This China expert believes economics and politics both played a role in China's yuan devaluation

China’s one-off devaluation of the yuan has certainly got markets talking.

Why China’s central bank, the PBOC, made the sudden decision to devalue the currency has sent speculation and rumours into overdrive.

Weak economic data released over the weekend, impending monetary policy tightening in the US, which could see the yuan appreciate further against major trading partners, and a possible delay to the yuan being added to the IMF’s SDR (special drawing rights) basket have all been floated as possible reasons for the PBOC’s seemingly sudden decision.

Huw McKay, Westpac’s well-respected China watcher, who goes by the pseudonym “Phat Dragon”, has weighed into the debate this afternoon, suggesting that there were likely several reasons to explain the PBOC’s decision.

Firstly, McKay believes it fits with the need for China to pursue an exchange rate policy that is in the best interests for its economy.

“As of June, China’s real effective exchange rate was up 14% from a year ago. That was clearly inappropriate then, and it is doubly so with the trend of deteriorating export performance codified in the July trade report. With inflation pressures absent – indeed, the strong currency had been contributing to a deepening deflationary impulse in certain segments of the economy – there seemed no economic reason to stubbornly hang on to a stable bilateral exchange rate with the strengthening US dollar”.

The chart below reveals just how far the yuan has strengthened in real terms over the course of 2015, making the nation less competitive globally and intensifying disinflationary forces.

Alongside that drag on the economy, McKay also suggests that the PBOC may be looking to move away from its currency ‘peg’ while containing speculation towards future movements in the yuan.

He suggests that there are three options available to the PBOC.

  • The first, a heavily escorted grind towards a new level, pre-announced or otherwise, something he believes the PBOC adopted in early 2014.
  • The second, to pick the peg up and move it far enough away from the starting point that the market is unsure which way to then push it.
  • And thirdly, to pick the peg up but to move it just a little, providing speculators with the proverbial one-way bet, an option he believes is “best avoided”.

McKay suggests that “the next few weeks will tell whether or not it has selected the second or the third option this time around”.

In other words, whether the PBOC will allow the market a greater role in determining the level of the yuan will be answered over the coming days, rather than weeks or months.

The final point McKay raises is the inclusion of the yuan in the IMF’s SDR basket, and the possible delay of the decision until September 2016.

For inclusion in the IMF’s SDR basket, the fund notes that a currency must play a central role in the global economy and also be deemed to be “freely usable”.

While China certainly qualifies as playing a central role in the global economy, something the IMF deems to meeting their “export criterion”, had the PBOC have maintained the status quo there were simply too many questions on whether the yuan was truly freely usable.

McKay believes the visit of Chinese President Xi Jinping to the US in September, home to the IMF, may have seen the PBOC act to address these concerns.

“Today’s move indicates China has not given up on near-term inclusion, with Mr Xi heading to Washington in September. A lack of a market basis for the daily fix was a specific criticism levelled by the IMF, and voila, that has been swiftly addressed”.

Indeed, McKay is not alone in this view.

Khoon Goh, senior FX strategist at ANZ, suggests “the exchange rate reform can partly be seen as a measure to strengthen the case for RMB’s inclusion in the SDR basket later in the year”.

“By changing the way the central parity rate is set, from one that is determined by the authorities to one that is more closely based on the onshore spot rate, it ensures that the new fixing reflects actual market realities”, said Goh, adding “the IMF’s preference was for a rate based on intraday market trades; hence the shift in the fix overcomes this issue”.

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.