BEIJING – In what China says is a strategic move to make the Yuan’s exchange rate to be market-oriented, the devaluation of the Yuan sent jitters all across the global financial markets. A 1.9% drop in one day was billed to be the largest in the decade. The jitters continued the following day as it dropped a further 1.6%. This significant drop means that Chinese products will be less expensive globally making them more competitive compared to products from countries with stable currencies. The result was a drop in U.S. stocks stoked by worries of a downturn in china’s economy.

What China did

China maintains a grip on its currency; the Yuan is not freely traded as per market forces, but it is a composite of a selection of currencies of Beijing’s preference. This secret composition has in some quarters been described as one with the U.S. dollar being in dominance. The People’s Bank of China sets a target every day and lets the Yuan to trade at between two percent above and two percent below this target. When the devaluation began, the target was fixed at below 1.9% of the previous day’s closing. Changes were also made to technically allow the Yuan to trade at market rates. David Dollar, a Brookings Institution senior fellow has the opinion that the Yuan will henceforth have fast rises and drops as per market forces and investors will have a better outlook for the Yuan and the Chinese economy.

Why China did what it did

The reason given by the People’s Bank of China to devalue the currency is that the Yuan has been rising at a rate that was not commensurate with the market situation. Cautious Chinese investors have been shifting their investment abroad which exerts a downward pressure on the Chinese currency. With its reported strong links to a strong dollar, the Yuan has remained up. China’s exporters have had the disadvantage of their products being expensive on the global market as a result of a strong Yuan. With a plunge of 8.4% in July’s exports, the economy was already in dire straits. The Shanghai index has been on a downward trend since June. At 7%, China’s economic growth will represent the slowest rate since the nineties and chances that it could drop further in the coming years.

Effect on China’s trading partners

With the Dow Jones and the FTSE sinking on the day of devaluation, investors believed that a weak Yuan would hurt U.S. exports to China which have been falling anyway. The American government remains jittery but economists believe a 2% drop in the Yuan’s value will not have any significant change in US exports to China, especially if China keeps its promise that the devaluation was a one-time affair. A 10% drop in a few months is what would be a game changer.

Economics in western countries have the opinion that China’s actions have more to do with adjusting the Yuan to the realistic level it should be rather than just to reduce it because it was too steady while it should have been falling.

What will the Federal Reserve do?

The Federal Reserve is unlikely to delay a hike in rates. A cheaper Yuan is going to hurt US exporters, but it will have a depressing effect on the inflation rate which is still quite low anyway. The devaluation move is not drastic enough to make any significant difference to the US economy. The Federal Reserve is likely to hike its rate for short-term borrowing in September.

The coming months will be interesting to watch, especially if China’s exports continue to drop and the reactionary measures Beijing is likely to take to arrest the situation.