China's currency cut hits markets, but is it an 'overreaction'?

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China on Tuesday shocked global markets with a surprise 1.9-per-cent devaluation to its yuan, the biggest since 1994, that raised new worries about the country's economic health.

But as investors fretted about China launching a new currency war, in Beijing the dramatic cut offered something different: a convenient way forward. In devaluing the yuan, Beijing can lend its suffering exporters a helping hand, while at the same time boasting that it is backing out of the currency manipulation game – allowing markets to decide price at a time when the yuan is already falling.

That gives it cover both for its own economy and its ambitions to make the yuan a global reserve currency.

It does little, however, for investors already nervous about the prospects for a Chinese economy on track for its slowest growth in a quarter-century, with sputtering exports and plunging prices for its industrial goods.

On Tuesday, markets responded with a broad sell-off that hit German car makers, industrial metals, U.S. bonds and other Asian currencies. Canada's metals and mining index fell nearly 5 per cent and the loonie dipped half a cent against the U.S. dollar.

The currency setback underscored a broader reality facing the emerging superpower and those who rely on its massive buying power: that after nearly four decades of remarkable gains, the China miracle is fading. Facing a heavy debt load and faltering prospects, the country's leadership has taken increasingly dramatic measures to keep growth going, with stimulus spending and cuts to lending rates.

At the same time, the makeup of the Chinese economy is changing, as it transitions from a heavy industrial buyer of coal and steel to a country more reliant on the service sector. This year, for the first time, services are expected to outweigh the industrial sector, a change that has profound ramifications for China's demand for the goods a resource-heavy country like Canada provides.

It's that "business cycle context" that provides the most reason for concern, wrote John Normand, head of foreign exchange, commodities and international rates research with JPMorgan Chase & Co.

"It is as negative a signal for near-term commodity demand," he said, as China's recent efforts to perk up economic performance by cutting interest rates.

Others worried that Beijing had taken a new shine to currency manipulation. "Choosing to go this route brings into question China's commitment to free market reforms," Adam Cole, foreign exchange strategy head at RBC Europe Ltd., lamented in a note. "There are obviously fears about an intensifying currency war," François Savary, chief investment officer for Reyl & Cie, told Bloomberg.

Yet the devaluation follows an unusual few months for the yuan. After years of bitter criticism from an international community that accused China of keeping its currency artificially low – and turbo-charging its export-heavy economy to the detriment of everyone else – Beijing let the yuan ride high. Among 32 major currencies tracked by the Bank for International Settlements, the yuan had the highest real effective exchange, a measure that assesses inflation and international trade. In late May, the International Monetary Fund declared the yuan "no longer undervalued."

By late July, it had become expensive.

The market panic Tuesday is "a bit of an over-reaction," said Qu Hongbin, chief China economist at HSBC. "Many people mistakenly take this as an indication that Beijing wants to use devaluation as a policy tool to support growth. I think that's the wrong reading. I think it's more about reform."

His theory: China's central bank can be believed when it says, as it did Tuesday, it wants to "improve quotation of the [renminbi, China's currency] central parity." In other words, China wants its currency to better reflect its real value. In normal times, this might be taken as a step forward, particularly after years of the international community hectoring China to loosen its currency controls.

"What you can expect is a more flexible, two-way, volatile normal exchange rate," Mr. Qu said.

Others openly questioned China's real motives. Its assurance that the currency drop is a one-time measure "is unlikely to be seen as a credible statement," wrote BMI Research in a note, suggesting more cuts are to come as China seeks to shore up its hurting export economy.

That in turn "is likely to delay investment decisions, further undermining China's already fragile economy," BMI warned.

Skepticism has been stoked in part by China's own conduct. Its extraordinary response to the recent tumble in its domestic markets, which included a deluge of money to prop up buying and an eyebrow-raising ban on executives from selling shares in their own companies, showed Beijing eager to interfere economically to suit its political agenda. Chinese leadership is centrally concerned with preventing public wrath that might disrupt national stability.

There may, however, be a simpler explanation: national pride. "They're pushing very hard for the yuan to be included in the International Monetary Fund's Special Drawing Rates basket," said Arthur Kroeber, the Beijing-based head of research for Gavekal Dragonomics. "And in order for the yuan to be included in that basket, it has to be freely usable."

The Special Drawing Rates is the IMF's international reserve asset, and the fund is currently conducting a five-year review of which currencies belong. Admission for the yuan would gain China entry to an elite international club.

That would hardly make the yuan a currency on par with the greenback dollar or the euro. Instead, it would likely look more like the Singapore dollar, which is freely convertible but still managed by the Monetary Authority of Singapore.

As for the size of the Chinese cut, Mr. Kroeber noted that it is in line with where the yuan already traded – but not enough to give its economy a leg up, since a 1.9-per-cent change "isn't going to make a dime's worth of difference to the Chinese export sector," he said. Besides, Beijing has more effective tools to prop itself up, such as cuts to lending rates and bank reserve ratio requirements.

And, Mr. Kroeber suggested, in at least one way the big currency cut may show Chinese strength.

"If the economy was going off the rails, they would be reluctant to allow this kind of movement," he said. "So you could interpret it as a sign of confidence from the government."