The Impact of China Devaluing the Yuan in 2015

On August 11, 2015, the People’s Bank of China (PBOC) surprised markets with three consecutive devaluations of the Chinese yuan renminbi (CNY), knocking over 3% off its value. Since 2005, China's currency had appreciated 33% against the U.S. dollar.

The first devaluation marked the most significant single drop in 20 years. The move was unexpected, and many believed it was a desperate attempt by China to boost exports in support of an economy that was growing at its slowest rate in decades. However, the PBOC claimed that the devaluation was part of its reforms to move toward a more market-oriented economy. The move had substantial repercussions worldwide.

Surprised Markets

After a decade of steady appreciation against the U.S. dollar, investors had become accustomed to the yuan's stability and growing strength. The drop, which amounted to 4% over the subsequent two days, was small by stock market standards. However, many speculators in foreign exchange (forex) markets use a high amount of leverage.

Stock markets in the U.S., Europe, and Latin America also fell in response to the yuan devaluation. Most currencies also reeled. Some argued that the move signaled an attempt to make exports look more attractive, even as the Chinese economy's expansion slowed. However, the PBOC indicated that other factors motivated the devaluation.

Effect on the IMF

Chinese President Xi Jinping had pledged the government’s commitment to reform China’s economy in a more market-oriented direction when he first took office in March 2013. That made the POBC's claim that the devaluation's purpose was to allow the market to be more instrumental in determining the yuan's value more believable.

The devaluation announcement came with official statements from the PBOC that as a result of this "one-off depreciation," the "yuan's central parity rate will align more closely with the previous day's closing spot rates." Furthermore, it was aimed at “giving markets a greater role in determining the renminbi exchange rate with the goal of enabling deeper currency reform."

At the time, Professor Eswar Prasad of Cornell University indicated that the move was also consistent with China’s “slow but steady” market-oriented reforms. The currency devaluation was one of many monetary policy tools the PBOC employed in 2015, which included interest rate cuts and tighter financial market regulation.

There was also another motive for China's decision to devalue the yuan—China's determination to be included in the International Monetary Fund's (IMF) special drawing rights (SDR) basket of reserve currencies. The SDR is an international reserve asset that IMF members can use to purchase domestic currency in foreign exchange markets to maintain exchange rates. The IMF reevaluates the currency composition of its SDR basket every five years. In 2010, the yuan was rejected on the basis that it was not freely usable. The IMF welcomed the devaluation, encouraged by the claim that it was done in the name of market-oriented reforms. Consequently, the yuan became part of the SDR in 2016.

Within the basket, the Chinese renminbi had a weight of 10.92%, which is more than the weights of the Japanese yen (JPY) and U.K. pound sterling (GBP), at 8.33% and 8.09%, respectively. The rate of borrowing funds from the IMF depends on the interest rate of the SDR. As currency rates and interest rates are interlinked, the cost of borrowing from the IMF for its member nations would now hinge in part on China's interest and currency rates.

Skeptical Views

Despite the IMF’s response, many doubted China’s commitment to free-market values, arguing that the new exchange rate policy was still akin to a managed float. Some charged that the devaluation was just another intervention, and the yuan’s value would continue to be closely monitored and managed by the PBOC.

Also, the devaluation occurred just days after data showed a sharp fall in China’s exports—down 8.3% in July 2015 from the previous year. That provided evidence that the government's slashing of interest rates and fiscal stimulus had not been as effective as hoped. Thus, skeptics rejected the market-oriented-reform rationale. Instead, they interpreted the devaluation as a desperate attempt to stimulate China's sluggish economy and keep exports from falling further.

China's economy depends heavily on its exported goods. By devaluing its currency, the Asian giant lowered the price of its exports and gained a competitive advantage in the international markets. A weaker currency also made China's imports costlier, thus spurring the production of substitute products at home to aid domestic companies.

The U.S. government was particularly incensed because many U.S. politicians had been claiming for years that China had kept its currency artificially low at the expense of American exporters. Some believed that China's devaluation of the yuan was just the beginning of a currency war that could increase trade tensions.

