Here's a quick traders guide to today's news that China's currency has been devalued

Background

China's onshore currency (CNY) has been partly pegged to the US Dollar. Consequently the Yuan appreciated significantly against other currencies like the Euro and Yen in recent years .

The central bank sets a daily mid point or fixing for the yuan and then allows the currency to fluctuate within a 2% range (band) on either side of this fixing each day. Today it was announced that this daily fixing will be based on how the yuan closes on the previous trading session (as determined by market maker quotes). The 2% band will continue to apply.

So while the USD and the Yuan have moved tended to move in lock step against other  currencies much to the time, we may now see more of today's action where EURUSD and EURCNH for example behave differently.

The chart below tells this story. It shows a close relationship until today when EURCNH (black line)  rallied strongly while EURUSD (pink line) is slightly lower. The CNH market charted below is the freely traded Offshore Renmimbi traded in Hong Kong. The offshore USDCNH has moved well beyond the band constrained USDCNY today suggesting further devaluation is in store for the onshore currency.

EURCHN Black Line EURUSD Pink Line Click to Enlarge EURCHN Black Line
EURUSD Pink Line
Click to Enlarge

Why has China made this move?

Potential benefits for China of a  Yuan devaluation include:

  • It's currency was being dragged up against other currencies because of the peg to the $US. While the US economy improves and the Fed gets ready to hike rates, other central banks have a continued easing bias. China is also actively easing, cutting rates and adopting other stimulus measures. Despite this an ongoing peg against $US could see the the Yuan strengthening against other currencies when the Fed hikes rates. This would dampen exports and inflation, undoing some of the benefits of its stimulus measures. This problem was highlighted by weekend news that China's exports declined 8% in the year to July
  •  Today's announcement is another step in the move toward a market oriented exchange rate which will ultimately be necessary if China is achieve its aim of having the Yuan used a reserve currency.

Implications of Yuan Devaluation

Here are some thoughts on implications

  • A weaker Yuan will make commodity imports more expensive for China, potentially leading to some downward pressure on $US commodity prices.
  • If the Yuan falls further against the $US, commodity currencies like the Aussie and Kiwi as well as other Asian currencies will fall against the $US to some extent to maintain an appropriate valuation against the Yuan given that China is their most important trading partner
  • A weaker currency will be a benefit for China's economic activity helping to stimulate activity and inflation
  • However, a weaker currency might increase pressure for capital outflows from China which could lead to short term uncertainty
  • A weaker currency might reduce the need for other forms of stimulus by China such as infrastructure spending. At the margin, this would be a negative for commodities at the margin
  • If the $US rallies significantly against the Yuan, it will be another factor influencing the Fed on the timing of rate hikes. The Fed is likely to be very measured and cautious about the pace at which it lifts interest rates until it becomes more confident that a broader global recovery is under way. Until that happens the potential for a stronger $US will be a limiting factor on the extent of higher US interest rates.