Just over one week ago the People’s Bank of China (PBOC) surprised markets with three consecutive devaluations of the yuan, knocking over 3% off its value. Since 2005, China’s currency has appreciated 33% against the US dollar and the first devaluation on August 11 marked the largest single drop in 20 years. While the move was unexpected and believed by many to be a desperate attempt by China to boost exports in support of an economy that is growing at its slowest rate in a quarter century, the PBOC claims that the devaluation is all part of its reforms to move towards a more market-oriented economy. The relative size of the devaluation appears to be in line with market fundamentals and thus, at least for now, the PBOC’s claims can be believed.

Surprised Markets

After a decade of a steady appreciation against the US dollar, investors had become accustomed to the stability and growing strength of the yuan. Thus, while a somewhat insignificant change compared to exchange rates that can sometimes move double-digit percentages over several days, the more than 3% drop had investors rattled.

U.S. stock markets, including the Dow Jones Industrial Average (DJIA), S&P 500 and Nasdaq, as well as European and Latin American markets fell in response to the devaluation. While some argue that the move is a sign that China’s economy is performing worse than expected and the move is an attempt to make exports more attractive, the PBOC indicated that the devaluation was motivated by other factors. (For more, see: China’s Economic Indicators, Impact On Markets.)

Devaluation: Just the Result of Free-Market Reform Policies

China’s president Xi Jinping has pledged the government’s commitment to reforming China’s economy in a more market-oriented direction ever since he first took office over two years ago. That and the fact that China is determined to be included in the IMF’s special drawing rights (SDR) basket of reserve currencies makes the POBC’s claim that the devaluation was the result of measures taken to allow the market to have a more instrumental role in determining the yuan’s value more believable. One professor at Cornell University indicated that the move should help China’s case for SDR reserve currency status and claimed that it was also consistent with China’s “slow but steady” market-oriented reforms.

The IMF re-evaluates the currency composition of its SDR basket every five years, the last time being in 2010. At that time the yuan was rejected on the basis that it was not “freely usable,” but the devaluation, supported by the claim that it was done in the name of market-oriented reforms is being welcomed by the IMF as it gets set to consider the yuan’s inclusion. But despite this welcomed response, the IMF has stressed that China will still have to do more and be willing to progress towards a “freely floating exchange rate.”

Many are skeptical of China’s commitment, arguing that the new exchange-rate policy really hasn’t changed and is still akin to a “managed float;” the devaluation is just another intervention and the yuan’s value will continue to be closely monitored and managed by the PBOC. The skeptics believe that the move was further evidence of China’s continued exchange-rate manipulation in order to boost its sputtering exports. (See also: 5 Economic Effects Of Country Liberalization.)

Devaluation Consistent with Market Fundamentals

With the devaluation occurring just days after data showed a sharp fall in China’s exports, many believe that China's insistance that the move was motivated by market-oriented reforms is just a convenient excuse. The Chinese government claimed that its exports had fallen 8.3% in July from the previous year. As the news is evidence that its interest rate cuts and fiscal stimulus were not as effective as hoped, many interpret the devaluation as a desperate attempt to stimulate China's sluggish economy and keep exports from falling further.

Washington was especially incensed, as U.S. politicians have been claiming for years that China has kept its currency artificially low at the expense of American exporters. Some believe that China’s devaluation of the yuan is just the beginning of a currency war that could lead to increasing trade tensions. Despite the fact that a lower valued yuan does give China somewhat of a competitive advantage, China has readily dismissed the idea that this was the reason for the recent move, and perhaps there are reasons that they can be believed.

While the drop in the value of the yuan was the largest in 20 years, the yuan is still stronger than it was only a year ago in trade-weighted terms. Over the past 20 years, the yuan has been appreciating relative to nearly every other major currency. This includes appreciation against the US dollar. Essentially, China’s policy has allowed the market to determine the direction of the yuan’s movement while restricting the rate at which it appreciates. But, as China’s economy has slowed significantly in the last number of years while the U.S. economy has done relatively better, a continued rise in the yuan’s value no longer aligns with market fundamentals.

Understanding the market fundamentals allows one to see the small devaluation by the PBOC as a necessary adjustment rather than a beggar-thy-neighbor manipulation of the exchange-rate. While many American politicians may grumble, China is actually doing what the U.S. has prodded it to do for years—allow the market to determine the yuan’s value. So long as there are no major declines in the yuan’s value going forward it appears that the PBOC can be taken at its word. (For more, see: What Causes A Currency Crisis?)

The Bottom Line

Despite surprising markets and being critiqued for exchange-rate manipulation, China has a good reason for the recent devaluation of the yuan. With slower growth in China and a strengthening US dollar, allowing the yuan to depreciate is in line with market fundamentals. Regardless of the fact that China’s exports may get a boost from the deprecating yuan, the move is consistent with the Chinese government’s commitment to let the market play a greater role in determining economic outcomes.

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