China devalued its currency, the Yuan


Ajit Kumar AJIT KUMARWISDOM IAS, New Delhi.

After devaluation of its currency by1.9%  a day earlier, China lowered its “daily fix” of the Yuan (CNY) on August 12, 2015 to 6.3306 per US dollar, a further decline of 1.6%. The Yuan is allowed to trade at plus or minus 2 percent around this midpoint. The first move pushed the Yuan down by another 1.4 percent to 6.4151 in onshore markets.
The People’s Bank of China (PBOC)  had described the devaluation as a one-off step to make the Chinese Yuan (aka renminbi) more responsive to market forces, sought to reassure financial markets and that it was not embarking on a steady depreciation.
The devaluation had sparked fears of a global currency war and accusations that Beijing was unfairly supporting its exporters.
In China, the PBOC 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. dollar. 
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 more often of late it has been following a strong-yuan policy, designed to encourage more imports and consumer spending.
Reactions around the World
The Chinese central bank's move to let its rate fall is "revolutionary," says Donald Brean, a finance and business economics professor at the Rotman School of Management, as it is "moving more towards market signals." The move hints at the beginnings of reform where eventually the exchange rate could be set solely by market forces, like in Canada, rather than a combination of that and government intervention, Brandt says. "Time will tell."
The International Monetary Fund said China's move to make the Yuan more responsive to market forces appeared to be a welcome step and that Beijing should aim for an effectively floating exchange rate within two to three years. Beijing has been lobbying the IMF to include the Yuan in its basket of reserve currencies known as Special Drawing Rights(SDRs), which it uses to lend to sovereign borrowers, a major step in terms of international use of the Yuan.
"Greater exchange rate flexibility is important for China as it strives to give market forces a decisive role in the economy and is rapidly integrating into global financial markets," an IMF spokesperson said.
The devaluation was decried by US lawmakers as a grab for an unfair export advantage.
According to Wall Street Journal, devaluation of Chinese currency would help it increase its export and will pressure China’s direct trade rivals, such as South Korea and Japan, to follow suit and let their own currencies fall.
The New York Times explained that China took such a decision for its economy to remain on an even keel, keeping growth and employment high and for its currency to become globally pre—eminent, helping promote the country’s diplomatic goals and solidifying the country’s centrality to the global economy.
"I don't think this is a reaction to the weak trade data over the weekend, I think it's because of the SDR," said Zhou Hao of Commerzbank AG in Singapore. The Chinese government "needs to have a market-based mechanism and it needs volatility," he said.
Indian Industry body Assocham said Yuan's devaluation could lead to a full-fledged "currency war". For India, the devaluation in the Yuan will prove to be a "triple whammy" as rupee volatility will increase, exports will come under pressure and there will be dumping of Chinese goods in India, it added.
What did China do?
China tightly controls the value of its currency by setting a daily rate for the Yuan versus the dollar. In China’s domestic market, traders are allowed to push the Yuan 2% stronger or weaker for the day. But the People’s Bank of China often ignores those market signals when it sets the next day’s rate, sometimes setting the Yuan stronger versus the dollar when the market is signaling it sees the Yuan as weaker. The central bank said it will now take the previous day’s trading into account.
Why did China do it?
In its statement, the PBOC said it wants to bring the Yuan more in line with the market. But the move also comes as China’s important export sector has weakened – and overall economic growth looks sluggish. Chinese July exports fell 8.3% compared with a year ago. A weaker currency helps China’s exporters sell their goods abroad.
What does this mean for the rest of the world?
The most immediate effect is that it signals to the world that Beijing thinks the Chinese economy is sputtering. The move suggests China is looking for ways to get it going again. But it also has major implications for the U.S. and other countries that trade with China because it puts their companies at a disadvantage. In the U.S., it will likely reignite criticism that Beijing keeps the currency artificially low to help its own manufacturers – a charge that could get added impetus during the presidential election campaign.
What does this mean for Currency Markets?
The move puts pressure on other central banks around the world to push down their own currencies to help their own exporters and to prevent destabilizing capital flows. The move could hurt commodities markets because it signals potential weak demand from China. It could also accelerate capital outflows out of China, especially if investors expect further devaluations.
What impact will it have on China?
The intended effect of the lowered exchange rate is to boost exports from the country to make Chinese exports less expensive and thus, more desirable. Local Chinese businesses could also benefit as imported goods could prove too costly for most consumers. However, "in the short run, it's very difficult to say" if the strategy will work for China.
