The Ripple Effect behind the Yuan’s Devaluation

A month ago, in my previous article on How China’s slowing economy could drag down the global economy, we talked about China cutting its growth target for 2015 to 7%, which would be the slowest expansion in more than two decades. Today, we learnt that China may have difficulties to even meet this this growth target.

In the Chinese domestic market, traders are allowed to push the yuan 2% stronger or weaker for the day. However the People’s Bank of China (PBOC) often ignore those market signals when it sets the rate for the next day, sometimes deliberately setting the yuan stronger than the dollar when the market indicates otherwise. As such, China has been having a semi-fixed exchange rate where exchange rate is not determined as expected by market forces. No doubt, maintaining such a tight monetary policy has seen China tiding through times of market turmoil like the Asia financial crisis and the Global Financial crisis.

However, it appears that the recent slowdown from the global economy is deepening such that China has finds it increasingly difficult to maintain its fixed rate. After the announcement that the central bank will now take the previous day’s trading into account, it attributed to the first decline of the yuan on Aug 11, 2015.

For the first time since officially de-pegging from the U.S. dollar in 2005, the Chinese Yuan/Reminbi went 1.9% down from 6.11 yuan per U.S. dollar to 6.22. That was the biggest one-day drop in a decade.

China stuns – not once, not twice but thrice in a row

A day after Aug 11 record of 1.9% devaluation however, China’s Central Bank has once again cut the rate for their national currency where it fell by another 1.6% the next day.

And as if it was not enough, the third cut came on Aug 13, with the rate being 6.40 against the greenback, down by another 1.1%.

It is inevitable that the first thought that comes to mind for such a move is that the Chinese government is deliberately devaluing its currency in an attempt to make exports more competitive in the world market. This new rate that marks the biggest three-day decline against the U.S. dollar in more than two decades, was said to be meant for boosting exports. This must have been after the Chinese government found out from a string of poor economic data that showed previous efforts to boost exports and growth had failed.

However, Jonathan Anderson, at Emerging Advisors Group, one of the clearest observers of China’s market clarified that China has been wanting its yuan to rise steadily against trade-weighted partners, and in order to keep its appreciation gradual as the dollar rockets upwards, it may have to devalue slightly. He added that “any attempt to gain truly meaningful competitiveness vis-à-vis trading partners would require a 20% – 40% devaluation against the dollar.”

While it seems that China may be playing a different ball game now by simply keeping its currency more aligned with trading partners’ currencies, central to this was a bid to have its yuan accepted into the IMF’s basket of reserve currencies, known as Special Drawing Rights, which it uses to lend to sovereign borrowers. The International Monetary Fund also welcomes China’s move to make the yuan more market-oriented and said that Beijing should aim to achieve an effectively floating exchange rate within the next two to three years.

Conflicting Goals for Exchange Rates

It is not a surprise that China wants to project itself more strongly around the world when it could boost the international use of yuan for political purposes. However, Chen Long of Gavekal Dragonomics in Hong Kong has explained that China sometimes have similar yet competing goals on exchange rate. On the domestic level, a weaker currency can definitely help to make exports more competitive yet, it wants to maintain a strong currency to prevent capital outflows which may weaken the economy further. On the international level, China would definitely wish to avoid a currency war with the U.S. as well, all of which is not entirely impossible if it had destabilized its currency relentlessly.

As China is the world’s largest consumer of commodities, a subtle shift of weight, a lowering of the hands, a leaning forward, a glance, and that is enough to set off a chain of events. A decision to devalue their currency in three consecutive days has sparked concerns of a currency war which could see other countries lowering their currencies to mitigate the negative impact of a weaker yuan on their exports. Although this has brought a momentary shock to the financial markets, its longer term effects has yet to be felt around the globe.

Winners and Losers

Without a doubt, there are bound to be winners and losers from this devaluation. The effects may be immediate where Chinese exporters, particularly textile and automobile companies, could become more competitive; foreign importers for goods that are “Made in China” are likely to find Chinese goods and services cheaper, and a devalued yuan may also boost their tourism sector to attract more tourists.

