China’s Yuan Move Highlights Importance of Exchange Rates for Policy Makers

China’s unexpected move Tuesday to devalue its currency highlights a growing trend among policy makers in Europe and beyond: the importance of exchange rates as a means to juice economic growth and keep inflation from weakening too much.

It also underscores how sensitive central bankers are to each other’s monetary policies. In China’s case, expectations of tighter monetary policies by the Federal Reserve have prompted a rise in the value of the U.S. dollar. Given that China’s currency, the yuan, is linked to the dollar’s value, it has risen as well against the euro and many emerging market currencies, weighing on Chinese exports.

Analysts don’t see China’s move as sparking a wider currency war, but rather as an indication that exchange rates will continue to play a central role in efforts by policy makers to protect fragile economies.

“The sensitivity about exchange rates is generally very high among central banks,” said Beat Siegenthaler, global macro adviser at UBS Investment Bank in Zurich. “The very limited choice of policy tools that central banks have means the exchange rate has become a much bigger deal.”

China’s central bank on Tuesday changed the way the yuan is fixed against the U.S. dollar, which will now be based on how the currency closed in the previous trading session. That pushed that fixing rate against the U.S. dollar down 1.9%. The decision came in the wake of recent data showing China’s exports fell in July from a year earlier.

“Europe is a very large export destination (for China). The appreciation of the yuan against the euro has clearly damaged demand for Chinese goods in Europe,” said Brian Jackson, analyst at consultancy  IHS Global Insight in Beijing.

The exchange rate is an issue European officials have grappled with for years. Faced with a stubbornly high exchange rate of the euro in the spring of 2014, European Central Bank officials began warning that the currency’s strength could weaken inflation, a condition that typically prompts easier monetary policies.

Subsequent stimulus measures by the ECB—including a €1 trillion-plus bond buying plan announced in January—led the euro to weaken more than 20% against the U.S. dollar between August 2014 and its 2015 low in March.

The ECB’s policies had knock-on effects throughout Europe. Faced with a persistently strong Swiss franc, the  Swiss National Bank in January abandoned a ceiling it had set on the franc’s value versus the euro. It has, however, intervened in currency markets since then to keep the franc from rising too much and damaging Swiss exports to the eurozone.

The Danish central bank intervened massively in early 2015 to keep its currency within a tight band against the euro, and Sweden’s Riksbank has said it is prepared to intervene in currency markets if needed.

In the case of many European central banks, as well as those in the U.S., U.K. and Japan, policy rates are near zero or even negative. That leaves central banks without traditional levers, such as rate cuts, to reduce borrowing costs and spur growth.

That is where currencies come into play. When they fall, countries typically see a boost in their exports. Inflation also tends to increase from higher imported goods prices. With many large economies struggling with inflation rates that are seen as too low, this is a welcome side effect for central bankers.

The danger occurs when too many policy makers pull the same exchange-rate lever, which leads to competitive devaluations that may ultimately damage the global economy. Central bankers are in almost universal agreement that exchange rates should be set in financial markets, though they also say that currency values reflect differences in monetary policies.

“It’s unlikely that we’ll see a string of these devaluations” in China, said Mr. Jackson.

Analysts said they would be eyeing other Asian economies to see whether China’s move has ripple effects. If policy makers in these countries take steps to weaken their currencies to maintain competitiveness with China, it could spark a more global trend toward easier monetary policies.

“European policy makers would probably be happy to be on the sidelines,” said Mr. Siegenthaler.

Source: The Wall Street Journal

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