The yuan devalued sharply after the People’s Bank of China, China’s central bank, started setting the yuan’s level relative to the US dollar’s closing level the day before, in effect handing part of the determination of the price of their currency to the private markets. This change has introduced a lot of volatility into the markets.

Everyone has immediately lost their mind. It might be because it is August and there’s not much else going on. It might be because China is big, and its stock market jitters have been much in the news. Everyone is worried what the currency volatility means for China’s exports, which is code for their own domestic issues. China is at the heart of the global supply chain for just about everything. So everyone has naturally run through their Econ 101 notes: currency depreciation means export values get hammered. Some of those exports come to us. China is big. Bad things happen, including deflations.

Deflation matters because across Europe, in particular, economies are still not growing. Germany’s GDP has grown by only 0.4 per cent in the second quarter of 2015, when 0.5 per cent was expected by markets. France did not grow at all. It was expected to grow by 0.2 per cent. Italy managed just 0.2 per cent, instead of the expected 0.3 per cent.

Economic growth in the Netherlands also fell short of estimates recently, and Portuguese GDP grew only 0.4 per cent, when they expected 0.5 per cent. The IMF has recently cut its forecasts for global growth. It’s all a bit messy.

Fed fears

We tend to hear only about Ireland’s rebound growth in our domestic media, but remember our size is such that if the economy grew by 20 per cent per annum, it wouldn’t make a shred of difference to the fortunes of Europe. Ireland is not important in the grand scheme of things. China is.

So is the US. People are worried that the Federal Reserve, the US central bank, will increase its base interest rate in the coming months, which will put huge pressure on Chinese exports to remain competitive. China’s economy has been slowing markedly in the past 12 months. Its stock market is on a downward trend, retail sales and construction are slumping, and it has lost a lot of competitiveness relative to its major trading partners - Japan, Korea, the US, and Europe, over the last few years.

Many people are seeing this move by the People’s Bank as a pre-emptive strike to force the Federal Reserve to alter its strategy of increasing interest rates in the coming months. Again, they should calm down.

It’s certainly not the end of the world or the start of a currency war, as some commentators have said, nor is it unplanned, nor is it a reaction to recent developments in the Chinese economy. Everyone needs to chill out a bit.

Spot market

A bit of background on what actually happened last week. Spot markets for currencies exist to trade large volumes at current market prices.

You buy 10 million yuan today using your home currency (for us that would be euro) and the stuff gets delivered to you in about two days. Forward markets work differently—you buy the 10 million yuan today and you get in 30 days, 90 days, 1 year, 5 years.

The way the yuan is typically traded across the international currency markets is that the Chinese authorities would set a reference level for the value of the currency, and then allow the spot market value to fluctuate up or down, perhaps 2 per cent around the reference value before the People’s Bank would intervene to either push it up or push it down, depending on what had happened. This direct intervention can still happen, it’s just much more jittery.

So for example on August 14, the People’ Bank raised the reference value of the yuan against the US dollar by 0.05 per cent, and everyone calmed down a bit. The currency slide slowed down markedly on foot of this change, and our hapless Argentinian sovereign debt manager probably unclenched for the first time in a few days.

People try to arbitrage between the one year forward rate and the spot rate. This market is draining of liquidity. The last six to eight months have seen a great deal of central bank bond buying by central banks - that is, a lot of quantitative easing - in China’s major trading partners like Japan and Europe.

These QE programmes have weakened their currencies relative to the yuan, which combined with a bucket load of bad economic data coming out of China showing it has been weakening all by itself. The People’s Bank has been intervening more or less constantly to prop the currency up (or down) throughout this period.

One interesting movement from the changes introduced by the People’s Bank last week: prices for long-dated sovereign and commercial debt in Japan, Germany, Britain and the US fell, pushing yields up, providing investors in these assets with a quick windfall before the summer ended. Meanwhile our Argentinian fund manager probably needs to shop for new underpants. Such is the interconnected nature of the global economy.

Reform process

Back to why we don’t need to be that concerned: this is all part of a very long-term plan. China has limited capital controls and its officials have consistently made the point that China is moving, slowly, towards a liberalised capital market, combined with a much more open economic structure. This reform process really means providing for an increasing role for the market in the determination of prices.

The dual-price system established under Deng Xiaoping, which began in agricultural markets in early 1978, was extended in the intervening decades throughout markets for primary factors like rice, and then for industrial inputs and outputs like coal.

The system consisted of a state-set price for centrally rationed supplies, and a higher free-market price. This began in the 1980s for most consumer products.

The dual-price system is best understood as a way of slowly introducing a private price-setting mechanism, by allowing markets to determine marginal prices while retaining central allocation away from the margins, and then “growing out of the plan”. Barry Naughton wrote the book (literally) on this reform process in 2006.

The key to understanding the reform process, now 30 years old, is to understand the role liquidity plays in keeping the process moving. China’s central bank will still be able to have a strong influence on the price of liquidity throughout the Chinese financial system after these reforms.

Market makers, government institutions, and the private banking sector, are being brought into this liberalisation process now. The exchange rate is one of the key ‘prices’ in the economy. Moving slowly towards a liberalisation of this price, along with other key ‘prices’, is all part of China’s plan. The world’s markets should be aware of this, and act accordingly.

But the world’s markets are stuffed full of young men and women with the historical knowledge of a small bag of grapes, and so this comes as a shock to them. The markets might be all-powerful, but all knowing they are not.