11/08/2015 11:42 BST | Updated 11/08/2016 06:59 BST

How the Chinese Devaluation Will Affect the UK's Current Account Deficit

Today's decision by the People's Bank of China (PBOC) to devalue the yuan by 2% and change the way Chinese currency policy works will have economic ramifications throughout the region, the world, and on the UK. The yuan has traditionally been pegged to the US dollar (much to the latter's consternation), but as the dollar appreciates in the run up to the Fed raising interest rates, so too has the yuan, putting downward pressure on Chinese exports' competitiveness levels, and incentivizing a beggar-thy-neighbour environment in Southeast Asia. At the same time, the sterling has appreciated as the BoE signals its upcoming intent to raise interest rates, likely after the Fed does, and is likely to continue to do so, relative to the yuan. This will make Chinese exports to the UK more attractive, while making UK exports to China more expensive, likely widening the UK's current account deficit.

In previous months, the PBOC opted for currency stability relative to the dollar as it sought membership in the IMF's Special Drawing Rights (SDR) group of global currencies (currently the USD, GBP, Euro, and Yen), by maintaining the yuan's price level within roughly a 2% band that it set. Now this 2% band will be based on the previous day's close, which will likely maintain downward pressure on the yuan. The key question, and one that remains to be seen, is how far the yuan will be left by the POBC to effectively float on a day-to-day basis.

Although the PBOC's previous strategy stabilized the yuan, because it was pegged to the US dollar, the yuan appreciated relative to other currencies like the Yen and the Euro. This in turn put downward pressure on the ability for Chinese firms to export. Chinese aggregate exports fell 8.3% in July compared to a year ago, and exports to the European Union and the United States fell by 12.3% and 1.3%, respectively. This prompted the POBC's decision that the benefits of yuan stability and IMF SDR ascension no longer outweigh the costs of currency appreciation and downward pressure on exports. This decision was likely made in light of China's economic slowdown, as the recent series of interest rate cuts and stock market volatility underscore. China's slowdown in turn has created a regional recessionary force among countries which predominantly trade with China but also compete with it globally.

The Chinese devaluation could trigger beggar-thy-neighbour policies by the region's central banks as they attempt to maintain their own competitiveness against Chinese exports. Southeast Asian currencies have depreciated sharply against the U.S. dollar as the region's economies slowed due to the Chinese slowdown, the decreased price of commodities (which many export to China), and the dollar appreciation ahead of an expected rise in U.S. interest rates later this year. In response to the POBC's decision, for example, the Thai baht fell 0.7% and the Singapore dollar fell 1.2% relative to the U.S. dollar, each of which represents a six year and five year low, respectively. The Philippine peso also fell to its weakest level in five years, and Indonesia's rupiah and Malaysia's ringgit dropped 0.2% and 0.5% lower, respectively, to their weakest levels against the U.S. dollar since the Asian financial crisis 17 years ago.

As the Fed and the BoE edge ever nearer to interest rate increases, the USD and the GBP will appreciate relative to the yuan, in turn making it easier for Chinese firms to exports abroad, but also more difficult for British and American firms to export to China. Although the shift to more market-based policies by the POBC should be welcomed, the economic effect on the UK could be significant. China is the UK's second largest import partner and its fifth largest export market, representing 8.7% and 4.8% of the UK's total in each category, respectively. If the yuan were to depreciate further at a time when the sterling is appreciating, it is likely that Chinese imports to the UK will significantly increase while UK exports to China decrease, putting a greater strain on the UK's already large current account deficit. Although the UK has traditionally run a deficit in goods and services, its net investment position, one of the other key components of the current account, has deteriorated in recent years due to the slowdown in Europe, dampening returns on UK-owned assets there. If these trends were to continue, as seems likely, and the Chinese yuan depreciation entrenches itself and continues, as also seems likely, then the UK's current account deficit could become a significant problem, especially as the BoE is expected to raise interest rates in early 2016, incentivizing and entrenching both trends.

Michael Martins is an Economic Analyst at the Institute of Directors