THE ORIGIN: SLOWING
CHINESE ECONOMY
China is
a socialist society run by a self-proclaimed Communist Party and contrastingly
features sky-high inequality and a
poor welfare state. After seeing two decades of nearly double digit
growth, China’s economy is slowing down finally and mainly because of sluggish
real interest market and decline in manufacturing. Despite being world’s most
populous country Chinese economy always has been investment driven economy
rather than being consumption driven. This model of investment driven economy
has now stopped yielding desired results and that’s why Chinese economy is
faltering now.
Figure 1:
China’s Growth Model
Due
to China’s unsustainable Investment driven growth model, even if Chinese
economy hold up well enough now, there will always be the worry that a sharper
slowdown lies ahead. The Chinese government faces mammoth task in managing the
economy. It has to clean up the debt mess caused by the stimulus that was
provided in 2009, when it had unleashed a huge investment spree to tackle the
global financial crisis of 2008.
China’s
debt has reached more than 250% of its GDP and had almost doubled over the past
7 years. Such level of increase in debt level has triggered a crisis situations
in countries like Spain, Portugal and Greece. Structural trends in China are
also not in favor of Chinese economy as its working age population is shrinking
over past so many years.
Economists
around the world have suggested a range of reforms that could help China tap
new sources of growth avenues like allowing private companies to compete
properly with state firms by opening up its economy; enforcing the measures to
boost the confidence of entrepreneurs and encourage them to invest; and also
major modifications in the labor laws of the state are needed to bring the
State back on the sustainable growth track
Chinese
stock market have suffered a lot in past few months and Chinese government’s
response to tumbling markets has not helped the Chinese cause too. China’s
economic policies have tarnished China’s image in the global markets and raised
questions on competency of China’s political establishment. The steps taken by
market regulators like banning short sell and halting IPOs has not gone well
with the investors and investors further moved their capital out of Chinese
stock market. State owned companies tried to stabilize the market by buying
back their own shares and pouring money into the market. But all this went into
vain and market sank further, eroding the government’s reserves.
SURPRISE DEVALUATION
On
Tuesday August 11th 2015, China’s central Bank, the People’s Bank of
China devalued Yuan by 1.9%.Tuesday's yuan devaluation followed a run of poor
economic data which again resulted in the fall of another 1.6% in currency
value. This in turn raised the market suspicions that China is embarking on a
long-term depreciation of its currency and wants to help its exporters by doing
so. This currency nosedive, sent shockwaves in the global markets and made
everyone think whether China, the world’s second biggest economy is weakening
at a rate faster than expected.
Figure 2:
Currency Chart: (USD/CNY)
The graph
above shows movement of CNY against USD between Aug 7th and Sep 6th.
One can clearly see two spikes on successive days. Aug 11th was the
devaluation and Aug 12th was the market reaction to the devaluation.
This move led to Yuan to a level seen three years ago against the dollar. It
was the biggest one-day fall since a 1994, when China had aligned its official
and market rates.
This
currency devaluation can be seen as Beijing’s signal to inform the world that
declining demand in the domestic market is not just the China’s problem but
world’s problem too.
CHINA’S EXCHANGE RATE
POLICY
The table
below shows Chinese Yuan Rate over past 25 years. It can be clearly seen from
the table below that Yuan has been consistently appreciating against USD since
2008. On August 11th when China devalued Yuan, it took Yuan back to
level which was seen 3 years ago.
Historical Chinese Yuan Rate (CNY)
|
|
|
|
|
|
|
|
|
|
1981
1982
1983
1984
1985
1986
1987
1988
1989
|
1.71
1.90
1.98
2.33
2.94
3.46
3.73
3.73
3.77
|
|
|
|
|
1990
1991
1992
1993
1994
1995
1996
1997
1998
|
4.80
5.33
5.53
5.78
8.64
8.37
8.34
8.32
8.30
|
|
|
|
|
1999
2000
2001
2002
2003
2004
2005
2006
2007
|
8.28
8.28
8.28
8.28
8.28
8.28
8.19
7.97
7.61
|
|
|
|
|
2008
2009
2010
2011
2012
2013
2014
|
6.95
6.83
6.77
6.46
6.31
6.15
6.16
|
|
|
|
|
|
Average annual currency exchange rate for the Chinese Yuan
(Yuan per U.S. Dollar) is
shown in this table: 1981 to present.
|
|
|
|
|
Figure 3:
Historical Chinese Yuan Rate
China’s
exchange rate is controlled by China’s Central Bank, People’s Bank of China.
