August 12, 2015 / 2:30 AM / 2 years ago

China's devaluation fires cannon in global currency war

LONDON (Reuters) - The global "currency war" entered a new phase on Tuesday as China's surprise devaluation threatened to unleash competitive devaluations and keep monetary policy around the world looser for longer, perhaps even forcing the U.S. Federal Reserve to delay its expected interest rate rise.

"Currency wars", a phrase used by Brazil's former finance minister Guido Mantega in 2010 to describe how competing countries explicitly or implicitly weaken their exchange rates to boost exports, have intensified in recent years.

As interest rates have fallen to zero in some developed economies and money printing has proliferated, exchange rate policy has become one of the few remaining levers to stimulate business activity and in some cases avoid deflation. So investors are now concerned that China may elect to keep pushing the yuan lower.

"Any devaluation greater than five to seven percent would be a serious problem for global markets and China's trading partners," said Ashraf Laidi, chief executive officer at Intermarket Strategy Ltd, a research firm in London.

The European Central Bank's move to quantitative easing in March, for example, was widely seen as a way for the euro zone to weaken what was seen as an overvalued euro and prevent a deflationary spiral in many of its heavily indebted countries.

The Bank of Japan's latest wave of money printing was also designed to weaken the yen.

Against that backdrop, China's tight peg to an appreciating U.S. dollar meant the yuan's real trade-weighted exchange rate had climbed more than 10 percent over the past year, even as its economic growth slowed and exports slumped.

But the near-2.0 percent devaluation of the yuan on Tuesday suggested Beijing was willing to risk pushing other Asian emerging market currencies lower in turn and brave fresh trade tensions with the United States.

U.S. DOLLAR'S STEEP RISE

The U.S. dollar has risen 20 percent on a trade-weighted basis in the past year. This de facto tightening of monetary policy has eroded the competitiveness of U.S. exports, eaten into economic growth and diminished company profits repatriated from overseas.

"(The yuan devaluation) puts the Fed in a difficult spot. It opens the possibility that the Fed might delay (a rate increase)," said Patrick Chovanec, chief strategist at Silvercrest Asset Management in New York. "On its own, it makes it harder to raise rates."

Over the past decade, the U.S. Congress has pressed Beijing to loosen its dollar-pegged exchange rate to allow the yuan to appreciate, arguing that trillions of dollars of currency market intervention had depressed the yuan artificially and given China an unfair trade advantage on global export markets.

That U.S. policy made sense with China's economy growing 10 percent per annum, attracting hundreds of billions of dollars of global capital every year, but with growth expected to slow to its weakest in 25 years and Beijing depleting foreign reserves to offset a big outflow of capital, a looser exchange rate regime now means a weaker yuan.

The People's Bank of China described its move on Tuesday as a "one-off depreciation" of the yuan CNY=SAEC and billed it as a free-market reform but the move may have implications for the Federal Reserve's plans to raise interest rates over the next 12 months.

Many analysts expect the Fed to raise rates in September, and both Fed officials and economists do not see China's actions as having much effect on that initial move but future policy may be another matter should the dollar keep rising.

"The overnight devaluation of the Chinese yuan will likely be seen by Fed officials as a minor headwind to growth, but is not significant enough to change our base view of September liftoff," wrote Michael Feroli, economist at J.P. Morgan Chase, on Tuesday.

The yuan's slide to a three-year low instantly rippled across the world markets. South Korea's won fell 1.6 percent against the dollar KRW=, its biggest fall in 10 months, and South African central bank governor Lesetja Kganyago said his country's exports would be less competitive. [MKTS/GLOB]

PRESSURE ON ASIAN CURRENCIES

"If China is really moving toward greater alignment with the market, which implies greater yuan weakness, this may be a factor that adds more pressure on China-related currencies," Barclays Asia-based strategists said in a note on Tuesday.

Their counterparts at Morgan Stanley also said Asian currencies excluding the yen were likely to slide against the U.S. dollar.

Many emerging market currencies, including the Malaysian ringgit MYR=, Indonesian rupiah IDR= and Brazil's real BRL=, had already slumped to their weakest levels against the dollar in over a decade as capital fled their slowing economies.

The big question now for emerging markets, where growth has slowed and capital flight has increased dramatically this year, is whether their officials respond to China's move in kind.

"It was inevitable that China would join the currency war at some point. The key will be the response of other central banks ... There should be further pressure on the currencies of China's trade partners," said Nick Lawson, managing director at Deutsche Bank in London.

Central banks dumped as much as $260 billion of foreign exchange reserves in the second quarter as emerging market central banks tried to mitigate the impact of capital fleeing their own economies.

The decline was the largest drop in global foreign exchange reserves in more than a decade, outstripping the depletion in 2008-09 when central banks frantically tried to manage the fallout from the global financial crisis.

Reporting by Jamie McGeever; additional reporting by Jonathan Spicer in New York; Editing by Kevin Liffey and Clive McKeef

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