The People’s Bank of China (PBoC) announced on Tuesday (11th August) that it would cut its daily reference rate for the Chinese yuan (RMB) by 1.9%, making it the largest devaluation in history. On Wednesday morning, it further lowered the daily reference rate 1.6% lower than the previous day, setting the RMB at 6.3306 to the US dollar. 

This unexpected move took markets by surprise. Asian currencies were significantly down on 12th August with the Australian dollar falling to its lowest in more than six years, the Malaysian ringgit at the weakest since 1998, the Vietnamese Dong is at a record low and the Korean won at its lowest since 2011 according to FT. Stock markets were flickering red on trading screens.

Alarmists call this a trigger that will spark off a curency war and create a beggar-thy-neighbour situation. Yet, there was little mention about the Japanese yen has plunged 35% since late 2012 and the Australia dollar has tumbled more than 20% over the past year.

This move from PBOC comes about as the RMB has exerted persistent downward pressures against a backdrop of weak Chinese growth, expectation of U.S. monetary policy normalization and depreciation of major Asia and emerging market (EM) currencies against the USD in recent months.

The main reason put forth by PBoC was that it believes that it is time to put in a market-based mechanism that would allow the market to play a bigger role in valuing the exchange rate based on demand and supply. The move was also something called forth by the International Monetary Fund as it assesses whether the yuan should be included in the currency composition of its special drawing rights, a global reserve asset comprising of the dollar, euro, pound and yen.

In a statement published this morning on the IMF website:

“The new mechanism for determining the central parity of the Renminbi announced by the PBC appears a welcome step as it should allow market forces to have a greater role in determining the exchange rate. The exact impact will depend on how the new mechanism is implemented in practice.

A more market-determined exchange rate would facilitate SDR operations in case the Renminbi were included in the currency basket going forward.”

Yet the move also suggests that China’s leaders are looking for new ways to boost growth in China as other methods such as look increasingly ineffective, raising the possibility of further and more dramatic efforts to come.

What this means is that the price of the yuan will be based more on the price in the previous trading session, as opposed to being controlled at a certain level dictated by PBoC. Before the announcement on Tuesday, the yuan typically moves around 2% above or below the reference rate during daily trading. The reference rate is dedicated for the onshore yuan (otherwise known as the CNH. In the offshore yuan market, the yuan floats freely and does not trade within a tight band like in the onshore market).

Once market forces are into play, yuan’s volatility is very likely to increase.The immediate concern is that Asian currencies are also expected to be volatile in the near term and likely till the market has priced in this devaluation.

In the bigger scheme of things, this is an important move towards currency reform. What China has done so far is to astutely combine a move that guides their currency lower and at the same time silencing critics by further liberalising the yuan.