On August 5, 2019, the People's Bank of China set the yuan’s daily reference rate below 7 per dollar for the first time in over a decade. This, in response to new tariffs of 10% on $300 billion worth of Chinese imports imposed by the Trump administration, set to go into effect September 1st, 2019. Global markets sold off on the move, including in the U.S. where the DJIA lost 2.9% in its worst day of 2019 to date.
It is just the latest salvo in the U.S. China trade war, but certainly not the first time China has devalued its currency.
- After a decade of a steady appreciation against the US dollar, investors had become accustomed to the stability and growing strength of the yuan.
- China’s President Xi Jinping had pledged the government’s commitment to reform China’s economy in a more market-oriented direction since he first took office in March 2013.
- Despite the IMF response, many doubted China’s commitment to free-market values arguing that the new exchange rate policy was still akin to a “managed float."
The U.S. Treasury Department officially named China a currency manipulator on August 5th, 2019. It was the first time the U.S. had done so since 1984. While mostly a symbolic move, the naming opens the door for the Trump administration to consult with the International Monetary Fund to eliminate any unfair advantage China's currency moves have given the country.
On August 11, 2015, the People’s Bank of China (PBOC) surprised markets with three consecutive devaluations of the yuan renminbi or yuan (CNY), knocking over 3% off its value. Since 2005, China’s currency had appreciated 33% against the U.S. dollar, and the first devaluation marked the most significant single drop in 20 years. While the move was unexpected and believed by many to be a desperate attempt by China to boost exports in support of an economy that was growing at its slowest rate in a quarter century, the PBOC claimed that the devaluation was part of its reforms to move towards a more market-oriented economy. The move had substantial repercussions worldwide.
After a decade of a steady appreciation against the US dollar, investors had become accustomed to the stability and growing strength of the yuan. Thus, while a somewhat insignificant change for Forex markets, the drop – which amounted to 4% over the subsequent two days – rattled investors.
U.S. stock markets and indexes, including the Dow Jones Industrial Average (DJIA), the S&P 500, and European and Latin American markets fell in response. Most currencies also reeled. While some argued that the move signaled an attempt to make exports look more attractive, even as the Chinese economy's expansion slowed, the PBOC indicated that other factors motivated the devaluation.
Effect on the IMF
China’s President Xi Jinping had pledged the government’s commitment to reform China’s economy in a more market-oriented direction since he first took office in March 2013. That made the POBC’s claim that the purpose of the devaluation 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," which 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, a professor at 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 re-evaluates 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.” But the devaluation, supported by the claim that it was done in the name of market-oriented reforms, was welcomed by the IMF, and the yuan did become 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 188 member nations would now hinge in part on China's interest and currency rates.
Despite the IMF 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 – 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 of interpreting the devaluation as a desperate attempt to stimulate China's sluggish economy and keep exports from falling further.
China's economy depends significantly on its exported goods. By devaluating 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 the domestic industry.
Washington 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 lead to increasing trade tensions.
Consistent with Market Fundamentals
Although a lower-valued yuan does would give China somewhat of a competitive advantage, trade wise, the move was not totally counter 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 is appreciated. But, as China’s economy had slowed significantly in the years prior to the devaluation while 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 value of the yuan 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 India in particular, 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 around the globe, including in India, where investors bought into the safety of the greenback 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 as a result of 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, apparels, 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, particularly highly leveraged companies operating in the steel, mining and chemical industries. Also, it was reasonable to expect the yuan depreciation would lead to further weakness in the price of other commodities that India imported from China making it all the more difficult for India to remain competitive both domestically and internationally.
The Bottom Line
China's justification for devaluing the Yuan in 2015 was the rise of the U.S. dollar, and the country's desire to shift to domestic consumption and 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. However, China's recent moves in 2019 will continue to send ripples across global financial systems, and rival economies should brace themselves for the after-effects.