BERKELEY – On August 11, China devalued its currency by 2% and modestly reformed its exchange-rate system. This was no earth-shattering event, but financial markets responded as if a meteorite had struck them. The negative reaction is no mystery: China’s devaluation was a textbook example of how not to conduct exchange-rate policy.

One of the government’s motivations was presumably to give a boost to China’s slowing economy. Although the service sector, which accounts for the majority of employment, is holding up relatively well, the country’s output of tradable goods, many of which are produced for export, is weakening sharply. Chinese exporters are caught between the pincers of weak foreign demand and rapidly rising domestic wages.

Devaluation is the tried and true remedy for such ills. But a 2% change in currency values is too little to make much of a difference, given that wages in Chinese manufacturing are rising at an annual rate of 10%.

It could be that Chinese policymakers regard the 2% devaluation as a down payment – the first in a succession of downward adjustments. But, in that case, they violated the first rule of exchange-rate management: Don’t cut off a cat’s tail in slices.

The rationale for this rule is straightforward: If foreign investors expect that more currency depreciation will follow, they will rush out of Chinese markets to avoid further losses. Capital outflows will accelerate, financial conditions will tighten, and investment will suffer. In fact, this is precisely what China is experiencing.

A single large devaluation that gets the entire adjustment out of the way minimizes this risk. Indeed, if investors expect the sharp improvement in competitiveness to lead to stronger economic performance, the currency will recover some of its lost value. Capital will flow in rather than out. Spending will rise rather than fall, which is precisely what China needs in the current circumstances.

Instead, by resorting to their traditional incremental approach, Chinese policymakers undermined confidence that they know what they are doing. Because they adjusted the exchange rate without describing their motives, they merely encouraged the belief that China’s economic performance is even worse than official data suggest.

Another interpretation of the August 11 move is that it paved the way for the renminbi’s inclusion in the basket of currencies that comprise the International Monetary Fund’s unit of account, Special Drawing Rights. In order to be included in the SDR basket, a currency must be widely used in international transactions. The renminbi is already widely used to invoice and settle international merchandise trade, notably other countries’ trade with China itself.

But it is less freely traded in global currency markets, ranking only 9th overall, according to the Bank for International Settlements. This relatively low standing partly reflects China’s maintenance of controls on capital flows, which make it hard for financial-market participants to get their hands on renminbi. But it is also a result of heavy-handed manipulation of the foreign-exchange market by the People’s Bank of China (PBOC), which makes changes in the price and availability of the renminbi opaque and uncertain.

The August 11 initiative may have been designed to alleviate this concern. In addition to devaluing, China announced that the opening "fix” – the price at which trading of the renminbi would commence each day – would be largely based on the previous day’s closing market price. Because the PBOC had been setting the opening fix pretty much wherever it wanted, this change could be seen as moving the renminbi toward a more market-determined exchange rate.

If so, it is at most a very modest move in that direction. The PBOC continues to intervene heavily once the market is open, thereby limiting fluctuations in the dollar-renminbi exchange rate to less than 2% a day.

In any case, gaining admission to the SDR club is a poor excuse for wrong-footing the markets. Given that the SDR, which the IMF uses to keep track of its own financial transactions, is of little practical importance, the Chinese authorities’ effort to add the renminbi to it amounts to little more than a vanity project. Inclusion would make no difference in terms of progress toward China’s goal of developing its currency into a first-class international and reserve currency widely used by private and official foreign investors.

If Chinese officials are serious about pursuing this goal, they should stop focusing on the SDR and start developing stable and liquid financial markets that are not subject to official manipulation. Only then will the international community embrace the renminbi as a proper international and reserve currency. The events of the last month suggest that China still has a long way to go.

Barry Eichengreen is Professor of Economics at the University of California, Berkeley.

Copyright: Project Syndicate.