VCCircle_Chine_Yuan (FILEminimizer)

Starting with two per cent devaluation on 11th August which was yuan’s or renminbi’s, biggest one-day devaluation in 20 years, China followed a three days devaluation that knocked more than three per cent off its currency value. The value of the Chinese currency dropped by 4.6 percent against dollar in the week ended 15 August 2015. It got stabilized at 6.395 per dollar. Those who closely watch the US economy alone, China’s attempt to devalue its currency is a surprise action which Arvind Subramanian, Chief Economic Advisor to Government of India had also affirmed. In contrast, those who are closely watching China for the past two years the recent attempt is not a surprise at all.

Factors that led to Devaluation

 Currency devaluation makes exports cheaper and hence China explicitly targets export markets in other countries. Economists often consider currency devaluation as a “win” for the devaluing country and a “loss” for the country whose currency gets more valuable. Can China realize more benefits than the cost for it? In fact, Chinese economy has been facing a number of problems at least for the past two years. The unsteadiness of stock market, the fall in export, and the slowdown in growth rate etc are some of them. Before the devaluation China was in newspapers for the crash in the stock market. This crash had come in the back of a 135 to 150 per cent increase in both Shangahai and Shenzhen indices in less than a year. Shangahai Composite Index (SCI) peaked at 5166 in mid June 2015 showing 150 per cent hike. In the next month it fell down to 3500 by falling 30 per cent. The unsteadiness of stock market can be watched from the following data:

  • Between end-July 2006 and mid-October 2007 SCI rose by 275 per cent.
  • Thereafter ending July 2008, the SCI returned to the pre-boom level.
  • Between 2008 and 2010 it decreased to 3000 level.
  • SCI went up from 2000 to 5000 in 2014.
  • SCI declined from 4277 to 3806 between June 15 and July 15 in 2015.

Another problem is the fall in exports. It is reported that exports fell by 8.3 per cent in July 2015. Adding to this, the country’s manufacturers are seeing their fourth year of price deflation in the domestic front. Strengthening of dollar has become another headache to the rulers in China. Since hitting a low in mid-2011, the US dollar is up 20 per cent. The dollar has increased so much in the last year due to many factors like cutting stimulus package in the US and massive stimulus programs in Europe and Japan. The Euro, yen and several other currencies have fallen in recent years against the dollar as the action of Federal Reserve has cut its stimulus package. In short, the domestic problems coupled with international problems like strengthening of dollar persuaded China to devalue their currency, Yuan. China’s decision is the latest evidence of a deep-seated lack of demand in the global economy. Chinese policy makers are in a hurry to switch their export –dependent economy to a consumer spending at home.

Further, People’s Bank of China wants to win inclusion in the basket used by the International Monetary Fund to determine the value of member-countries’ Special Drawing Rights (SDR). China is prompted to go for devaluation in order to make the currency value to market determined levels. The justification may be that the dollar went up by 18 per cent since July against the world’s seven most traded currencies, but by only 0.6 per cent against the yuan. Hence, this latest move could also be seen as a way of winning the approval of the Washington-based lender.

 Consequences

The immediate consequence is that a cheaper yuan will send “a tidal wave of deflation” breaking over the world economy. Cheap goods are good when economic demand is relatively strong, but developed countries, especially US have been facing falling prices. Hence it can prompt businesses and consumers to postpone spending – hoping prices have farther to fall.

Another impact is on the intention of Fed to hike the interest rate. US plans to have a hike in the interest rate, which is likely to take place in the month of September, in the background of recovery of the economy may be postponed. If the Federal Reserve is worried about the fall in their exports due to Chinese devaluation it could delay an interest hike that is widely expected to occur in September 2015.

There is every reason to believe that the costs of devaluation outweigh the benefits for China. One example often cited is that Chinese companies have borrowed over $1.6 trillion in foreign currencies. A big drop in the renminbi would make that harder for some Chinese companies to pay back, because it would become more expensive to service if the yuan lost ground. A falling Yuan might spur the outflow of capital too. Hence it is doubtful whether devaluation would deliver the desired economic outcome. It should be noted that the US is now in a better position to offset the consequences of devaluation of yuan than it was five years ago.

The politics behind the devaluation is another factor to worry. Foreigners accused China of keeping the Yuan artificially weak to boost exports. At this juncture a little history has to be explored. Until 2005, China pegged its currency to the dollar so that one dollar was worth around 8.2 Yuan. Since then, the currency has been pegged to a basket of currencies, and as a result the exchange rate has changed over time. Pegging the Chinese currency against the dollar has become increasingly costly because of its vast foreign exchange reserves, with the dollar up as much as 21 per cent against other global currencies in the last year.  Still she actively manages the currency’s value on a day-to-day basis. This is a clear currency manipulation. The US accused China of keeping their exports artificially cheap on the one hand and giving Chinese companies an unfair advantage over the US companies on the other. However, the situation has changed now. The US economy has become stronger and the Chinese economy became weaker. It naturally exerts downward pressure on yuan. It means that China does not make deliberate intervention to make its currency cheaper. The market will automatically push down the value of yuan. Moreover, there would be renewed complaints in the US against the Chinese currency manipulation in the short period. In the long period it would hamper China’s efforts to make the yuan a rival to the dollar.

Finally, a weaker yuan makes import costlier, especially for gold in China. The country consumes a third of the gold that is produced globally. Naturally the import bill of China will go up which is not at all good in the background of a slowing down in the economy.

Conclusion

China has many reasons to avoid an uncontrolled plunge in the renminbi. As the dollar has risen against most currencies over the past seven months, it exerted downward pressure on the Chinese currency Yuan. During the Asian financial crisis of 1997-98 and the global meltdown of 2008, China maintained a steady exchange rate against the dollar, despite having ample cause to allow depreciation. Such actions have bolstered the Yuan’s credibility. A rush to devalue now would undermine it. At the same time, it is criticized that the present devaluation of the People’s Bank of China is not an adequate one. It is reported that there will be some further depreciation of yuan in the medium term. To Krugman, “China .however did not let the renminbi float, nor did it devalue by enough to persuade investors that any future move was likely to be up. Instead it devalued only a little”. Quoting Charlie Kindleberger, Krugman described it as “taking the first bite of the cherry” (Nobody takes just one bite out of a cherry!).It throws light on what is going to be witnessed through higher dosage of devaluation in the medium term which may be severe for the world than the present one.

* The Author is the Chief Economist of CPPR. His views are personal and does not anyway represent that of CPPR

Dr. Martin Patrick
Dr. Martin Patrick
Dr Martin Patrick is Chief Economist at CPPR. He has a PhD in Applied Economics from the Cochin University of Science and Technology (CUSAT), Koch and had a post-doctoral training at Tilburg University, Netherlands. Presently, he is a Visiting Fellow at Indian Maritime Institute, Ernakulam and Xavier Institute of Management and Entrepreneurship, Ernakulam. He can be contacted by email at martin@cppr.in