LAST week, the Chinese Central Bank announced a devaluation of its national currency, the Chinese Yuan Renminbi (CNY), writes Oliver York at Brewin Dolphin.

The CNY/USD fixing rate was devalued by a magnitude of 1.9 per cent last Tuesday, followed by a further 1.6 per cent drop on Wednesday and another 1.1 per cent on Thursday.

The motivations for the policy adjustment appear to be twofold. The primary incentive for the currency devaluation is ‘international recognition’. By allowing market forces to play a greater role in determining the exchange rate, rather than managing a peg to the dollar, the CNY improves its prospects for inclusion in the International Monetary Fund’s (IMF) basket of recognised currencies (known as Special Drawing Rights). Such a promotion would raise its profile, and use, in international trade.

That the IMF has spoken so swiftly and firmly in favour of the policy changes implies the Chinese were aware this move would increase their chances of inclusion.

The Chinese authorities are unlikely to let the full force of the market determine the exchange rate, however, given the scale of the devaluation that would transpire. An adjustment of 10 per cent or more would be highly damaging for the private sector that has amassed a staggering level of dollar denominated debt.

The second motivation is an attempt to stem the increasingly dour prospects for the Chinese economy.

At its core, the Chinese economy continues to suffer as a result of previous excesses in bank lending. Under the centralised regime, however, banks do not realise these bad loans; choosing instead to extend further finance in order to prevent a jobs crisis. Such a drain on bank resources is weighing heavily on the growth outlook.

With only limited success from interest rate cuts, China is now looking to boost growth by capturing a greater share of global demand.

In isolation, currency devaluation improves global competitiveness, but if what follows are further rounds of devaluations from competing countries, then a currency war may begin; and this is rarely a force for good in the global economy.

Under these circumstances prices come under continued pressure, profits contract, and a deflationary pulse is sent through the global system. It is no surprise, therefore, that Asian and Emerging Market currencies, as well as stock markets at large, are selling off. Falling prices also weigh on inflation expectations, reducing the need to raise interest rates, and lifting the demand for bonds.

Our base case is that China recognises the damaging consequences aggressive devaluations would bring to the global economy and, therefore, will act only at a measured pace. Indeed if UK and US interest rates remain anchored lower for longer, it would continue to support broader business prospects and equity market performance.

As we are witnessing, however, in the short-term the softening levels of Chinese demand is weighing heavily on commodity and energy related stocks as well as the automotive and luxury brand sectors.

The Chinese will continue to intervene to support the yuan given the high levels of private sector dollar denominated debt, but currency risks remain firmly on the downside.