January 7, 2016 / 3:57 PM / 2 years ago

How pulling the Chinese yuan thread frays the fabric of global markets

3 Min Read

A clerk counts Chinese 100 yuan banknotes at a branch of a foreign bank in Beijing January 4, 2016.Kim Kyung-Hoon

LONDON (Reuters) - If ever proof were needed of how deeply financial markets are interconnected and dependent on investors' "sentiment", look no further than the worldwide tremors set off by a 1 percent fall in China's currency this week.

Free-floating currencies routinely fluctuate by greater amounts in a single day. Nevertheless, the yuan's seemingly miniscule move is being blamed for everything from the crash in Chinese stocks to oil's slide to a 12-year low to the worst start to the year on Wall Street since 2001. Few corners of the financial world have been untouched.

The yuan remains far from a free-floating currency, and is tightly controlled by the Chinese authorities, so the 1 percent fall against the dollar is significant. It's the largest weekly drop since the People's Bank of China's mini-devaluation last August and the second biggest on record.

This week's turmoil echoes the turbulence of last summer after the Chinese central bank staged the 2 percent devaluation on Aug. 11 in the midst of an emerging market and commodity rout. This culminated in Wall Street's biggest one-day fall in four years on Aug. 24. China matters.

This GRAPHIC shows how currencies, stocks, commodities, bonds and some economic indicators have reacted to the yuan slippage since last August: reut.rs/1VMvXYf

The yuan moves suggest Beijing is trying to engineer a weaker currency to cushion the impact of slowing growth in its economy, a slowdown that many analysts believe is much more serious than official statistics indicate.

As the main driver of global economic growth over the past 15 years, a "hard landing" in China would be bad news for everyone.

The prospect of weakening demand from China has clobbered the price of oil, industrial metals, energy and resources. This means the budgets, exchange rates and economies of commodity exporting countries - mainly emerging markets - are suffering.

Falling emerging market demand slows trade and economic activity with the developed world. Together with falling commodities and EM exchange rates, it also creates a powerful global deflationary force that pushes down bond yields.

It's a vicious circle, one that looks increasingly difficult to break out of until China's economy roars back to life.

It's also an increasingly difficult one for global policymakers to tackle given that many analysts say central banks and governments have used up all their ammunition fighting the global financial crisis and recession of 2007-09.

GRAPHIC by Vincent Flasseur; editing by David Stamp

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