The devaluation of Chinese currency, yuan, has rattled the global financial markets, boosting the dollar and stirring concerns about a delay in the Federal Reserve's plan to raise interest rates.
The yuan's value had declined 1.9% on Tuesday, its biggest one-day drop in a decade, and dropped a further 1.6 percent on Wednesday. The move could help Chinese companies by making their products less expensive in global markets. US stocks sank, partly on fears about a worsening economic slowdown in China.
Here is a the how and why of yuan devaluation:
What did China do?
China doesn't let its currency trade freely in financial markets as the United States does. Instead, it links the yuan's value to a basket of currencies the composition of which is secret but is believed to be dominated by the US dollar. Then it restricts trading to a band 2% above or below a daily target set by the People's Bank of China.
On Tuesday, the central bank set the target 1.9% below Monday's level, the biggest one-day change in a decade. It also made a technical change to give market forces more influence in determining the yuan's value: Its daily target will now be based on the previous day's closing value and on currency supply and demand in the market. That change will allow the yuan to make bigger, faster moves up or down and better reflect investors' outlook on the prospects for China and its currency, said David Dollar, senior fellow at the Brookings Institution.
Why did China devalue its currency?
The People's Bank of China said it acted because the yuan has been rising even when market forces say it should be falling. Worried Chinese have been moving money out of the country, putting downward pressure on the yuan. Yet the yuan has remained up anyway because of its link to the dollar, which has been rising. An overvalued yuan has hurt Chinese exporters by making their products more expensive overseas. In July, Chinese exports plunged 8.3% year over year. China's economy already needed help. The economy is expected to grow less than 7% this year, its slowest rate since 1990, and could decelerate even more next year. The stock market has been in a freefall since June.
How will China's trading partners be affected?
Investors fear the worst. US stocks sank Tuesday, dragged down by falling shares in such big exporters. In theory, a weaker yuan could reduce exports of U.S. goods to China, already down nearly 5 percent this year through June. American politicians, who have long charged that China keeps its currency artificially low to give its exporters an edge, denounced the devaluation. But economists doubt that a one-day 2 percent drop in the yuan, which is a move China has called a one-time event, will do much damage to exports from the United States or other countries.
"Two percent is no big deal," said Mark Zandi, chief economist at Moody's Analytics. "Ten percent over the next few months would be a big deal." Economists didn't see Beijing's move as an effort to reduce the yuan to an artificially low level. Rather, they perceived an attempt by China to catch up to an economic reality that dictates a cheaper yuan. And the plan to let market forces play a bigger role is something the US government itself has called for.
Might the Federal Reserve dealy a rate hike?
Probably not. True, a cheaper yuan hurts US exporters and likely depresses US inflation, which is already below the annual 2% rate the Fed targets. But Tuesday's move wasn't big enough by itself to make much difference. So the Fed is likely to go ahead, possibly at its September meeting, and raise the short-term rate it controls, which has been pinned near zero since 2008. The US economy grew at a steady 2.3% annual from April through June, and US unemployment has fallen to a seven-year low 5.3%. If the US economy continues to look healthy, wrote JP Morgan Chase economist Michael Feroli, "the yuan move will largely be a sideshow " by September's Fed meeting.