On Aug. 11, 2015, the People’s Bank of China (PBOC) surprised markets with three consecutive devaluations of the yuan renminbi or yuan for short (CNY), knocking over 3% off its value. Since 2005, China’s currency has appreciated 33% against the U.S. dollar, and the first devaluation marked the largest 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 is all part of its reforms to move towards a more market-oriented economy. The move had serious repercussions around the world.
Surprised MarketsAfter 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 in the grand scheme of Forex things, the drop – which amounted to 4% over the next two days – had investors rattled.
U.S. stock markets and indexes, including the Dow Jones Industrial Average (DJIA) and the S&P 500, as well as European and Latin American markets, fell in response. Most currencies were set reeling as well. While some argued that the move signaled an attempt to make exports look more attractive, even as the Chinese economy's expansion was bogging down, the PBOC indicated that the devaluation was motivated by other factors. (For more, see: China’s Economic Indicators, Impact On Markets.)
Effect on the IMFChina’s president Xi Jinping had pledged the government’s commitment to reforming China’s economy in a more market-oriented direction ever since he first took office over four years ago. That made the POBC’s claim that the devaluation was the result of measures taken 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, one professor at Cornell University indicated that the move was also consistent with China’s “slow but steady” market-oriented reforms. And in fact, the currency devaluation was one of many monetary policy tools the PBOC employed in 2015, including interest rate cuts and tighter financial market regulation.
There was another motive: China's determination to be included in the International Money Fund (IMF)’s 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 in order to maintain exchange rates. The IMF re-evaluates the currency composition of its SDR basket every five years, the last time being in 2010. At that time 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 at the end of the year.
Within in the basket, the Chinese renminbi has 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 will now in part hinge on China's interest and currency rates.
Skeptical ViewsDespite 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 devaluation was just another intervention and the yuan’s value would continue to be closely monitored and managed by the PBOC, they charged. Also, the devaluation occurred just days after data showed a sharp fall in China’s exports – down 8.3% in July from the previous year – evidence that the government's slashing of interest rates and fiscal stimulus had not been as effective as hoped. So, skeptics didn't buy the market-oriented-reform rationale, instead interpreting the devaluation as a desperate attempt to stimulate China's sluggish economy and keep exports from falling further.
China's economy still depends significantly on its exported goods. By devaluating its currency, the Asian giant makes exports cheaper and gains a competitive advantage in the international markets. A weaker currency also makes China's imports costlier, thus spurring production of substitute products at home and so aiding domestic industry.
Washington was especially incensed, as many U.S. politicians have been claiming for years that China has 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 FundamentalsDespite the fact that a lower-valued yuan does give China somewhat of a competitive advantage, trade-wise, the move wasn't totally out of line with 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. But, as China’s economy had slowed significantly in the last number of years while the U.S. economy has done relatively better, a continued rise in the yuan’s value no longer aligned with market fundamentals.
Understanding the market fundamentals allows one to see the small devaluation by the PBOC as a necessary adjustment rather than a beggar-thy-neighbor manipulation of the exchange rate. While many American politicians may grumble, China is actually doing what the U.S. has prodded it to do for years—allow the market to determine the yuan’s value. (For more, see: What Causes A Currency Crisis?). And, while the drop in the value of the yuan was the largest in two decades, the currency still remained stronger than it was the previous year in trade-weighted terms.
Impact On Global Trade MarketsCurrency devaluation is nothing new. From the European Union to developing nations, many countries have done so to help cushion their economies from time to time. That said, China's devaluations could spell trouble 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 tends to have serious repercussions.
With Chinese goods becoming cheaper, many small- to medium-sized export-driven economies may see their trade revenues reduced. And if these nations are debt-ridden and have a heavy dependence on exports, their economies could take a beating. For instance, Vietnam, Bangladesh and Indonesia greatly rely on their exports of footwear and textiles. They could be in serious trouble should China's devaluations make its goods cheaper in the global marketplace.
Impact on IndiaFor 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 dollar-to-rupee exchange rate referenced by the global currency markets strengthened more than 5% since mid-August. The threat of greater emerging market risk-off as a result of the yuan devaluation led to increased volatility in Indian bond markets, which triggered additional weakness for the rupee.
Normally 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 a number of industries, including textiles, apparels, chemicals and metals. A weaker yuan means more competition and lower margins for Indian exporters; it also means Chinese producers will be able to dump goods into the Indian market, thereby undercutting domestic manufacturers. India has already seen its trade deficit with China nearly double between 2008-2009 and 2014-2015.
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 crumble. In fact, global benchmark Brent crude has declined more than 20% since China devalued its currency in mid-August. For India, every $1 drop in oil prices results in a $1 billion decline in the country’s oil import bill, which stood at $139 billion in fiscal year 2015.
On the flip side, falling commodity prices are making it much more difficult for Indian producers to remain competitive, especially highly leveraged companies operating in the steel, mining and chemical industries. In addition, it is reasonable to expect the yuan depreciation will lead to further weakness in the price of other commodities that India imports from China, making it all the more difficult for India to remain competitive both domestically and internationally.
The Bottom LineDespite being critiqued for exchange-rate manipulation, China had a good reason for the 2015 devaluation of the yuan. With slower exports and a stronger U.S. dollar, allowing the yuan to depreciate was in line with market fundamentals and the desire of the nation's leaders to shift to a more domestic consumption- and service-based economy. While fears of additional devaluations continued on the international investment scene for another year, they faded as China's economy and foreign exchange reserves strengthened in 2017. But one lesson is ongoing: China's moves will likely keep sending ripples across global financial systems, and rival economies should brace themselves for the after-effects.
