Yesterday, China’s central bank devalued the yuan by a 1.9 percent, and today it further cut the reference rate by 1.6 percent. What does it mean for the global economy and the gold market?

On Tuesday, the People’s Bank of China surprisingly entered the currency wars and cut the reference rate of the yuan (from which trade can rise or fall 2 percent during the day) by almost 2 percent, the biggest devaluation in two decades. Although the Tuesday move was said to be a “one-off depreciation”, the PBOC further reduced the official rate by 1.6 percent today.

What are the reasons behind the devaluation? Central bank officials claim that the decline was only a by-product of making the rate more market-driven (the rate will now be based on previous trading day performance and overnight global market developments). However, most of analysts believe that China wanted to boost its exports, since the devaluation followed weak trade data published over the weekend, showing an 8.3 percent drop in exports in July. Of course, this mercantilist policy is completely ineffective in the long run, but this is exactly what all central banks are doing right now (setting zero interest rates and introducing quantitative easing programs as an indirect way of depreciating currencies).

What are the possible consequences of the PBOC’s last moves? Well, these desperate actions will further shake confidence in the economic prospects of China. The increased uncertainty and lower exchange rate may exacerbate capital flight. The end of the probably world’s most profitable and easy carry trade (due to interest rate differentials and a fixed exchange rate) would significantly impact the global economy and boost the demand for safe-haven assets, such as the U.S. dollar and gold.

The price of gold initially fell after the devaluation, probably because gold became more expensive for Chinese buyers. However, gold hit a three-week high yesterday, due to safe-haven demand – there are concerns about the new Chinese exchange rate policy and global developments in the new environment. Gold may gain also as a hedge against the devaluation of the yuan for Chinese investors seeking the preservation of their purchasing power. And the Fed’s hike in September has become less probable now, as the U.S. central bank would not want risking further strengthening of the greenback.

To sum up, China changed its exchange rate policy and devaluated the yuan by 1.9 percent on Tuesday and by 1.6 percent today. These moves show how desperate the government is over the state of the economy. The consequences for the global economy may be significant, from further downward pressure on raw materials prices to the unwinding of the China carry trade. If investors believe in possible spillovers into other markets, the price of gold should find some support.

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Arkadiusz Sieron
Sunshine Profits‘ Gold News Monitor and Market Overview Editor

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