During the second week of August, the Chinese central bank devalued its currency, the yuan. This decision ignited market volatility around the world, caused stalwart Chinese stocks — such as China Mobile, Baidu and Alibaba — to drop in value by as much as 20%, and made a negative impact on investor portfolios.
Why Did The Chinese Government Devalue The Yuan?
The official reason given by The People’s Bank of China is that it devalued the yuan by almost 2% relative to the U.S. dollar in response to weaker-than-expected economic growth in China. Some argue the action was designed to stimulate exports. In addition, I believe the Chinese devalued their currency because they would like the yuan to become a reserve currency.
What Is A Reserve Currency?
A reserve currency is a foreign currency that is held by central banks and other major financial institutions as a way to pay off international debt obligations, or to influence domestic exchange rates. For some time, China has been pushing for the yuan to join the U.S. dollar, euro, yen and pound as a designated reserve currency. The Chinese government would like this to happen for several reasons: it will stabilize China’s currency, relieve pressure on its banks to keep a higher level of reserves of foreign currency on hand, and, of course, reserve status for the yuan would have high symbolic value as well.
So What Does A Reserve Currency Have To Do With The Devalued Chinese Yuan?
For quite some time, the international financial community has felt that the Chinese government has manipulated and overvalued the yuan in relation to the U.S. dollar. Many market watchers feel that the recent devaluation of the yuan by almost 2% has brought it more in line with what foreign governments and the International Monetary Fund (IMF) believe is its true market value. This action, in my opinion, is a strategic move on China’s part to tell the world it runs an open, transparent, credible financial marketplace—criteria that are key in the eyes of the IMF when determining whether a currency becomes a reserve currency.
When Will Market Volatility Subside?
Financial markets don’t like uncertainty. There are always a number of factors in play which can cause volatility. When China devalued the yuan, it caused a great deal of uncertainty and, as they tend to do, markets around the world overreacted and panic selling set in. Markets should begin to settle and the volatility should be less dramatic once investors realize that this change in the valuation of the yuan is a good thing because it aligns China’s currency with where the rest of the world thinks it should be.