Yuan devaluation kills two bird with one stone

Yuan devaluation kills two bird with one stone

The three-day devaluation, which rattled markets last week, serves two ends for the Politburo; it is a move towards a slightly more market-based rate, and it tests the last tool left untried in the fight to sustain the Chinese export-led growth model.

The recent 4.4 percent devaluation of the Yuan by the Chinese central bank reignited talk of a global currency war. A cheaper currency translates into relatively cheaper exports and more expensive imports, improves a country’s terms of trade, and boosts domestic industry – in sum, a more competitive standing in international trade, at the expense of domestic purchasing power.

China is actually comparatively late to the devaluation party, but when you’re the second largest economy and the largest exporter globally, any change in currency rates will stir up international reactions. The motivation for the devaluation is due in part to the slowing economy and to China’s ambition to see the yuan attain reserve currency status.

Export-led growth is increasingly unsustainable

2015 has not been encouraging so far in terms of global commerce, with world trade growing at a meager rate of 0.7 percent in Q1, which has been bad news, especially for China. Renewed turmoil in the Eurozone over Greece, a weak first quarter for the US due to unusually harsh weather, dollar appreciation and port strikes, as well as waning demand in EMEs such as Brazil and Russia contribute to subdued global trade.

There is evidence elsewhere of the slowdown. Commodity prices have taken a nosedive, and Chinese exports dropped 8.3 percent in July, against a consensus estimate of -1.0. Meanwhile, inflation stood at only 1.6 percent against a target of 3. This hurts in a country where growth is still largely dependent on exports.

Add to that the stock market crash, in which the Shanghai stock exchange plummeted by more than a third of its value. Facing such headwinds, it is clear why more competitive terms of trade seemed like a good idea to the Chinese administration.

Devaluation was in the cards

Expectations for a devaluation occurred early in March this year, with evidence of large capital outflows from China, reflecting dwindling confidence in the renminbi and a slowdown in the economy. Exporters and individuals preferred holding foreign exchange as opposed to renminbi, as reflected in surging FX deposits.

The downward pressure on the yuan was, until recently, countered by the Peoples’ Bank of China (PBoC), which appeared to be intervening in the FX market in order to prop up the yuan and defend its trading band of +/- 2 percent relative to the US dollar.

In effect, the recent devaluation means that trading will depend on the closing price of the yuan from the previous trading day, which is why the yuan slid over 4 percent over the course of three days.

However, increased market influence over the value of the yuan is exactly what China intends to do. At the National People’s Congress in March, plans for ongoing financial reforms included “widen[ing] the floating range of the RMB exchange rate, allowing it to float more freely.” In addition, according to IMF, the yuan is on track to be included in the basket of reserve currencies that make up the Special Drawing Rights. To accomplish this, expect China to continue to open its capital account, deepen its financial markets and gradually ease the tight control over the exchange rate.

Devaluation could delay the Fed’s rate hike

Spillovers from this latest move by PBoC include renewed uncertainty about the Federal Reserve’s possible rate hike in September. The odds that one of the most significant interest rates globally will increase this autumn has fallen from over 50 percent to a 39 percent according to the Fed funds futures.

Other market observers maintain that the end of the zero-interest-rate climate will come to an end in September, but that the subsequent pace of Fed tightening will be slower. Either way, whether manifested as a delay in the rate increase or a slower climb after a September hike, the US Federal Reserve’s easing horizon has just been expanded by the yuan devaluation.

Categories: Asia Pacific, Finance

About Author

Mikala Sorenson

Mikala Sorensen is an Economist with regional expertise in Europe. She holds a first class honours degree in Philosophy, Politics and Economics from the University of York and a Masters in Economics from the University of Copenhagen. Having interned at the Danish OECD-delegation in Paris and currently working at the Danish Ministry of Finance, she specialises in politics and macroeconomics. Analysis for GRI is an expression of her own views.