The move recalled an episode more than four decades earlier, on Aug. 15, 1971, when President Richard Nixon stunned the world by unilaterally severing the dollar’s last link to gold. Like the U.S. action at the time, China’s was portrayed as a measured, one-time adjustment that amounted to approximately a 3% depreciation in the currency. Just as America’s eventual moves would prove far more substantial, China’s might also turn out to be bigger than initially advertised, notwithstanding Beijing’s protestations to the contrary. The yuan could fall a total of 10% or more.
China pinned its surprise devaluation on a desire to allow market forces greater play in setting the currency’s exchange rate. The shift came after signs of a sharp economic slowdown, including a steep fall in exports in July; a series of stimulus measures, including interest-rate cuts, to counter the slowing; and a sharp break in its stock market.

Last week’s depreciation of the yuan was but a fraction of the rise in the currency’s value over the past several years, which now appears to be weighing on China’s economy. China’s economic weakness suggests that further declines in the currency lie ahead. And as the yuan loses more value, there will be greater repercussions for the global economy.
The People’s Bank of China emphasized last week that the yuan had appreciated by 55.7% against its trading partners, after adjusting for inflation, since the currency was allowed to float in mid-2005.

That’s well in excess of its roughly 33% appreciation versus the greenback until last week’s devaluation.
In a news conference last week, the PBOC described market commentary that China was seeking a 10% currency depreciation to boost exports “completely groundless and unfounded.” Beijing backed those words by actions, supporting the currency in the market later in the week.
There are good reasons for Chinese officials to resist a sharp drop in the yuan, not least their longtime avowed aim to maintain stability above all. More substantively, the burden of Chinese corporations’ heavy debt load in dollars becomes even greater as the yuan loses value versus the greenback.
Even so, last week’s actions to lower the yuan look tiny relative to its previous rise and the loss of competitiveness. Japan’s yen has been effectively devalued by a third under Abenomics, albeit from a severely overvalued level. But at the same time, there have been sharp declines in the South Korean won, the Indonesian rupiah, the Malaysian ringgit, and the Vietnamese dong. Vietnam has undercut China as the low-cost producer in the region.
One wonders what a 3% adjustment in the yuan will do to spur China’s economy, which reported an 8%-plus year-on-year plunge in exports for July, in the context of the currency’s sharp previous appreciation. Granted, greater exchange-rate flexibility would complement the domestic monetary-easing moves since last year, including a series of interest-rate and bank reserve-requirement cuts, plus the various moves to prop up the stock market. But a 3% change goes only so far.
To a longtime observer of finance ministers and central bankers, the claim that the initial moves to tweak a currencies will suffice is a familiar refrain. The larger the underlying imbalance, the larger the eventual exchange-rate adjustment. And, seemingly, the louder the official protestations that no further dramatic moves are needed.
Some rich, powerful money managers continue to trust in China’s leaders to maintain control, as they have through that nation’s remarkable economic revolution. But to skeptics, the Beatles ring truer: “If you go carrying pictures of Chairman Mao, you ain’t gonna make it with anyone, anyhow.”
Looking back at that fateful evening in August 1971, Nixon also portrayed the U.S. move as a one-time adjustment to protect U.S. interests against nefarious international forces. In actuality, he dumped the prevailing monetary order for the current nonsystem of currencies that neither float freely in a free market nor are stabilized with a fixed value.
Today, the world remains in this neither-fish-nor-fowl environment in which governments manipulate exchange rates along with the other policy levers at their disposal—interest rates, tax rates, and spending. That is even as they insist the price of currencies is set by a free market, as are commodities such as wheat and copper.
To be sure, the analogy isn’t exact. The U.S. dollar was the linchpin of the Bretton Woods system in which the greenback could be exchanged for gold at $35 an ounce (by governments and official institutions only, not regular folks), while other currencies were defined in terms of the dollar. The yuan, by contrast, isn’t freely convertible and is only in the early stages of having a major international role.
But the same pressures that led Nixon to abrogate the U.S. promise to maintain the dollar’s international value figured into Chinese officials’ decision to end tight control of the yuan. Domestic considerations take precedence for any politician—in an authoritarian regime or a democracy. When a currency rate hurts more than it helps, it goes.
That has been the history of exchange-rate schemes, from the classic gold standard to Bretton Woods to Britain’s exit from the European exchange-rate mechanism in the early 1990s to the break of the currency pegs of Asian nations later in that decade. (The history of the euro is incomplete at this point.)
More recently, much of the world is engaged in what has been described, perhaps hyperbolically, as a currency war. Many nations, especially in emerging markets such as Malaysia to Brazil, have seen their currencies decline as their economies have faltered, notably as commodity exports have waned.