One of the concerns is that China now appears to be entering the currency wars 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.
If one country goes ahead and devalues their currency, then everyone feels like they need to devalue their currency even more to remain competitive with them.
In some ways, China is coming late to this game. Japan embarked on the devaluation of its yen two years ago, using U.S.-style quantitative easing to drive down its value, and Britian and the European Central Bank have also deployed monetary polices aimed at bringing down the value of the pound and euro as well.
What impact will it have on India?
The fall in the Yuan -- despite a central bank statement that it will keep the currency stable -- implied that more depreciation could be in the offing. This raised dollar demand globally, including in India, weakening the rupee. Exchange rates, after all, are a function of demand and supply.
(i) Rupee volatility: The sharp fall in the rupee has already rattled stock markets, which fell for a fourth straight session today. If the rupee continues to fall sharply, imports will become costlier, stoking inflation. This will force the Reserve Bank to hold on to high interest rates, which will hamper the ongoing economic recovery. Since India runs a trade deficit (imports are more than exports), chances are the current account deficit will also rise, which will further pressure the rupee. Falling rupee is bad for those companies that have dollar-denominated loans and also for foreign flows because stock market returns become unattractive.
(ii) Pressure on exports: In normal course, falling rupee would have aided domestic exports, which have contracted for seven straight months until June 2015. However, analysts are betting against a rise in domestic exports because of a global slowdown. The fact that China and India compete for several export items such as textiles, gems and jewellery, etc. will also go against domestic exporters, analysts say. "The large overlap between Indian and China in markets and also products highlights the threat Indian exporters face from China," said DK Pant, chief economist of India Ratings and Research. The economic slowdown in China - which is among the top five countries for Indian exports - is another negative for Indian exporters, analysts say.
(iii) Dumping of Chinese goods: There's fear that the sharp devaluation in yuan will help China dump goods into the Indian market, which will impact domestic manufacturers. The fear is already playing out on the Dalal Street with tyre stocks and steel makers falling sharply over the last two days.
Currency War
Currency war is when a nation's central bank uses expansionary monetary policy to deliberately lower the value of its currencies. Low currency values aid exports by making them cheaper in comparison to other currencies.
It is a term coined in 2010 by Brazil’s Finance Minister Guido Mantega to describe the competition between the United States and China to have the lowest value for their currencies.
The U.S. allows its currency, the dollar, to devalue by expansionary fiscal and monetary policy. It's doing this through increased spending, thereby increasing the debt, and by keeping the Fed funds’s rate at virtually zero, increasing credit and the money supply. However, since the U.S. dollar is the world's reserve currency, investors buy it during uncertain economic times as a safe haven. As a result, the dollar strengthened 15% during 2014.
China keeps its currency low by pegging it to the dollar, along with a basket of other currencies. It keeps the peg by buying U.S. Treasuries, which limits the supply of dollars, thereby strengthening it. This keeps the Yuan low by comparison.
Japan stepped onto the battlefield in September 2010. 
The European Union entered the currency wars in 2013, to boost its exports and fight deflation. The European Central Bank (ECB) lowered its rate to .25% on November 7, 2013. This drove the euro to dollar conversion rate to $1.3366.
The Alternatives of Dollar
(i) Gold Standard
A currency defined entirely in terms of gold. Its value is determined by demand and supply.
Pros: Long-term price stability; fixed exchange rates spurs trade; eliminates central planning.
Cons: Limited global gold reserves. Supply of gold (money) will not keep pace with demand. Critics point out that the average was higher during the gold standard compared to modern monetary standards.
(ii) IMF Special Drawing Rights
An international reserve asset (used like a reserve currency). Consists of the euro, yen, pound and U.S. dollar. Serves as a unit of account.
Pros: Nobel Laureate Joseph Stiglitz advocates the creation of a new global reserve system based on SDRs; it boosts global liquidity in a crisis by supplementing standard reserve currencies; China is pushing for SDRs to dethrone the supremacy of the U.S. dollar.
Cons: Hasn’t gained widespread acceptance in replacing the U.S. dollar as the de facto reserve currency.
(iii) Basket of Currencies
A broad selection of international currencies, including currencies of the BRIC bloc, whose weighted average determine the value of the obligation.
Pros: Shared reserve currency creates diversification of risk; exchange rates are pegged to the basket; minimizes trade wars. 
Cons: Requires extraordinary international co-operation.
 
 
 
 


Thursday, 13th Aug 2015, 08:00:41 PM

Add Your Comment:
Post Comment