Consistent with Market Fundamentals

Although a lower-valued yuan would give China somewhat of a competitive advantage, trade wise, the move was not wholly counter to market fundamentals.

Over the past 20 years, the yuan had been appreciating relative to nearly every other major currency, including the U.S. dollar. Essentially, China’s policy allowed the market to determine the direction of the yuan's movement while restricting the rate at which it appreciated. However, China's economy had slowed significantly in the years before the devaluation. On the other hand, the U.S. economy had improved. A continued rise in the yuan’s value no longer aligned with market fundamentals.

Understanding the market fundamentals clarifies that the small devaluation by the PBOC was a necessary adjustment rather than a beggar-thy-neighbor manipulation of the exchange rate. While many American politicians grumbled, China was actually doing what the U.S. has prodded it to do for years—allow the market to determine the yuan's value. While the drop in the yuan's value was the largest in two decades, the currency remained stronger than it had been in the previous year in trade-weighted terms.

Impact on Global Trade Markets

Currency devaluation is nothing new. From the European Union to developing nations, many countries have devalued their currency periodically to help cushion their economies. However, China's devaluations could be problematic for the global economy. Given that China is the world’s largest exporter and its second-largest economy, any change that such a large entity makes to the macroeconomic landscape has significant repercussions.

With Chinese goods becoming cheaper, many small- to medium-sized export-driven economies could see reduced trade revenues. If these nations are debt-ridden and have a heavy dependence on exports, their economies could suffer. For instance, Vietnam, Bangladesh, and Indonesia greatly rely on their footwear and textile exports. These countries could suffer if China's devaluations make its goods cheaper in the global marketplace.

Impact on India

For the Indian economy, a weaker Chinese currency had several implications. As a result of China's decision to let the yuan fall against the dollar, demand for dollars surged worldwide. That included India, where investors bought into the greenback's safety at the expense of the rupee. The Indian currency immediately plunged to a two-year low against the dollar and remained low throughout the latter half of 2015. The threat of greater emerging market risk due to the yuan devaluation led to increased volatility in Indian bond markets, which triggered further weakness for the rupee.

Usually, a declining rupee would aid domestic Indian manufacturers by making their products more affordable for international buyers. However, in the context of a weaker yuan and slowing demand in China, a more competitive rupee is unlikely to offset weaker demand going forward.

Additionally, China and India compete in several industries, including textiles, apparel, chemicals, and metals. A weaker yuan meant more competition and lower margins for Indian exporters. It also meant that Chinese producers could dump goods into the Indian market, thereby undercutting domestic manufacturers. India had already seen its trade deficit with China nearly double between 2008 to 2009 and 2014 to 2015.

As the world’s largest energy consumer, China plays a significant role in how crude oil is priced. The PBOC’s decision to devalue the yuan signaled to investors that Chinese demand for the commodity, which had already been slowing, would continue to decline. The global benchmark Brent crude fell more than 20% after China devalued its currency in mid-August.

For India, every $1 drop in oil prices resulted in a $1 billion decline in the country’s oil import bill, which stood at $139 billion in the fiscal year 2015. On the flip side, falling commodity prices made it much more difficult for Indian producers to remain competitive.

Charges of Currency Manipulation

The Chinese yuan generally depreciated against the U.S. dollar between 2015 and 2019, leading to charges of currency manipulation. The U.S. Treasury Department officially named China a currency manipulator on August 5, 2019. It was the first time the U.S. had done so since 1984. However, the U.S. lifted the currency manipulator label in early 2020. According to then-U.S. Treasury Secretary Steven Mnuchin, “China has made enforceable commitments to refrain from competitive devaluation, while promoting transparency and accountability.”

The Bottom Line

China's main justification for devaluing the yuan in 2015 was the rise of the U.S. dollar. Other reasons included the country's desire to shift toward domestic consumption and a service-based economy. While fears of further devaluations continued on the international investment scene for another year, they faded as China's economy and foreign exchange reserves strengthened in 2017. The negative impact of currency devaluations on relations with the U.S. also contributed to China briefly being labeled as a currency manipulator in 2019 and early 2020.