There have been a number of analysts of the foreign exchange market (shorthand: forex) who in recent months have pointed out a troubling trend by central banks. Through extreme monetary tools such as quantitative easing, or "QE," countries have been systematically devaluing their currencies in order to gain a competitive advantage in international trade. By driving the value of the national currency lower, a country can boost its exports to other countries (and improve its trade deficit) due to the cheaper cost of the goods.
Until recently, China was front-and-center in this "race to the bottom," as gold expert Jim Rickards has dubbed the fight among nation-states for an ever-larger portion of the international trade market. Yet, as the economic relationship between China and the U.S. has become increasingly integrated over the last ten years, the People's Republic—and the People's Bank—has expressed a commitment to moving away from such practices and instead allowing the free market to dictate the value of the Chinese currency.
What this week's volatility with the yuan reveals is that a) in whichever direction (i.e. up or down), the Chinese government still intervenes in its markets; and b) this has set off a chain reaction of different countries devaluing their currency just to compete.
How far will the "race to the bottom" go?
China: to Intervene, or Not to Intervene?
Regardless of its many other efforts to open its economy to true free market principles, China still engages in interventionist monetary policy. After a surprise devaluation of the yuan on Tuesday, the biggest for the currency in any single trading day in two decades, Chinese authorities said they were moving to reform their monetary regime.
The central bank now fixes the price of the yuan (or renminbi, as its widely known in China) relative to the U.S. dollar each day, and will not allow the currency to trade more than 2% above or below the daily fixing level. Though this soft peg to the dollar and attempt at currency stability is not necessarily the most aggressive of market interventions, it is nonetheless short of allowing a free-floating currency exchange rate.
You may wonder, how does China control the exchange rate of its currency? In lieu of issuing any law or official order that sets the currency value, the People's Bank of China influences the exchange rate through its foreign reserves. By adjusting the amount of foreign currencies the central bank holds, it can affect the value of the renminbi: when the bank buys more of other countries' currencies with yuan to add to its reserves, its value is suppressed; when the bank sells off foreign reserves to buy up yuan, it supports its currency's value. Currently, China has quite a bit of flexibility to do so, as it's both the world's largest holder of foreign reserves and has been flooding the market with yuan in an attempt to increase the international use of the Chinese currency.
Battles Over Policy, Internal and External
The tension between modernizing economic policy by accepting free market principles or remaining protectionist in its aims is certainly playing out in the Communist Party's Central Committee. China's leaders are somewhat split between those that want to adopt more open economic strategies and those who believe China must do everything possible to maintain a competitive advantage over its rivals, which includes devaluing its currency. The People's Bank of China, however, has officially dismissed notions of a deliberate 10% devaluation for the yuan, believing the currency is already near its fair market value. Dissent within the party remains nonetheless.
The protectionist faction in the government does have a point, at least from a tactical standpoint. Even after both the European Central Bank (ECB) and the Bank of Japan unleashed massive quantitative easing packages in an effort to kick-start economic activity through inflation, speculation abounds that if China engages in any deflationary tactics that keep the exchange rate of its currency down, then its competitors—Japan and Europe chief among them—will undoubtedly follow suit, starting the "race to the bottom." About the only thing that Japan and China compete more fiercely over than the devaluation of their respective currencies is the use of disputed waters the lie between the two nations in the East China Sea.
Its uncertain what the future holds for China and yuan. The IMF is mulling over whether or not to add the yuan to its basket of currencies as part of the Special Drawing Rights, which would go a long way to legitimizing the renminbi as a global currency. Meantime, China is dealing with the fallout from a massive explosion at Tianjin port, a disaster that has left scores dead and hundreds injured in addition to doing extensive property damage. With the Chinese economy clearly slowing down from its breakneck pace over the last 25 years, only time will tell whether the People's Republic matures into a well-integrated, developed economy or continues to command economic trends to match its short-sighted will.