Central Bank fixes USD/CNY- rate on each trading day, this gives market forces
very little say in determining currency value. This exchange rate policy has
helped China to keep its exports cheaper and thereby more attractive against
its competition. This policy has helped China sustain its high growth rate over
past two decades.
But such
fixed and rigid exchange rate policy has many adverse effects too. Fixing
exchange rate requires selling domestic currency in the domestic market when
there is upward pressure on currency, which may lead to excess supply of
currency in domestic market. As the money supply in the domestic market rises
this may lead to inflation which may ultimately result in social unrest.
In July
2015, Chinese Central bank devalued Yuan by 2% and modified its exchange rate
system. Central Bank announced that China will now move to the Managed Floating
Rate currency regime and instead of pegging Yuan to USD, it will be pegged to
basket of currencies but the composition of basket of currency was not
disclosed. World over economic policy
makers have always complained that China keeps its currency undervalued in
comparison to its competition, resulting in unfair trade advantage to China.
MODIFICATION IN EXCHANGE RATE REGIME
Central
Bank of China sets the reference rate or fixing rate, it’s a rate at which
Central Bank in China wants its currency Yuan to trade against the USD. The
Yuan is allowed to trade 2 percentage on either side of the reference rate,
which is declared every day in the morning at 9.15 AM by People’s Bank of
China. Central Bank in China ensures that Yuan trades in the pre decided range
by buying or selling Dollar in order to manage the Yuan value.
PBoC on
Tuesday, August 08, 2015, modified the methodology of determining reference
rate. Yuan reference rate is now linked to closing exchange rate of previous
day. Central Bankers in China explained that devaluing currency was a
mechanical move and not a push to boost exports. China’s central bank issued a
statement saying Tuesday’s Yuan depreciation was in line with Country’s
objective of making Chinese financial system more market oriented. It also
mentioned that devaluation was part of its effort to give market forces more say
in the currency exchange rate. It is a small step towards opening China’s
exchange market, something which IMF as well as developed countries like USA
have been asking China to do for long time.
DEVALUATION – CHINA’S
VERSION OF THE STORY
For long time now, China has been trying to get Yuan
labelled as one of the reserve currency of IMF. Getting Yuan in the basket of
currency along with the currencies like Dollar, Pound, Euro and Yen would give
much needed prestige to the currency of the world’s second largest economy. It
will also allow China to flex its muscle in the Global Markets, and boost its
role in world economy. It would likely increase the demand for Yuan, mostly by
central bankers around the world.
It is
said that, in its current form IMF won’t accept yuan as its reserve currency as
it is still closely controlled by Central Bank of China. The reports have
suggested that decision to include yuan in the reserve currency basket will
hinged on exchange rate flexibility, further opening of capital account and
financial market development in China. IMF wants investors to have greater
access to China’s foreign exchange and securities market. China needs to
address these issues before dreaming of yuan being a globally accepted reserve
currency.
The
Central Bank on Tuesday said market spot prices would now decide the daily
position, indicating central bank would not interfere much to influence the
currency exchange rate. China’s decision on Tuesday of tweaking the reference
rate calculation is seen as a move to give market greater sway in exchange rate
determination. IMF has also welcomed the move, but it also added that it will
wait to see how this mechanism is implemented.
DEVALUATION – 360°
VIEW
It may be
a mere coincident that China’s devaluation came after weak economic data and
statistics depicting slump in exports. Five interest rate cuts since last
November and fiscal stimulus to spur growth didn’t give expected results to
China. Despite being world’s most populous country and second biggest economy,
China’s problem of declining domestic demand is hurting the economy badly.
China devaluing its
currency has more to do with the dynamics of global currency markets than its
urge to help domestic exporters by making their goods cheaper on the world
market. China is wise enough to understand that such step would surely lead to
currency war and affect Yuan prospect of becoming IMF’s reserve currency. If we
see yuan movement over past decade, it can be easily seen that Yuan maintains
close relationship with USD and it has moved in sync with USD. It is known that
China manages its currency rate against the basket of currency but the
composition of currencies in the basket is unknown. Even if composition is not
known it can be observed that USD must be having most of the weight in the
basket of currencies which China tracks for its reference. It is seen whenever
US dollar rises against the world currencies, the yuan also rises against the
currencies of the trading partners’ of China.
China has wanted the yuan
to rise steadily against the currency of its trade partners. US Dollar is bound
to get strengthened after FED rate hike in September. As yuan is closely linked
to US Dollar, to keep the yuan appreciation gradual, China might have devalued
its currency. Many economist suggested that this is not a competitive
devaluation of yuan and there’s nothing of that sort on the cards. It is
believed that all Beijing is doing today is managing the pace of trade-weighted
yuan appreciation.
