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Why a weakening yuan is rattling markets

FREE EXCHANGE rates, argued Milton Friedman in the 1960s, would probably lead to freer world trade...and a reduction of tariffs. In Chinas case his logic is being turned upside down. The imposition of tariffs is leading to a freer exchange rate. On August 1st President Donald Trump warned that he would soon impose a 10% levy on roughly $300bn-worth of Chinese goods that have not already been hit by the trade war. Four days later China responded by giving its exchange rate unaccustomed freedom to fall. The yuan weakened past seven to the dollar, an important psychological threshold, for the first time in over a decade. And stock prices in America duly fell, with the Dow Jones Industrial Average dropping 2%.Since a messy exchange-rate reform in 2015, Chinas authorities have said they will keep the yuans value broadly stable against a large basket of currencies, which now has 24 members, from the Thai baht to the Polish zloty. The combined weight of the dollar (and other currencies pegged to the dollar) in this basket is only about 30%. But that understates the dollars continued significance. Because most holders of Chinas currency remain fixated on its value relative to the greenback, Chinas authorities cannot afford to take their eyes off this benchmark either. Any conspicuous weakening of the yuan against its American counterpart makes people nervous, regardless of what is happening to the broader basket. And that nervousness can feed on itself, leading to further selling pressure.
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