Chinese Engineer Devaluation

"After recent data showing falling exports and a stalling manufacturing sector, the central bank said on Tuesday that it was allowing the yuan to weaken by nearly 2% in the hope of making China’s exports cheaper and pushing down borrowing costs."

From the Guardian. Chris Balding adds that "The trading rate was already near the new official rate almost 2% away from the old official rate prior to the devaluation." He goes on:

"The biggest currency risk here is that by resetting expectations on the RMB/$, it is creating future expectations of devaluations. The [People's Bank of China] PBOC can talk all day about market conditions and their models, but markets don’t like to be surprised and the PBOC has just created future expectations.  It will be very hard for the PBOC to put this genie back in the bottle.  The real risk is that China is going to be forced to release the RMB."

Two things to add:

1) Sweeping policies (even with forward guidance) inject uncertainty and volatility into markets which respond in complex ways.

2) China now has less than $4tn of reserves, which isn't a whole lot for a nation its size. If we consider the RMB 'backed' by foreign reserves (such as the US Dollar), then their position is precarious indeed. The devaluation helps reduce the value of China's liabilities (i.e. the RMB currency), and could perhaps stave off a liquidity crisis if a crunch comes.

"To supplement the liquidity outflows, economists expect the central bank to further reduce the amount of cash that is required to be held as reserves by financial institutions."

Further, there's this:

"Since March 2014, around the time China’s holdings of US Treasuries peaked at $1.65 trillion, through May 2015, China reduced its holdings by $180 billion, according to the US Treasury Department’s most recent data, reported Bloomberg."

This devaluation is likely part of a response to a broader crisis than a slump in exports.