Many economists believe
that mere devaluation by 2 percentage won’t help Chinese exporters much, if
China wants to gain meaningful competitive advantage over others in export
market then it might have to devalue yuan by 10-20% against the US dollar.
People’s Bank of China showed the verbal support for the currency two days
after markets reaction to the yuan devaluation. Central Bank in its statement
said it will take action if excessive volatility persists in the market.
Central Banks Assistant Governor Zhang Xiaohui stressed on the fact that there
is no basis for the depreciation in the yuan to persist. To gain reputation in
international market and sustain it China for the most part would actually want
its currency to steadily rise. Last few months have been difficult for Chinese
markets, investors are taking out money from the country and capital is flowing
out of the country. To keep capital from flowing out of China and for political
reasons, China would want to keep its currency at par with US Dollar.
Had China devalued its
currency by 10-20%, it would have clearly been an effort to boost exports for
its advantage, but a 2% devaluation is different. Devaluation of this extent
will help yuan to be in a range of its trading partners’ currencies, as they
have depreciated relative to US dollar. US dollar has consistently strengthened
since FEDs announcement of inevitable interest rate hike planned for 2016.
Devaluation of this level is in line with China’s political ambition to boost
international use of yuan and assert itself more strongly around the world.
China’s foreign exchange
reserves decreased by USD 94 billion to USD 3557, it was sharpest monthly fall
in since May 2012. It shows China’s intent of not letting yuan depreciate
further as People’s Bank of China sold Dollar to prevent yuan from sliding
further.
IMPACT OF YUAN
DEVALUATION ON MAJOR GLOBAL CURRENCIES
The
Chinese yuan devaluation was one of the major reason behind volatility in the
foreign exchange market in the month of August. Devaluation negatively affected
the mainly the Asian currencies due to perceived risk of currency war. To
remain competitive in export market and to maintain their own market share many
countries adjusted their currencies accordingly. Currencies of China’s major
trading partners’ link South Korea, Australia and Malesia also fell in tandem
with the Chinese devaluation.
Decline
in the commodity prices and sluggish growth expectations in the Chinese economy
has impacted the Latin American currencies too. Devaluation of yuan is going to
impact the Chinese imports, and most of the Chinese import come from South
American countries, so even these currencies have felt the heat of slowing
Chinese economy. Crude prices have also been impacted due to sluggish growth
and demand supply gap, this has impacted Middle East countries adversely. The US Dollar index too was impacted
unfavorably by yuan devaluation. Developed countries benefited from this as
their currencies strengthened against US Dollar.
China is
undoubtedly world’s biggest consumer of raw materials and producer of finished
goods. The China slowdown story has most impacted the big commodity producing
economies like Russia, Brazil, South Africa and Kazakhstan. The declining oil
prices has also shattered the investor confidence in the prospect of the big
energy exporters.
Let’s
have a look at how slowing Chinese economy and surprised devaluation has
affected the countries around the world.
South Korea
The trade
figures declared on 1st of September by South Korea surprised
economists around the world. Exports shrank by 14.7% in the month of August,
its largest monthly decline in six years. Though exports have been on decline
since January but monthly decline rate was always in the range of 2%-4%, slow
growth in China and Chinese devaluation were the major reasons behind this
debacle. South Korea is export oriented economy and it contributes to nearly
half of the country’s GDP. China is major trade partner of South Korea and it
contributes to 20% South Korean exports. It is also struggling with the rise of
its currency won against the Japan’s yen in key export markets, now China’s
devaluation has put more pressure on the economy.
Australia
China’s
manufacturing is slowing and its services sector also showed new weakness,
reflecting the deteriorating health of Chinese economy. China’s deceleration is
resulting in the decline of commodity prices around the world. Resource rich
Australia is one of the biggest dependent on China’s commodity appetite s
suffering due to declining Chinese economy. Many economist have predicted that
Australia will report contraction in the second quarter when it publishes its
trade figures. BHP Billiton, Australian mining giant has this year eliminated
thousands of jobs at its various mines showing clear signs of economic
distress.
India
Changing
scenario in China has also impacted Indian businesses. China is dumping its
commodities specially metals in Indian markets. After devaluation Chinese steel
exporters have further reduced their prices and this has reduced cost of steel
imported in the India to a level which is even below the domestic cost of
production of steel. Companies like Tata steel have been adversely affected by
this increase in steel import and government is considering steps to protect
domestic industry by levying support duty on imports from China.
