China's Yuan Devaluation: What You Need To Know

Some mornings I wake up and wonder what I should blog about. Not today. Looking at my phone in bed to scan the headlines, I couldn’t believe the news—China had devalued its currency! This is a big deal in the financial world.

Why Did China Make This Move?

The Chinese government is very smart and very rational. By devaluing its currency, in this precise way, it intends to achieve some specific goals.

Goal #1: Make the yuan more market oriented. This is the goal China wants to talk about. With the yuan’s trading price now based on the previous day’s exchange rate, the new valuation is arguably more responsive to market conditions and conforms more closely to general practice, possibly increasing the yuan's chances of inclusion in the International Monetary Fund's currency basket come October. China very much wants the power that would come with the yuan achieving reserve currency status, not to mention the credibility the IMF’s endorsement would provide. That said, it’s looking like that will not happen this year.

Goal #2: Give exports a boost. The goal China isn’t talking about is that a cheaper currency will help Chinese exporters and hopefully kick-start slowing economic growth. Historically, this has been the main motivation behind devaluations—a desire to get a cost edge over competitors. With much of China’s growth coming from exports, this makes a lot of sense, but it’s not the sort of thing a government can admit.

What Are The Likely Consequences?

Both of these are reasonable and rational goals. From here in the U.S., the second goal looks like the real one, while the first seems to be window dressing. Why change the currency’s value now, and why in this way? Regardless of the actual reason, however, there will be costs—many of them.

Negative international reaction. To reduce its trade surplus, the U.S. government wants China to make the yuan more expensive, not cheaper, and it will react badly to the change. Europe has also been at pains to weaken its currency—though not explicitly, of course—and will potentially suffer from a weaker yuan. Other countries, particularly those that compete directly with China for jobs or exports, such as India or the Philippines, will take a direct hit as well. Expect an almost uniformly negative international reaction.

Economic costs in China itself. Because the export model is largely played out—other countries simply can’t buy all that much more—China has been trying to shift from export-oriented growth to consumer-driven growth. This is a difficult transition, with very few successful examples, and requires slowing the export sector while allowing consumers to spend. The yuan devaluation moves directly against both those goals: a cheaper currency will help exports and hurt consumer spending.

The benefits for China of devaluing its currency are clear: more potential export growth and possible political upside domestically. The costs are also clear: certain international political risk, and jeopardizing necessary internal policy changes. China apparently believes it needs the export growth badly enough to risk the political and policy downsides.

A Message Of Power—Or Desperation?

This policy change could have been phased in slowly. The decision to drop it as a bombshell was deliberate, seemingly designed to emphasize that the government is firmly in control. After the mismanaged stock market crash, perhaps the Chinese government thought it needed to make that statement very clearly.

As I see it, the real message here is one of weakness. China has been managing its currency all along, slowly transitioning it to a market-determined value. This kind of change makes investors and policymakers uncertain, and the markets hate uncertainty. If the need to juice exports is that pressing, then things in China may well be much worse than the outside world expects.

The U.S. dollar, in contrast, continues to appreciate. This will no doubt be held out as a bad thing, and it has done some damage. In reality, though, a currency appreciates when things are going right—when the economy is growing, when investors trust the markets and institutions, and, in short, when it’s a good place to be. The depreciation of the Chinese currency signals the exact opposite, especially if that is what the market is demanding.

What Does This Mean For The U.S.?

In the short term, not much. The U.S. dollar has already strengthened substantially, so most of the possible damage here has likely been done. In the medium and longer term, this measure will probably make the Chinese currency and economy less attractive for investors while making the U.S. more attractive.

Overall, the devaluation of the yuan will affect many people, but not so much here in the U.S. The real thing to watch is how China grows over the next six months or so. The yuan devaluation may end up being a major crack in Chinese policymaking. The question is whether it will continue to widen or whether the government will succeed in patching it.

Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation’s largest privately held independent broker/dealer-RIA. He is the primary spokesperson for Commonwealth’s investment divisions. This post originally appeared on The Independent Market Observer, a daily blog authored by Brad McMillan.