Yuan Devaluation and its Aftermath

China was very well known as the sleeping dragon. But the events of the recent past have had us questioning the facts. It turned out to be an ailing Dragon, posing as a potentially powerful but technically weak economy.

China is a country with a tremendous labor force. This is a catalyst in making it a secondary sector oriented country i.e. major GDP arises from production and manufacturing. Yuan is managed by fixed exchange rate system while most of the developed and developing nations have flexible exchange rate system. Public Bank of China (PBC) sets the exchange rate irrespective of the market forces. The Chinese government maintained a fixed Dollar-Yuan rate to make the exports prosper. The government then infused more and more capital to increase capacities and be a major player in global exports. They had predicted a specific rate of growth for this to happen and to succeed.

The failures started at the prediction of the growth rate. The exports did not grow as predicted because the USA and the EU, the major importers of Chinese products, started facing a slowdown. The cycle at the sales side started slowing down leading to products lying unsold in the country and giving rise to idle capacities. As a result, recovery of the investment became difficult. Over-investment in various projects and infrastructure has led to ghost towns and unutilized production capacities, leaving the economy with an enormous pile of junk investments and less scope of recovering the same.

Amidst all these troubles, the Yuan remained put at its levels, meaning the global currencies kept falling with respect to Yuan. This further led to increased import costs as the global prices fell. A need arose to adjust the currency with the global forces of demand and supply.

The economic need was mixed with ambition. The ambition was to get Yuan to be included in the SDR (Special Drawing Rights) basket. The flexible exchange rate is a necessity; so that the currency can always remain convertible; for it to enter the basket.

And then in August 2015, the second largest economy in the world, China, devalued its currency for three straight days, from August 10 to 12, sending a shockwave in an already slowing global economy. Then began the big downfall.

Currency exchange rate is a significant factor in determining economic conditions. It affects not only the two countries whose exchange rates change but also other countries indirectly.

The already falling Shanghai Composite had a much larger fall and then, every major stock exchange went tumbling down when the Yuan was devalued. 7000 million worth of investment was wiped off the NSE (National Stock Exchange, India). NYSE, Hong Kong Stock Exchange, London Stock Exchange, Australian markets; were all in red. The investors’ confidence has reduced in China, which has led to the questioning of other emerging markets too. As a result, capital flight from emerging markets has increased leading the money back to the stable developed markets. This will make borrowing more costly for developing nations. The slowing down of the emerging markets shall result in prolonging and thus increasing the global debt repayments.

It’s a fact that devaluing Yuan has made Chinese products cheaper. Therefore, Chinese exports will get a major boost since lower prices will lead to an increased demand of Chinese products. The production houses in other countries shall again feel the pinch of cheap production costs. This will further result in a slowdown in the production capacities of EU and USA, developed but already faltering economies. This is because China would be preferred over the home facilities, as imports shall get cheaper, leading to economic deflations. Job opportunities shall reduce pushing the demand even lower. Revival through monetary policies shall be difficult since monetary and economic rates in several countries are already very low. This shall again affect the exports of China, as the global economy shall suffer from low demand and purchasing power. USA and EU are the main importers of Chinese products. As such, the world is already reeling under a flood of Chinese imports. This subsequent Renminbi (RMB) devaluation meant that China will begin exporting deflation.

Devaluing Yuan will make the imports for China expensive, demotivating citizens from purchasing foreign products. Nations exporting to China will feel the heat of reduced demands from

China. It wants to convert its economy from an only-investment economy to one, which increases its consumption along with keeping the production cycle running smoothly.

China was a major consumer of commodities and fuel until now, the basics required to boost its rapid infrastructure development and industrial production. Imports are costly, and a falling stock market led to an instant reduction in demand by China. This affected global steel and oil companies, reducing their market values and damaging the economies of their home countries.

The Southeast Asian regional economies are not free from deflation either. The weakening of the Yuan is not well received by China’s neighbors. The currencies of South Korea, Indonesia, Malaysia, Singapore, and Thailand fell to minimum levels immediately after the devaluation of Yuan. This could ignite a currency and trade war among nations in the region as well as several other nations.

The more pain this ailing dragon feels, it might burn several other economies until another fast-developing nation like India replaces the importance of China in the world economy. The devaluation of Yuan and its aftermath has clearly shown the dominance of China as a global power. A couple of years in the coming future will show if China reforms its economy back towards consolidation of its power, making it the Numero Uno country by its economic size, or will some other nation replace China and muscle it out of its current Numer-Two position.

By Mitul Shah and Abhay Goswami

PGPB Class of 2017

References:

China’s currency devaluation could spark ’tidal wave of deflation’, Heather Stewart, The Guardian, August 12, 2015.

Renminbi fallout threatens Asian neighbors, Steve Johnson, The Financial Times, August 14, 2015.

China’s Renminbi Devaluation May Initiate New Phase in Global Currency War, Peter Eavis, The New York Times, August 13, 2015.

The devaluation of the yuan tests China’s rise as a world power, Ariel Noyola Rodríguez, VoltaireNet, August 31, 2015.

Monday Market Mayhem, Ajit Ranade, Mumbai Mirror, August 25, 2015.

Black Monday, Zee News, August 24, 2015.

How Asian Nations Reacted to the Chinese Yuan Devaluation, David Ashworth, MarketRealist