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Here's what China needs to do now

Two big devaluations in two days have spooked markets around the world with fears of a currency war on the cards as China looks to boost its exports and economy.

Starting a campaign to weaken the yuan would be counterproductive, if that is the Chinese government's aim, and would not be seen in a good light by the International Monetary Fund as it decides later this year whether to put the yuan in its special drawing rights basket (SDR) with the U.S. dollar, euro, sterling and the yen.



A vendor holds Chinese Yuan notes at a market in Beijing.
Jason Lee | Reuters
A vendor holds Chinese Yuan notes at a market in Beijing.

It already has good reason to delay the inclusion: when you compare it to the U.S. dollar the yuan is barely on the same scale. According to the last Bank for International Settlements (BIS) survey the dollar was used in 87 percent of bilateral trades, whereas the yuan was used in less than 3 percent. It has a lot of catching up to do to take over the U.S. dollar as the vehicle for trade around the world.

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But the increase in the yuan's activity in recent years has been rapid, and it is this trajectory plus China being the second biggest economy in the world that gives its aim to be in the SDR credence — so China will not want to harm its long-term goal.

Officially, the People's Bank of China said the first 1.9-percent devaluation was part of a new mechanism as it moved towards a more market-oriented exchange rate, something the IMF has welcomed. Part of this new process means a daily evaluation of the fix — the 2-percent range the yuan is allowed to move around in. It seems to me that China wanted to grab the attention of the markets with this move and, now that it's moving toward a more market-based system, attain a more competitive exchange rate through expectations of future depreciations.

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Indeed, with the U.S. dollar's recent strength, and the yuan pegged to the dollar, the yuan has become relatively expensive compared to the euro and pound. So, dropping the fix, it could be argued, is justified.

Yet, in the short term, there is no guarantee that this devaluation will have the desired effect of improving exports; it takes time and businesses do not suddenly switch from one product to another because there are contracts in place.

The PBoC has sought to reassure the markets that the recent devaluation is not part of a broader devaluation agenda, but that may only be credible if the PBoC is prepared to revalue the yuan when the market commands. Ironically, the Chinese system to reduce uncertainty and volatility in the exchange market through intervention has produced uncertainty for investors, who may well pull out of the yuan as they struggle to pre-empt the PBoC's next move.

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China has been liberalizing its market since 2005, it is a slow process, but as it seeks to internationalize its currency, perhaps quickening steps to a more transparent currency regime would alleviate concerns.

Commentary by Arie Gozluklu, assistant professor of finance at Warwick Business School. Follow him on Twitter @arieskenazi.