By Amit Singh
A fortnight back, an unexpected devaluation of the Yuan by China saw it plunge the most in about 20 years, sending shockwaves across the currency markets globally.
China’s central bank is allowing its tightly controlled currency, the Yuan, also known as the Renminbi, to fall in value. (The Renminbi is the official name of the Chinese currency, meaning “the people’s currency.” Yuan is the name of a unit of the Renminbi.)
The move signals a shift in the bank’s monetary policy which may indicate that the country is moving towards a more market-oriented approach for its currency, which Beijing has been hinting at, as believed by financial analysts.
Lets start with some basic macroeconomics so that we can understand the issue better.
Depreciation and devaluation are two economic events that deal with the value of a country’s currency. Both these situations cause the value of the currency to drop vis-a-vis the rest of the world. However, they have two different causes and long-term effects on the economy.
Depreciation
Depreciation happens in countries with a floating exchange rate. A floating exchange rate means that the global investment market determines the value of a country’s currency. As of 2012, all major economies use a floating exchange rate. Depreciation occurs when a country’s exchange rate goes down in the market. The country’s money has less purchasing power in other countries because of the depreciation.
Devaluation
Devaluation happens in countries with a fixed exchange rate. In a fixed-rate economy, the government decides what its currency should be worth compared to that of other countries. The government pledges to buy and sell as much of its currency as needed to keep its exchange rate the same. If a government decides to make its currency less valuable, the change is called devaluation. China was the last major economy to openly use a fixed exchange rate. It switched to a managed floating system in 2005.
Long-Term Effects
While depreciation and devaluation have the same immediate impact, they have different long-term effects. A drop in the currency’s value generally improves a country’s economy as people spend more domestically and countries buy more, leading to an increase in exports. In a floating economy that faces depreciation, this spending boost makes the country look better, for investors. They’ll want to buy more of the currency and push its value back up, cancelling out some, if not all the depreciation. This can’t happen in a fixed-rate economy as only the government can change rates. While this can keep a boom going longer, it also increases the risk of inflation as the government must keep printing money to keep its exchange rate from rising.
Theory
Currency exchange rates are determined in one of two ways. Most countries, like India, have a floating exchange rate. The government has limited ability to indirectly influence the exchange rate like selling and buying Dollars in open market. Few nations like China have an exchange rate that is “fixed in some way or the other by authorities.”
In China, the bank determines the Yuan’s exchange rate based on its own basket of foreign currencies, which economists tend to believe is primarily made up of the U.S. Dollars. Generally, the Central Bank allows the Yuan to move two per cent above or below the rate it sets for that day, which it calls the daily fixing. But of late, it has been following a strong-Yuan policy, designed to encourage more imports and consumer spending.
360 Degree View
[su_pullquote align=”left”]China has adopted an export Led economic growth model which ran successfully for the last two decades, making it the second largest economy after the US. But this dream run has started losing to reality since last year.[/su_pullquote]
China has adopted an export Led economic growth model which ran successfully for the last two decades, making it the second largest economy after the US. But this dream run has started losing to reality since last year. In 2014, China’s economic growth fell to 7.4 per cent, a notable drop from years of double-digit growth. In July, exports fell by 8.3¹ per cent and the country’s manufacturers are seeing their fourth year of price deflation as reported by Reuters. In the first and second quarters, Chinas economy grew at an annual rate of 7 per cent, the slowest pace in six years. A weaker currency would help make Chinese exports competitive.
Then the Shanghai Stock Exchange fell steeply, losing 30 per cent² of its value in June, and then plunged more than eight per cent in one day.
The Chinese government has already taken several steps to remedy its economic downturn, says Peter Dungan, an economics professor at the University of Toronto’s Rotman School of Management. “This is not just one thing, one time.”
The central bank lowered interest rates³ a number of times since November 2014. Most recently, in June, it cut the rate for both one-year loans by commercial banks and for one-year deposits by 25 basis points. The bank also lowered reserve requirement ratios for small businesses. A few months prior, it had done the same for banks to free up more of their money for lending.
Finally, India rose and the flurry of the Modi Governments initiatives led fear to creep into the Chinese think tank- that of losing the worlds manufacturing hub.
What impact will it have?
The intended effect of the lowered exchange rate is to boost exports. Local Chinese businesses could also benefit as imported goods would prove too costly for most consumers. But that can only be true in the short run. Though past experience has shown how these measures dont last long, in the short term, it has the potential to disrupt many other Asian currencies.
One of the concerns is that China now appears to be entering the currency war and that others may follow suit, perhaps by using other monetary tools like lending rates to attempt to influence their currencies, as the Bank of Canada did earlier this year, which led to the falling Dollar.
