3 reasons why China's historic currency move is deflationary to the world

The big news in markets on Tuesday is China's devaluation of the yuan.

The People's Bank of China fixed the yuan midpoint at 6.2298 against the dollar and weakened it 1.85% below yesterday's closing level. Afterwards, the yuan fell to a three-year low against the dollar.

In a note to clients, Morgan Stanley strategists point out three ways that the historic decision poses a deflationary threat for the global economy:

1. A weaker yuan and stronger dollar stronger dollar to the yuan will raise the prices of commodity imports for China and may weaken demand.
2. The cost of Chinese exports will drop (weakening the yuan in the first place was part of an effort to keep exports competitive). While China's profits rise, its trading partners' margins would drop.
3. China may need to tap into its foreign currency reserves to tame the yuan if the currency starts making wild swings. If its reserves shrink, China may have to sell some international bonds in turn, making global funding costs more expensive.