Laura Banks
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Here’s why China devalued the yuan

hina’s exports are slumping, and its FX reserves are dwindling

China’s decision to devalue the yuan Tuesday marked the most significant shift in the country’s foreign-exchange policy since it abandoned a hard peg to the U.S. dollar 10 years ago.

Chinese policy makers have continued to exercise tight control over the yuan. The currency, also known as the renminbi, is allowed to trade 2% in either direction around a central fixed rate, which is set daily by policy makers at the People’s Bank of China. The process of how the central rate was set was relatively opaque.

Now, policy makers will base the fixing rate on how the yuan traded at the close of the previous trading day, ceding more control to market forces.

In a statement, representatives of the People’s Bank of China said they devalued the yuan because they want it to better reflect market forces. But a weaker, more market-oriented yuan will also benefit China’s economy in several ways.

Here’s how:

Exports are weak

China’s exports posted a surprisingly steep decline of 8.3% in July from a year ago, according to trade data released over the weekend. Overall, China’s economic growth has been sluggish. Its economy expanded at a rate of 7.4% in 2014—the slowest level in decades. And, according to official data, it’s on track to log 7% growth this year.

But while investors were disappointed by the magnitude of the decline, it was hardly a surprise.

The currencies of China’s rival exporters—like the Japanese yen USDJPY, +0.30% and the South Korean won USDKRW, +0.05% —have depreciated against the dollar while the yuan has been relatively stable.

Indeed, the Chinese currency has been the second-best performing emerging-market currency against the dollar this year (the Hong Kong dollar has recorded the best performance).

Their relative weakness of their currencies has given China’s rivals an advantage in the export market, as the data shows. By allowing the yuan to weaken, China is helping its exporters regain their competitive edge.

Exports were responsible for 22% of China’s gross domestic product in 2014, according to data from the World Bank. So more-robust export growth can have a large impact on the country’s GDP.