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What is China doing with its currency, and why?

What is China doing with its currency, and why?
Specialist Meric Greenbaum works at his post on the floor of the New York Stock Exchange, Wednesday, Aug. 12. Another drop in China's currency sent global markets mostly lower on Wednesday as the move raised worries about the world's second-largest economy. (Richard Drew / Associated Press)

Answering some longtime critics, China announced this week that it would take a significant step toward a more market-oriented approach to its currency. Going forward, it said, the Chinese central bank would tie the initial daily value of the yuan more closely to its price on China's currency exchange markets — in other words, the value set by supply and demand. The government's actions, however, led to a sharp devaluation of the yuan, which could help China's flagging exports at the expense of other countries' economies. Was that a coincidence or deliberate currency manipulation? It's almost impossible to tell, and maybe that was the point.

Unlike the U.S. Federal Reserve and many other nations' central banks, the People's Bank of China intervenes directly in currency markets, buying or selling yuan to prevent it from deviating more than 2% from its initial daily value. For many years, critics have accused the People's Bank of setting the initial value far too low, artificially reducing the price of the goods China exports while making U.S. goods more expensive to Chinese shoppers. Those complaints receded after China slowly raised the value of the yuan by 25% from 2006 to 2014, but the huge trade imbalance between the countries remains.

The People's Bank kept holding up the currency's initial daily value this year as China's fast-growing economy lost steam. On Tuesday, however, the bank announced that it would no longer fight the currency markets. The initial daily value would reflect the yuan's price at the markets' close the previous day, the bank said as it cut the value against the dollar by almost 2%. The yuan fell further on currency markets through the day, leading the People's Bank to lower the initial daily value again Wednesday by more than 1% — although it later intervened in the markets to prevent the yuan from losing even more value.

This double whammy shocked global stock markets and investors, who evidently took the news as a sign that the Chinese economy was growing even more slowly than previously thought and that a currency war was about to break out in Asia. For its part, the People's Bank claimed no ulterior motives. In fact, some analysts speculated that China was simply trying to comply with the demands of the International Monetary Fund and the U.S. Treasury to let currency markets determine how much the yuan was worth. Doing so would improve China's chances of having the yuan — formally known as the renminbi — become a standard currency for international transactions. Others said the changes were too small to have much of an effect on exports, and so were better viewed as an effort to adapt to increases in the value of the dollar.

But if China wants to elevate the yuan as a global currency, it has to stop surprising the world with dramatic shifts in monetary policy, especially when such changes give Chinese companies an advantage over foreign rivals. Yes, some of the actions the Fed has taken to lower interest rates and spur growth have tended to weaken the dollar, but that's a byproduct of steps that the Fed signaled well in advance, not a direct result. The test of China's motives will be how far the yuan ultimately sinks, whether the government takes further steps to tie its value to currency markets, and whether it allows the value to go up when investors are bullish again.

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