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Politics

The stealth devaluation inside China's currency basket

The People's Bank of China caught the world off guard with its announcement Dec. 11 that the yuan's exchange rate will no longer be managed in reference just to the U.S. dollar, but instead to a basket of currencies that includes the Russian ruble, Thai baht and Malaysian ringgit as well as the British pound, the euro and the Japanese yen.

     The move sounds in theory like thoughtful reform, but looks in practice like a stealth devaluation.

     At first glance, the Chinese central bank's latest move sounds like a perfectly reasonable step toward a more open capital account as the yuan rises to take its place among the world's major reserve currencies in the International Monetary Fund's Special Drawing Rights basket. But Beijing's decision to depeg from the dollar can also be interpreted as an intentionally timed move to support the country's slowing economy with a refusal to lose trade competitiveness and even to seek to regain lost ground.

     Motivations aside, consider what such a move may mean for global growth at a time that commodity prices are already collapsing, emerging markets are showing fresh signs of internal and external stress, and the U.S. Federal Reserve is tightening monetary policy, which could lead to a meaningful acceleration in Chinese capital outflows.

     While the PBOC's move to manage the yuan's exchange rate based on a currency basket sounds like a responsible move to reassure the global community that it intends to maintain a stable currency, the reform opens up significantly more room for weakness versus the dollar. As the dollar rallies in the wake of the Fed's decision on Dec. 16 to raise its benchmark interest rate by a quarter of a percentage point, many of the currencies in China's new basket are likely to weaken, accelerating the yuan's engineered devaluation.

     Time will tell whether the world's second-largest economy is leaping headlong into the global currency wars or simply moving to a more market-driven exchange rate, but it is likely to have the same effect either way. Though the currency realignment should prove successful in deflecting the blame for global instability onto the Federal Reserve and other foreign central banks, it is still likely to stoke global currency tensions by boosting Chinese companies' price competitiveness at the expense of rivals in places like Germany, Japan and South Korea.

High-stakes reform

A weaker yuan will likely shake the world in unintended ways. And a more independent yuan will give the PBOC a status commensurate with China's role as the world's second-largest economy and largest trading nation. From yuan-denominated trade finance to the issuance of yuan-denominated sovereign and corporate debt in emerging and middle-income countries -- especially in Asia where trade flows with China are particularly concentrated -- the yuan's rising prominence will provide China with a powerful vehicle to exert influence.

     From that perspective, the People's Bank of China is ringing in the end of the Bretton Woods consensus on monetary management as the country works to transform its role from that of a inward-facing command economy to the hub of a regional and global economic empire, starting with an aggressive push to shore up its own growth, establish the yuan as a more functional global currency, and revive the ancient trade routes that once linked Asia to Europe and Africa.

     Collectively, China is biting off a lot with the new currency basket, the Belt and Road initiative (formerly known as One Belt, One Road), the Asian Infrastructure Investment Bank and a host of other visionary global projects. Though it is perfectly rational for Beijing to exercise its global economic and political power, its own economy is working through a high-stakes rebalancing with little room for error. Regardless of how the world perceives China's latest reforms, care must be taken or the best of brave economic intentions could put intended beneficiaries at risk.

Tony Nash is chief economist at Complete Intelligence, an economics, risk and industry advisory firm in Singapore. Worth Wray is chief economist at Evergreen GaveKal, an asset management company based in the U.S. state of Washington.

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