A more prolonged effect is that China’s unquenchable demand for natural resources has been one of the main factors in supporting the price of oil and commodities in recent years. With what seemed like a distress call from China’s devaluation, the economy may indeed be weaker than it appears. Oil prices have previously been under pressure for several months due to oversupply concerns, but the slump has just plummeted further in recent weeks on fears and uncertainties that the slowdown in the Chinese economy and its impact on global markets and energy demand is deepening. For the first time since Feb 2009, oil prices settles below $39 per barrel. Matt Parry, a senior oil analyst at the International Energy Agency in Paris mentioned in an email that China’s risk has been pretty much factored into oil prices from a pure demand perspective. Of course, we need not explain further what cheaper oil prices could translate to consumers like us. (You may also refer to “Will Oil Prices Recover in 2015?” to find out more.)

With the yuan cheapening, Chinese companies would have to pay more interest on debts as foreign currencies are now deemed more costly. China may also import lesser foreign goods and services, luxury goods in particular, as they are now deemed more expensive to Chinese consumers.

While currency devaluation may boost exports in the short term, it may not only be the solution to revive its economy as exporters like South Korea and Taiwan are hurting because of the weak demand. Vietnam for one, has already responded by widening the band of their currency to allow it to weaken against the greenback. Sluggish economies in Europe and the U.S. influence China’s exports as well and it certainly puts pressure on central banks around the world to devalue their currency in response to help their own exporters and to prevent any destabilizing of capital flows. While it may be still too early to say, a currency war may very well ensue if demand in Asian economies and the West were to wane further.

What yuan move means for the Fed’s rate hike

While China’s slowing economy is shown to be deepening, the U.S. economy on the other hand, is strengthening to the extent that there has been speculations whether what the yuan devaluation means for interest rate hike. A currency war (if ensued) may affect the Fed’s decision to raise interest rates as people would now see the strong dollar as more expensive and the rise in interest rates may not only be unable to improve capital inflow, it may hurt the U.S. exports as well. Of course, not all agree that higher interest rates spell doom. If the tightening of the monetary policy is gradual as what the Fed may do, then emerging markets may possibly perform better than expected since higher rates in the U.S. have been positively correlated with returns on emerging market currencies and with increasing risk appetite. After all, the U.S. economy is strengthening and raising rates is indeed necessary to curb inflation. We know that the Fed would definitely not want to forestall their recovery by a sudden increase in interest rates, so long as they raise the rates in a very gradual and gentle manner, it is likely that people would still be able to take the pinch better than a punch.

Regardless of what happens then, we know today that by devaluing its currency three days in a row, China has changed the way the game is played. Whether the game will continue to spiral upwards in complexity and reaction and twitch and rise, it is now the turn of other countries (players), including the U.S. to play the ball in their court.

 

References

Anonymous. 2015. “China’s yuan currency fall for a second day.” BBC.

Cendrowski, S. 2015. “Here’s why China devalued its currency.” Fortune.

Curran, E. 2015. “Why China Devalued the Yuan.” Bloomberg Business.

Davies, G. 2015. “Is China changing its exchange rate policy?” The Financial Times Blog.

Inman, P., Farrer, M. and Ryan, F. 2015. “China stuns financial markets by devaluing yuan for second day running.” The Guardian.

Johnson, S. 2015. “Rising US rates ‘good news for emerging markets.’” The Financial Times.

Kok, C. 2015. “How devaluation of yuan affects other economies.” AsiaOne Business.

Sjolin, S. and Yep, E. 2015. “Oil settles below $39 a barrel for the first time since Feb 2009.” Marketwatch.

Tejada,C. 2015. “5 Things to Know About China’s Currency Devaluation.” The Wall Street Journal.

The Economist. 2015. “Yuan thing after another.”

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