Other Asian Economies
Malaysia and Vietnam
declared decline in manufacturing for the month of August. This was done after
Beijing’s yuan depreciation which will lead to cheaper Chinese exports. Yuan
devaluation was immediately followed by devaluation of Vietnamese dong against
dollar by 1%. It has also impacted other Asian economies like Indonesia.
Indonesia’s central bank sighted yuan devaluation as the prime reason for fall
in Indonesian rupiah and it also said that it would step into the foreign
exchange market to deal with the volatility if it persists. Yuan devaluation
has certainly created the new competitive hurdle for these economies and these
economies are certainly feeling the heat.
Since yuan devaluation, an index of 20
developing-nation exchange rates has been falling fast depicting the impact of
yuan devaluation on those currencies.
WILL IT DELAY FED’s
INTEREST RATE HIKE?
Before Chinese devaluation
Federal Reserve looked all set to opt for interest rate hike in the month of
September. This rate hike could put pressure on emerging markets in many ways.
This rate hike will definitely make investments in America more attractive and
these investments may come at the cost of further capital outflow from the
emerging markets which are already struggling with same since Federal Reserve’s
announcement of possible rate hike. This rate hike could potentially lead to
further strengthening of US dollar impacting emerging market currencies even
more. For the firms, households and governments in the emerging markets which
have borrowed trillions of dollars in recent years, interest and debt repayment
cost will rise in local currency which may lead to crisis situation. Such fear
of increase in interest and debt repayment may further lead to more capital
outflow from developing countries and they might get trapped in vicious cycle
of economic slowdown. In such circumstances central banks in affected countries
will have options of letting their currencies plummet or hiking interest rates
to defend them. The former will further aggravate the burden of foreign loan
and latter will stagnate the growth in the economy.
This surprised devaluation by
world’s second largest economy will certainly make central bankers in America
think whether the September is the right time for rate hike or to delay it
further. If this surprised devaluation is immediately followed by interest rate
hike in the US, then it may lead to currency war which world can’t afford.
Although the strengthening domestic employment market in America is something
Fed is looking at as a signal for inevitable interest rate hike, the thought
that weaker growth in major trading partners and emerging economies cannot be
ignored. Economies are so inter-linked these days that a decision by one
country has chain reaction on entire world and America being the strongest and
largest economy, impact of its economic policies surely has noteworthy impact
on the world as compared to any other economy in the world. It is certain that
Fed will consider the Chinese devaluation as a factor before going ahead with
the rate hike.
WILL IT TRIGGER GLOBAL CURRENCY WAR?
Currency devaluation is
expected to be the feature of global economy in the near future especially if
the threat of slow global growth remains. Currency war is negative sum game
with lose-lose outcome when everyone is involved. If global economy fails to
regain growth and accelerate then there is possibility that currency war may
prevail as when growth is feeble and tools to boost aggregate demand are
limited then currency devaluation can be useful tool to stimulate the growth
temporarily. In competitive devaluation one country gains at the expense of
other. Also devaluation results in foreign exchange volatility which may lead
to increased cost of international trade and investments, leading to decline in
capital flow and global growth, hence, a lose-lose outcome and negative sum
game.
Game theory shows that even
if it is lose-lose game there is incentive for a country to enter into currency
war. Currency devaluation helps country to maintain its strategic positioning
and it is the major incentive for country in the time of crisis. As the
intensity of devaluation increases, the cost in terms of hedging also increases
and trade contracts which ultimately results in slow growth.
Let’s understand foreign
exchange game theory with the help of one hypothetical example. Assume that
country X and Y do not communicate with each other on their foreign exchange
policies. Each has option to stay put or devalue their currency. If X devalues but Y stays put, X gains 2 %
growth and Y contracts by 1%, as X will be able to attract more FDI and export
more to the world market at cheaper rate.
On the other hand now consider if X stays put and Y devalues, this will
lead to Y growing by 2% and X shrinking by 1%. It is clear from above example
that country gets higher pay-off by devaluing its currency. Strategically
devaluation is best choice for both Country X and Country Y. This reasoning
involves prisoner’s dilemma that neither of the country knows what the other
will do.
This year
has seen a trend of consistent and rapid capital outflow from the emerging
markets as fear of sharp slowdown in the global economy is growing. Over past year $1 trillion has flowed out of
the 19 emerging markets. The International Monetary Fund has predicted that
global growth among the developed and developing economies to be just 4.2% this
year, lowest since 2009.
