How much further will the yuan fall – and what does it mean for you?

The value of the yuan has dropped for the third day in a row.

But the pace of the drop is easing. And the People’s Bank of China (PBOC), the country’s central bank, called a press conference this morning to calm everyone down.

The PBOC argued that there is no reason for the currency to continue to fall.

Of course, as Gavyn Davies put it in the FT, they would say that, wouldn’t they?

So what’s next?

Here’s why China wants a weaker yuan

Let’s try to take a step back here. Every government and central bank in the world now manipulates their economy in a pretty blatant manner. But China has more leeway and more power to do it than most. So what are they trying to achieve here?

China certainly wants more influence over the global currency regime. So while the idea of being deemed a reserve currency by the International Monetary Fund (IMF) might seem like a cosmetic point to us, I suspect it’s a genuine motivator for China. And that means loosening up the currency regime.

Having a weaker currency would also be helpful. You can argue that the export figures at the weekend weren’t as bad as they looked, as Capital Economics point out. But even the IMF recently noted that the yuan was no longer undervalued. In fact, the central bank has been forced to sell US dollars in recent months to prop up the yuan.

Probably even more pertinent, is that by tying its currency to the rising US dollar, China has effectively been importing tighter monetary policy, which is deflationary at a time when China’s growth is slowing. That has made the central bank’s various interest rate cuts less effective.

So allowing the market a bit more say in the matter meets both goals. It allows China to take a step towards making the IMF happier (by liberalising its currency regime) with the happy coincidence that the market happens to think the yuan should be weaker than it was.

As Gavyn Davies notes in his FT blog: “China wishes to avoid any hint of ‘currency manipulation’… but it no longer has to manipulate the currency market in order to achieve a devaluation. All it has to do is to stop manipulating the free market, and capital outflows will probably take the exchange rate much lower.”

Of course, the tricky thing is figuring out how far this might go. The PBOC has stepped in to stop things from falling too far too fast, and it has also argued that it has no desire to see the currency fall much further.

But – knee-jerk cynicism aside – you would expect that. This is a nation that prizes stability and control. It’s already seen a debacle in the stockmarket on that front. The last thing it wants is uncontrolled upheaval in a much more significant market.

China might not want a currency war – but that’s what it’ll get

Presumably, the ideal for China is for the yuan to steadily decline, but at a rate that doesn’t scare the horses too much. And, for now, let’s assume that they can manage that – the truth is they probably can, but given their inexperience with ‘jawboning’, the move might not be smooth.

All else being equal, a weaker yuan means less deflation for China, but more for the rest of the world. That won’t help demand for commodities. And markets in countries that are seen to be relying on weaker currencies to buoy their economies – particularly Europe, but also Japan – have taken a hit too.

Trouble is, it’s not as straightforward as that.

For example, Japan has already responded – one adviser to prime minister Shinzo Abe came out and said that Japan could print more money to offset any devaluation in China. That’s got some analysts expecting even more quantitative easing from the Bank of Japan, which in turn gave stocks a boost this morning.

And this is probably the key point right now. None of these economies are operating in a vacuum. Japan has been virtually explicit about the fact that a weaker yen is key to its campaign to boost economic growth. Europe, meanwhile, has been less explicit – but a weaker euro is clearly a key policy aim of Mario Draghi, no matter how much he denies it.

Are these central banks going to roll over if China sends deflation their way? No. They’re going to retaliate by cranking up their own printing presses.

And what about the US Federal Reserve, the most important central bank of all? Is it really going to raise interest rates next month if the stronger US dollar is already effectively tightening monetary policy? And even if it raises them by a quarter point, how much further will it go?

China may not want to start a currency war – no one wants to do that, not explicitly. But if your goals for your domestic economy depend on your currency being weaker than that of your rival economies – well, a currency war is what you’re going to get.

In short, this all points to looser monetary policy across the globe, as central banks everywhere crank up the fight against each other and deflation. To me, that means stick with the stockmarkets we’ve been recommending, including China. Hang on to gold as insurance – always a good idea when the monetary framework is looking wobbly.

And as for commodities, while some brutal times may still lie ahead, I can’t help but feel that this move by China actually takes us closer to a bottom. Check out our recent MoneyWeek magazine cover story by Alex Williams to read more about some stocks in the sector that might be worth investigating.

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