China devalued its currency on Tuesday after a run of poor economic data, a move it billed as a free-market reform but which some suspect could be the beginning of a longer-term slide in the exchange rate.
The central bank set its official guidance rate down nearly 2 percent to 6.2298 yuan per dollar — its lowest point in almost three years — in what it said was a change in methodology to make it more responsive to market forces.
It was the biggest one-day fall since a massive devaluation in 1994 when China aligned its official and market rates.
"Since China's trade in goods continues to post relatively large surpluses, the yuan's real effective exchange rate is still relatively strong versus various global currencies, and is deviating from market expectations," the central bank said.
"Therefore, it is necessary to further improve the yuan's midpoint pricing to meet the needs of the market."
The People's Bank of China (PBOC) called it a "one-off depreciation," but economists disagreed over the significance of a move that reversed a previous strong-yuan policy that aimed to boost domestic consumption and outward investment.
"For a long time, I gave the PBOC credit for holding the line on the renminbi (yuan) and recognizing that while it might be tempting to try to shore up the old-growth model by devaluing the currency, that really was a dead end," said fund manager Patrick Chovanec of U.S.-based Silvercrest Asset Management.
He said a strong yuan was needed to force China toward consumption and away from low-end manufacturing. "What the world needs from China is not more supply; what it needs is demand."
The devaluation followed weekend data that showed China's exports tumbled 8.3 percent in July, hit by weaker demand from Europe, the United States and Japan, and that producer prices were well into their fourth year of deflation.
The move hurt the Australian AUD=D4 and New Zealand NZD=D4 dollars and the Korean won KRW=D4, fanning talk of a round of currency devaluations from other major exporters. But some of Asia's most interventionist central banks appeared to be holding their nerve on currency policy.
"I don’t think the move would trigger a global currency war," a Japanese policymaker said.
Economists pointed out that until Tuesday, China had held the yuan firm while its neighbors had debased their currencies.
FEAR OF DEFLATION
While a weaker yuan will not cure all the ills of China's exporters, which suffer from rising labor costs and quality problems, it would help relieve deflationary pressure, a far bigger economic concern in the view of some economists.
Falling commodity prices have been blamed for producer price deflation, putting China at risk of repeating the deflationary cycle that blighted Japan for decades.
Growth in China, the world's second-largest economy, has slowed markedly this year and is set to hit a 25-year low even if it meets its official 7 percent target.
The devaluation hit shares in Asia and Europe. Chinese airline stocks also fell, given the impact higher fuel prices would have on their bottom line, though exporter stocks rose.
Some said the move was also to blame for a fall in futures contracts tracking the S&P 500 index SPc1, given the potential hit to U.S. exports to China.
Spot yuan ended at 6.3231 on Tuesday, its weakest close since September 2012. The spot yuan is allowed to rise or fall by 2 percent from a midpoint that is set each day.
In the past, the central bank set the midpoint by a formula based on a basket of currencies, but the methodology was never publicized and many believed the midpoint was frequently used as a way to bend the market to policy goals.
Under the new method, investors moving assets out of yuan could take the rate lower in the weeks ahead.
The yuan had been locked in an extremely narrow intraday range since March, varying only 0.3 percent.
Some economists said the devaluation was also designed to support Beijing's push for the yuan to be included in a basket of reserve currencies known as Special Drawing Rights (SDR), which are used by the International Monetary Fund to lend money to sovereign borrowers.
"The PBOC aims to move the renminbi to a freer floating and accessible currency, prerequisites for it to be given the IMF’s reserve stamp of approval, and will see it move in a wider band," said Angus Campbell, analyst at FXpro.
The IMF proposed in a report this month to put off any move to add the yuan to its benchmark currency basket until after September 2016, and it gave mixed reviews of Beijing's progress in making key financial reforms to its currency market.
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