Many
financial analyst are of the view that emerging markets still have high
currency devaluation risk. China’s devaluation on 11th August, took
everyone by surprise, causing several emerging market economies to devalue
their own currencies to remain competitive. Chinese devaluation sent the wrong
signal that Beijing is ready for currency war to combat sputtering growth. China
is facing weak growth prospect and increasing deflationary pressure, few
economist are of the view that strong yuan may further damage the economy
that’s why China may devalue its currency further to find an escape route. Many
analyst around the world are expecting more global devaluations once US Federal
Reserve, declares the interest rate hike for the first time since sub-prime
crisis of 2008. Even though China’s devaluation might have helped Chinese
exporters to a certain level but to gain any significant competitive advantage
yuan must be devalued by 10-20%.
If China
triggers currency war then it could be the beginning of Asian currency battles
and might send global rates lower. It would also be bearish for commodity
currencies, which are highly dependent on Chinese demand for their exports.
IS IT A CHINA’S PUSH TO
GET SDR STATUS AT IMF?
China’s
yuan devaluation is seen as its attempt to win the Special Drawing Rights
status at International Monetary Fund. China has taken a big step towards
making its currency freely usable by attaching yuan value to market forces. The
push for Special Drawing Rights is pressing China to reduce capital control and
it is also the driving force behind making market-based way of valuing yuan.
Once China gets the much needed SDR status, this move could also convince
central bankers across the world to hold reserves in yuan and stabilize its
value. Special drawing rights might also cut borrowing costs for Chinese
exporters.
China
being second biggest economy is striving to get recognition that it deserves,
and aligning currency value in accordance with the market forces will
definitely help the cause. When looked in this way this move by China looks
like it is trying to trade short-term pain for the long-tern gain.
IS IT BEGINNING OF
GLOBAL MELTDOWN?
Beijing’s
devaluation may be seen as a distress signal from the world’s second largest
economy. If this is the case then it means that China may be destined for
slower growth than 7% a year growth forecasted by Chinese authorities. China
need to engineer a shift from export-led growth to a growth based on consumer
spending. It also need to do away with the property market bubble which may
impact its economy adversely in near future. Nobel Prize winning economist Paul
Krugman described China’s move as “the first bite of the cherry” suggesting
that many countries may follow the move. If Chinese economy is weaker than the
figures which are thrown by the government, then it would be alarming signal
for the companies hoping to export to world’s largest consumer base. China will
remain the biggest market but rising inequality and falling demand may not keep
it as attractive as it should be.
The
official reason given for the yuan devaluation by the People’s Bank of China is
that the Chinese central bank wants the exchange rates to be more market driven
and should be determined by the demand and supply of yuan. After devaluation demand supply of the
currency led to further depreciation of currency and made yuan cheaper than
what it was before. Developed countries around the world for long time have
asked China to let market determine fair value of yuan. But when China actually
took a step towards that global mayhem followed, the reason behind it could be
the timing of the step. Had China done it a year back, impact could not have
been as severe as it had now. But this decision came in the backdrop of weak
economic data, slump in exports and decline in factory output which sent the
wrong signal to global investor community. Many investors might have looked at
this step as China’s attempt to boost exports and stabilize its economy.
however this move may not work as unlike in the past there aren’t enough
customers for the Chinese goods in the domestic as well as global market reason
being global consumers have been hit by hard times themselves. More importantly
this devaluation is a signal that Chinese economy is under serious pressure and
if world’s second largest economy is in the trouble then that can only be bad
news for the rest of the world. This worry has led to the sell-off in the
global stock markets.
LESSONS TO BE LEARNT
The global reaction to
China’s devaluation was bigger than what Chinese authorities had expected. It
was clear indication of the fact that the global economy is indeed very
fragile. It was also seen that capital outflow accelerated post devaluation,
this was because investors thought that yuan may devalue further, eroding their
wealth.
Policymakers in China
clearly underestimated the global impact of yuan devaluation, as this
devaluation had taken place when jitter about China’s slowdown had intensified
due to Chinese stock market plunge. One of the prominent Chinese economist was
of the view that making correction in currency when economy has weakened the
stock markets plunged, sent a wrong and undesired signal to the world that
China wants to spur the economy through devaluation. This put China on the
defensive, it looks like China is the trigger.
There are
many things to be learnt from this event, the most important being
understanding and accepting that the countries no longer live in isolation but
everyone is more closely linked with each other than ever before. Global
coordination is need for country level policy making to limit the impact of
such economic policies. Therefore there can be no excuse for having greater
international cooperation in economic policies. Policy makers need to opt for
the long term solution to economic challenges rather than implementing policies
which may just help in short terms. Central bankers have been over dependent on
quantitative easing interest rate cuts and lending to resolve the economic
issues. For sustained growth throughout the world there is need of coordinated
efforts on improving productivity, infrastructure and quality of life across
the globe for global prosperity.
