WASHINGTON — For years, American politicians have been pressing Beijing to loosen its grip on the Chinese currency and let market forces determine the value of the yuan.
This week, China took a step toward complying, but the result wasn’t what many in Washington expected.
Since China devalued the yuan Tuesday and simultaneously announced a shake-up in the way it sets its exchange rate, the currency has fallen nearly 3% against the dollar.
That’s the largest two-day drop in 20 years, setting off alarm bells around the globe about the strength of the world’s second-largest economy. It comes a month after China’s main stock exchange in Shanghai suffered unprecedented slides.
In pledging to make the yuan more market-based, Beijing rattled what had been a stable, government-controlled currency that has become increasingly important to global trade and commodity markets. Its pledge heightened growing uncertainty about the slowing Chinese economy, where trends and risks are often difficult to measure because of the lack of transparency.
“There’s much more we don’t know, than what we know, about China’s new exchange rate policy,” said David Loevinger, a former China specialist at the Treasury Department who now is at Los Angeles investment firm TCW Group.
“There’s also uncertainty about how much more growth is going to slow, the leaders’ tolerance for slower growth and what tools they’re going to use to promote adjustment,” he said.
Loevinger and other experts said it may be weeks or months before markets settle on a so-called equilibrium value of the yuan and before other pieces of China’s economic puzzle come together.
Until then, given a world economy already unnerved by the Greek debt crisis and the global slowdown in general, China’s latest step is likely to create more volatility in financial markets.
On Wednesday, U.S. stocks and many currency markets were jolted for a second straight day. The Dow Jones industrial average dropped more than 270 points in early trading but recovered to close down a third of a point. Copper and some other metals hit multi-year lows before recovering a bit.
Beijing’s action also has complicated the Federal Reserve’s plans to raise interest rates this year, a move that would likely strengthen the dollar more and put further pressure on U.S. exporters.
China’s critics in Congress and some corporate boardrooms have long argued that Beijing’s tight control of the yuan had kept the currency artificially low, giving Chinese exporters an unfair advantage by making Chinese goods cheaper in foreign markets. For years the expectation was that the yuan would appreciate if it were left to market forces, potentially helping to reduce America’s large trade deficit with the Asian giant.
But in what analysts described as a classic case of “be careful what you wish for,” Beijing’s shift to a more market-based exchange rate system instead pushed the yuan decisively in the opposite direction, likely a reflection of investors’ jitters about the overall health of China’s economy.
Analysts said one reason that the yuan didn’t rise against the dollar is that China’s economy isn’t growing at double digits as it did a few years ago. This year, it is on pace to grow 7%, the slowest rate in years.
Moreover, since 2005 when Beijing lifted its decade-old peg to the dollar, the yuan has appreciated about 25% against the dollar and much more against other major currencies such as the euro and Japanese yen.
While China experts weren’t so surprised — capital outflows from China in recent weeks had suggested as much — its moves were unwelcome news to those lawmakers who for years have pummeled China to adjust its currency policies and have accused Beijing of currency manipulation.
Some members of Congress remained skeptical that Beijing has made real reforms toward a more market-oriented exchange rate, saying China is allowing its currency to fall as a short-term strategy to boost exports and fuel economic growth.
Some also said the sudden fall in the yuan pointed to the need for an anti-manipulation clause in the Pacific Rim trade deal that the Obama administration is now working to wrap up with 11 other countries.
“This action highlights the need to include a strong and effective obligation on currency manipulation” in the Trans-Pacific Partnership, said Rep. Sander Levin (D-Mich.), the ranking member of the House Ways and Means Committee.
But experts on the Chinese economy viewed Beijing’s move as a potentially momentous step toward establishing a market-determined exchange rate. Previously China’s central bank each morning had fixed a mid-point for the value of the yuan in relation to the dollar. But the criteria for basing the value was secret.
Under the new system, the People’s Bank of China said that it would set the mid-point by taking into account the yuan’s closing value from the previous day’s trading session as well as conditions in the foreign exchange market. Both the new and the old rules only permit the value to rise or fall a maximum of 2%, though some analysts predict the next step for China might be to relax that restriction.
This doesn’t mean that Beijing won’t intervene in currency markets to control excessive swings in the value of the yuan, a step it took near the end of the trading session Wednesday.
“The action taken by China, far from being a step to manipulate its currency, is actually an effort to let the [yuan] fluctuate according to the dynamics of the exchange markets,” said Nicholas Lardy, a China economy expert at Peterson Institute for International Economics in Washington.
He called the action “courageous,” given the risk in moving from a government-controlled currency system to a market-controlled one.
“The transition is filled with potholes,” he said.
Many experts believe the motivation and timing of Beijing’s move was tied to the International Monetary Fund’s review later this year to determine whether the yuan should be included in something called “special drawing rights,” which would basically designate the yuan alongside the U.S. dollar, the euro, the British pound and the Japanese yen as a formal reserve currency.
Beijing has long wanted to internationalize the yuan and to be less dependent on the dollar, but the IMF made clear last week that China must first liberalize its currency market.
Investors are preparing for further depreciation of the yuan in the coming days, especially given the expectations of additional declines and the fact that traders tend to overshoot when currencies slide one way or another. “People don’t know what the equilibrium rate is,” Lardy said.
Analysts said it would take a much sharper fall in the yuan, something close to 10% or more, to have a major impact on China’s economy. That’s because a cheaper yuan might help some Chinese exporters, but also would hurt others as they face higher oil bills and pay more on dollar-denominated debt.
Even for Chinese exporters, a fall of a few percent in the yuan may not make much difference, said Damien Ma, a fellow at the Paulson Institute, a Chicago think tank that focuses on U.S. and China economic issues.
“With what’s happening in China in terms of wage hikes and other prices, it’s hard to see how the exchange rate will meaningfully help export sectors,” he said.