises the euro, sterling, the US dollar and Japan’s yen.

Inclusion in this basket is unlikely to help China financially, but it will advance the yuan’s claim to be recognised as one of the world’s major currencies.

In the past the IMF has said that China needs to have a more flexible exchange rate, so that the value of the yuan adjusts to China’s growth – as other currencies do in other market-driven economies.

Earlier this year the IMF postponed a decision on the currency’s inclusion in the SDR basket until September 2016.

The IMF reacted to Tuesday’s cut by saying the move to make the yuan’s rate more market-based “appears a welcome step”.

But many of China’s trading partner’s, most notably the US, are wary of the Chinese Government’s influence over financial markets.

:: What happens next?

Some economists believe China’s economy is already growing only half as fast as official data shows, which could mean there may be further devaluations on the cards.

A number of US lawmakers yesterday condemned China’s move as a way to keep its currency artificially low giving its exporters an edge.

Chinese President Xi Jinping is due to pay a state visit to the UK in October - the first by a Chinese leader in 10 years.

These visits usually trigger a wave of bi-lateral trade deals, but the value these contracts may waver dramatically over the coming months as the yuan finds its level.

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