Same sentiments were expressed by RBI Governor Raghuram Rajan4 recently when he termed devaluation of currencies as a “worrisome trend”. He said at the second SBI Banking and Economics Conclave, I think more generally across the globe, because of a weak demand, we’ve seen significant efforts to depreciate currency, you can call it monetary policy or direct exchange rate intervention. That’s a worrisome trend. The Chinese move raised some questions about the true strength of its economy too.
Is China really moving towards a market-based rate?
The modern equivalent of that Hippocratic maxim is: “Desperate times call for desperate measures.” Though that is what it appears to be, the real reason behind it is much deeper than it appears to be. The stated purpose for the move was market reform. The central bank said this was a one-time move to enhance the market-orientation and benchmark status of the Renminbi.
[su_pullquote align=”right”]China wants the IMF to include its currency in the Special Drawing Rights. The IMF has insisted that China needs a floating exchange rate to be admitted into the pool of currencies in the SDR5.[/su_pullquote]
Before the end of this year, the International Monetary Fund (IMF) will decide whether to include the Renminbi in its special drawing rights- a global reserve asset comprising the Dollar, Euro, Pound, and Yen. Inclusion would mean endorsing the Renminbi as a formal reserve currency. China wants the IMF to include its currency in the Special Drawing Rights. The IMF has insisted that China needs a floating exchange rate to be admitted into the pool of currencies in the SDR5.
Previously, the Peoples Bank of China (PBoC) would set the currency wherever it liked. Now it will give markets a voice: the daily fix will refer to the closing rate of the interbank foreign exchange market on the previous day.
China’s move to devalue its currency is perhaps a step in the right direction to meet those conditions. In doing so, China has killed two birds with one arrow. Some say it is master stroke. On one hand, it has saved the dropping exports while on other it has shown IMF that they are moving towards market reform. But will the reform continue in future? Only time will tell.
In response to criticism, China in a statement to the IMF released this Saturday, said its exchange-rate regime will be improved in a gradual and controllable manner. Exchange-rate flexibility will gradually increase, with attention paid to the value of a basket of currencies. The statement added that since currency reforms in July 2005, the Yuan, in fact, had appreciated by 7% against the Dollar as of March this year.
Can China follow this policy for long term?
Chinese know that the positive impact of currency devaluation on export growth will be minimized not only by competitive devaluation both by partner nations and competitors, but also by tariff and non-tariff barriers. Indian metal producers have already called for raising import tariffs to protect the domestic Industry. And countries like India, which already have a large trade deficit with China, are unlikely to allow any further widening of the gap between export and imports. Given such a scenario, it is unlikely that the Chinese would venture too far and unleash an impractical currency war that would only hurt global trade where it has much larger stakes than most other nations.
Impact on India!
The two fold impact appears to be a problem for policy makers here, although consumers might enjoy cheap inflow of mobiles, electronics and toys. But for policy makers it will hamper Indian exports which are already in doll drums. Cheap imports will adversely impact the trade deficit with China. Further devaluation of Yuan would make the depreciating Rupee more volatile, thereby adversely impacting the current account and the stock market. Also, such downward pressure on the Rupee would lead to higher import prices and inflation though the caution is that oil prices (the biggest component of Indias Import bill) are hovering around $50. Another silver lining may be the volatility of the Chinese stock market. The unstable economic condition may lure investors towards India thereby increasing the inflow of dollars.
Conclusion
This week, even before China’s currency move, the San Francisco branch of the U.S. central bank issued a report titled Is China’s Growth Miracle Over? , warning that the Asian giant may follow the path of the smaller Asian Tigers economies like those in South Korea or Taiwan into lower growth.
“With an aging population, slowing productivity growth and the policy adjustments required to implement structural reforms, growth is projected to slow further,” says the report’s author Zheng Liu.
And while it would be wonderful if China can indeed follow the path of Japan and South Korea into middle class stability, it is not clear if the path will be easy.
[su_divider style=”double”]So Marcos Rojo might have some explaining to do when wife Eugenia Lusardo asks why he quite is so excited in this Instagram post.[/su_divider]
Sources
1http://www.dailyherald.com/article/20150824/business/150829411/http://www.dailyherald.com/article/20150824/business/150829411/
2http://www.abc.net.au/news/2015-07-03/panic-on-chinas-share-market-as-stocks-lose-3-7-trillion/6594316
3http://www.bloomberg.com/news/articles/2015-08-25/china-lowers-interest-rates-for-fifth-time-since-november
4http://articles.economictimes.indiatimes.com/2015-08-20/news/65667149_1_rbi-governor-raghuram-rajan-currency-stock-markets
5http://www.cbc.ca/news/business/china-s-currency-devaluation-what-you-need-to-know-1.3188290