By Vatsal Srivastava
Beijing, Aug 12 (IANS): Devaluing the domestic currency during gloomy economic conditions has always been an important and crucial ammunition tool for policymakers.

In the recent past, almost all major developed countries have adopted this approach. When the European Central Bank announces QE and sends the Euro tumbling, it is for a strong and united Europe. When Japan announces the largest bond buying program in financial history (as a percentage of the monetary base) and sends the yen on a freefall, it is because of the dismal demographic trends. When the United States QE program sends the Dollar Index to multi-year lows, it is to save the global economy. But when the People’s Bank of China (PBOC) devalues the yuan by two percent, it is an all out currency war! However, that is not the case.

This is mainly because Chinese officials still have sufficient policy ammunition to boost domestic demand to offset external headwinds. Consensus forecast is for another 25bps policy rate cut and 200bps reserve ratio cut in the second half of 2015. Further, the change in the USD-CNY fixing mechanism will not impede RMB internationalization efforts.

First and foremost, China’s move has most-affected the foreign exchange market - an asset class which is usually most susceptible to overshooting and trading at levels which are not warranted as per the fundamentals. The long-term impact of this intervention by the PBOC will only be known in a few weeks depending on how actively they decide to further devalue the yuan, if at all they do.

Of course, this move will provide relief to its ailing economy. A weaker yuan will make exports more competitive and imports more expensive. Thus, the short-term economic aim is diverting both internal and external demand to domestic production - at the expense of foreign suppliers. Now, before we start calling China a currency manipulator and accusing it of making the world trade markets an uneven playing field, we should remember the following: China’s exports have continued to rise as a share of global exports so there is little indication that CNY had appreciated to a level that had made China materially non-competitive despite the strong appreciation of CNY since 2012. So clearly, the currency war view does not add up just yet.

The bigger theme in play here is China’s attempt to meet the IMF criteria for being included in the Special Drawing Rights (SDR). The PBOC announcement effectively means to allow the market to play a bigger role in the formation of daily fixing. Now, market makers will submit their quotations of RMB central parity by referencing to the closing rate of the previous day (vs previously asking for the price quotations from market makers before the market starts).

This clearly goes to show that China’s central bank is accelerating reforms to raise the chance of the RMB's inclusion in the IMF's SDR basket. Although it is not explicitly mentioned, it is nevertheless understood that a reserve currency cannot be a highly managed one (which was the case with the yuan), which could potentially deviate from its underlying fundamental value thereby resulting in eventual instability. That was indeed the risk for USD-CNY, which has been held very steady, despite ongoing capital outflows from China. We can expect the PBOC to announce further FX reforms - such as the extension of the CNY trading hours and promoting convergence between the onshore and offshore exchange rates.

In the short-term, volatile moves in the markets as a result of the Yuan devaluation will make the headlines. But China only stands to gain over the long term by adopting a more efficient and market determined exchange rate.