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CHINA'S announcement on Tuesday that it is changing the basis of valuing the yuan has resulted in a near 2 per cent drop in the currency against the dollar and triggered market alarm that the surprise move could herald fresh economic problems in the world's second-largest economy.
Some analysts said that the move appeared aimed partly at making the yuan more responsive to currency market forces in line with China's desire to have the yuan included along with the dollar, euro, yen and the pound in the International Monetary Fund's Special Drawing Rights (SDR) currency basket.
But others noted that Beijing's decision to devalue also appears to be driven by domestic economic problems and the need to relieve pressure on increasingly uncompetitive sectors of the economy.
There will probably be further downward pressure on the yuan, they said, at a time when currency markets are nervous about continuing appreciation of the US dollar as monetary policy in the US "normalises".
The yuan has been "slightly overvalued" and the market should expect "an adjustment of up to 5 per cent (in its value) by the year end", Kenneth Courtis, chairman of investment firm Startfort Holdings and former vice-chairman of Goldman Sachs Asia, told The Business Times. "We now have the first 2 per cent of that."
Concern is mounting, meanwhile, among Japan's neighbours about the dramatic 40 per cent drop in the yen against the dollar since late 2012, and over the yen's 25 per cent fall against other leading currencies over the same period. This could provoke competitive devaluations, some fear.
Though "technical" in nature, the adjustment in the yuan rate by the People's Bank of China (PBOC) - the central bank - also comes at a time when exports are slipping and when the economy is generally seen to be losing steam, raising fears of rising unemployment.
"China's economy is slowing partly because rising labour costs and the appreciation of the yuan in recent months have reduced its products' international competitiveness," Japan's Kyodo news service noted.
The effective devaluation of the yuan could increase the international competitiveness of China's flagging exports and at the same time boost the yuan value of corporate earnings in the aftermath of the recent dramatic plunge in its stock markets, analysts said.
The PBOC said that the yuan was too strong against the dollar and other major currencies, and that the change in valuation is aimed at better reflecting the market situation, Kyodo reported from Beijing.
The central bank said in a statement that the yuan's real effective exchange rate was "deviating from market expectations". "Therefore, it is necessary to further improve the yuan's mid-point pricing to make it more consistent with the needs of market developments."
The PBOC on Tuesday set the mid-point of the yuan at 6.2298 per dollar, compared with Monday's 6.1162. This sparked selling of the yuan and, pushed down the value of the Chinese currency against the dollar at one point to a level not seen since September 2012.
The yuan, also known as the renminbi, is allowed to fluctuate in a band of 2 per cent above or below a rate set each day by the PBOC based on the previous day's trading. On Tuesday, the mid-point of the trading band was set 1.9 per cent below Monday's level.
This change was the biggest one-day decline since Beijing ended the yuan's direct link to the US dollar in July 2005 and switched to basing the exchange rate on a basket of foreign currencies, TheWashington Post reported.
"The composition of that basket is secret but the dollar appears to dominate it, which means the yuan has been rising even as the currencies of other developing countries fell," the paper said.
In its statement, meanwhile, the PBOC said that Tuesday's devaluation - the biggest in a decade - was a one-time adjustment, although currency analysts said that further moves probably depend on how the dollar and other currencies move from here on.
The yuan has strengthened in recent months along with the dollar, making Chinese exports more expensive and raising the risk of politically dangerous job losses in industries that employ millions of workers. China's July exports fell by an unexpectedly large margin of 8.3 per cent from a year earlier.
The PBOC said that the yuan's value should be more market-oriented and that, with effect from Tuesday, the mid-point would be decided based on the previous day's closing rate of the currency, supply and demand in the market, and price movements of major currencies.
The change in policy comes at a time when China's leadership is calling on the IMF to include the yuan in the quasi reserve currency known as the SDR - a move which would add to the international credibility and acceptability of the yuan.
As reported in The Business Times, the IMF appears to be inclining towards including the yuan and has given China nine months to demonstrate that its currency is sufficiently market-responsive to be used in international transactions. Tuesday's move could help in that regard, sources told BT.
The PBOC's move, meanwhile, took financial markets off guard and the broad MSCI (Morgan Stanley Capital International) index of Asia-Pacific shares outside Japan fell 0.9 per cent on Tuesday to its lowest level in 11/2 years. Tokyo stocks also fell.
China "is transiting from an economy driven by capital and commodity intensive, old line, smoke stack, low margin, export industries to one that is more fully centred on the services economy", Startfort's Mr Courtis said.
"This process has been proceeding at a very fast clip. This year, services will top 50 per cent of total GDP, while the industrial sector has shrunk to 42 per cent of GDP. This shift is the result of tremendous pressure on the heavily indebted and increasingly unprofitable old export economy."
China's central bank "has been keeping the currency tightly pegged to a surging US dollar, which has substantially increased deflationary pressure on the old export driven industrial sector (and which has) reached breaking point for many", said Mr Courtis.
Tuesday's "small adjustment", he added, "will release to some extent pressure on the export sector, which with everything else going on - high real interest rates, vast excess global capacity, much tougher environmental regulation, rising real wages - needs some (relief)".