Whether they have driven down exchange rates to gain advantage or allowed them to retreat, the changes smack of the competitive devaluations that exacerbated the Great Depression of the 1930s.
China had, until last week, seemed to stand aside from the fracas. Since July 2005, it had allowed a controlled float of the yuan and in recent years had permitted a steady appreciation against the dollar. But far from being an anchor, the greenback has successively sunk and floated higher, with the yuan following in its wake.
If there is a currency war, moreover, the U.S. arguably started it with repeated rounds of quantitative easing following the 2008 financial crisis, greatly expanding dollar liquidity and driving down the greenback. QE from other major central banks, including the Bank of England and later the Bank of Japan and then the European Central Bank, followed the same script. Then, currencies such as the Australian dollar slumped due to weakness in commodity prices, importantly driven by China’s slowing economy.
NOW THE EFFECTS are washing up on American shores. U.S. companies that sell to China will get hurt as overseas profits are translated back into dollars. As Fitch Ratings notes, these currency effects will only exacerbate pressures already being felt by consumer-product multinationals such as Procter & Gamble PG (ticker: PG), which derives 8% of its revenue from China, and Colgate Palmolive (CL) and Kimberly Clark (KMB). They have also seen a steep sales decline in Latin America.
China is inextricably wound into the global weakness in commodities, which is in turn weighing on U.S. corporate earnings. Standard & Poor’s Howard Silverblatt notes that 2015 operating earnings per share for companies in the S&P 500 index now are forecast to decline 1.1% from 2014 results.
But the impact of lower energy prices has been far more severe for the high-yield bond market. Energy credits make up a big chunk of the junk market, and as Gluskin Sheff’s chief economist and strategist, David Rosenberg, points out, the average yield in that sector has jumped 120 basis points (1.2 percentage points), to 7.3%, since May. That’s a move comparable to a 9% correction in the stock market; were that to happen, the S&P 500 would be down around 1910, not 2091.54, where it ended on Friday.
BCA Research further observes that high-yield energy debt now is trading at “distressed” levels, which is defined as 10 percentage points over comparable Treasuries (or 1,000 basis points of fright), as debt is at the center of the energy sector’s stresses. Hercules Offshore (HERO) filed a prepackaged bankruptcy on Thursday. The Wall Street Journal also reported late on Friday that Samson Resources, owned by KKR (KKR), plans a Chapter 11 filing next month. 
The deflationary tide also swept through global bond markets, notably markets for inflation-indexed issues such as Treasury inflation protected securities, or TIPS. According to Nomura Securities, these markets marked down inflation expectations by seven basis points in the U.S. in the three days following China’s devaluation, and 11 basis points in Germany. Since July, inflation expectations are down 29 basis points in the U.S., and 30 basis points in Germany.
Still, expectations remain that the Federal Reserve is on course to hike its short-term interest-rate target at next month’s policy meeting from the zero to 0.25% target that has prevailed since December 2008. The report on the July Consumer Price Index, due out on Wednesday, may show inflation creeping up, largely because of upward pressure on rents.
A modest proposal to solve two problems: Import all of the empty apartment towers in China to the U.S. to satisfy Americans’ demand for flats. Hmmm, perhaps free trade and currency adjustments can’t solve everything.