Last week’s surprising action by the People’s Bank of China (PBOC) to devalue their currency sent shock waves throughout financial markets across the globe. After the news was announced, the Dow Jones Industrial Average Index fell more than 500 points over the next two days before recovering about half the loss. Other stock markets also suffered significant declines as investors sought the safe haven of U.S. treasury bonds. Yields fell.

As the world’s second largest economy, what is the significance of China’s move on the global economy, especially if things worsen? In short, is China’s economy broken?

China’s growth rate has certainly slowed from the torrid 10% of the last several decades (or even its “official” 7% rate), but it is hardly broken. Most large economies would be quite pleased with even half of China’s stated growth. Nonetheless, China is facing some significant issues as it attempts to counter the effects of the strength of its currency over the last several years.

In order to maintain some stability with the U.S. (one of their largest export markets), China fixed its exchange rate in a very tight band with the U.S. dollar, which resulted in significant strength in the Chinese yuan (up almost 10% in the last 18 months, even after the recent decline). With their economy slowing, the Chinese were hemmed in by their connection to the dollar, and needed to devalue their currency in order to make their exports more competitive with global competitors.

Despite the violent reaction in the U.S. stock market, the roughly 3% devaluation in the yuan is likely to have little direct impact on U.S. economic growth. Only about 7% of U.S. exports go to China, and since exports are a relatively small part of the U.S. economy, Chinese exports represent only about 1% of U.S. GDP.

Other countries more dependent on exports to China are likely to feel a bigger impact, especially if the value of the yuan continues to fall. European countries view China as a major export market, and the cheaper yuan will crimp demand for German machinery and other high value goods. China’s voracious appetite for commodities has been cooling in recent years, and this move will put further downward pressure on big commodity exporters such as Australia. In addition, Japan’s nascent recovery will be challenged by its significant dependence on exports to China.

A lower yuan will make Chinese imports to the U.S. and other countries cheaper and keep downward pressure on global inflation. This has caused some economists to push out their forecasts for the first Fed tightening. Despite this new development, we continue to believe that the Fed will make its first move in September, and stick to its stated plan of slow and deliberate rate rises over the next several years.

Beyond this initial devaluation, China made an important modification to the process for setting the exchange rate, which is likely to create more of a free-floating currency in the long-term. While the adjustment process may be painful at times, letting the market establish an equilibrium price is a positive development. Many economists believe that the yuan will depreciate further in the near-term, despite the PBOC’s public statements against such an outcome. While a declining currency may be helpful in stimulating export demand, it introduces another set of less positive impacts on a nation’s economy. Such is the delicate balancing act that the PBOC must navigate as it tries to reinvigorate growth in the world’s second largest economy.

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Index Definitions

Dow Jones Industrial Average Index: A price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq.