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Devaluation of the Yuan: A new currency war?

August 14, 2015 by Blog Editor

 With the move by the People’s Bank of China to devalue the yuan on Tuesday this week, markets globally were spooked. Considering the country’s total debt to GDP –  currently at a whopping 228% – it is not surprising that concerns about the health of the Chinese economy were raised.

chinese-yuan

Beijing tried to present Tuesday’s decision – the biggest one-day drop in the currency’s value since January 1994 – as a move to a more market-orientated and freely floating exchange rate rather than an intentional devaluation, which could prompt other countries to follow suit.  However, it remains unclear exactly how the central bank decides the daily fixing rate. The PBoc only stated that between 10 and 20 banks acted as market makers and that the daily fixing rate was an average of the quotes they sent to the PBoC each morning.

It seems that, when necessary, the PBoC – with $3.7tn in foreign exchange reserves – is fully capable of stabilising the market exchange rate by means of direct intervention in the foreign exchange market, in order to prevent the irrational fluctuation of the exchange rate caused by herd behaviour.

But Beijing is trying to walk a delicate line between allowing market forces to set the exchange rate and “guiding” the rate to a level China’s leaders think is ideal to boost exports and prop up flagging domestic growth.

“Global Currency War”?

China is not the first country that is trying to boost its economy by devaluing its currency. In the recent past, the European Central Bank and the Bank of Japan had to face criticism accusing them of pushing artificially the external value of the euro and yen through the loose monetary policy to stimulate the economy in their currency areas. Already in 2010, the Brazilian Finance Minister Guido Mantega had warned that a “global currency war” could be imminent.

Scientists who prefer to use the word “competitive devaluation” instead of “currency war” have acknowledge repeated phases in history where one such “competitive devaluations” have taken place. In the 1930s, several countries, among them the United Kingdom, devaluated their currencies in connection with the departure from the gold standard. In 1931, the pound sterling lost in 1931 around 25% of its external value. Many other countries responded with the introduction of new tariffs and trade barriers. The result was fatal: the international division of labour fell below the level they had reached before the First World War which further led to an escalation of the crisis and helped to nurtured WWII.

Beggar thy Neighbour

The devaluation of the yuan could be problematic if the short-term export success is targeted at the expense of others – economists call it “beggar thy neighbour”. One lesson learned with regards to the politically induced devaluations is that they usually lead to no lasting improvement in the country’s competitiveness. In the short term, a depreciation policy for a country can appear quite successful due to a stimulation of exports and the GDP may rise initially. However, the decline in purchasing power domestically, i.e. when imports would become more expensive, devaluation causes poverty with the risk of inflation increasing.

In the case of China, it seems that the most straightforward reasons behind its move is that China wants to stimulate the growth in it economy after its growth has slowed down and its stock market has been in turmoil for the last few months, with stocks plunging by 32% after a high earlier this year. Although the move was a “one-off” adoption of a market-based approach to setting the yuan’s value, the decision looks an awful lot like an attempt to stimulate the economy as the currency’s strength was putting pressure on exporters, hampering output and most likely employment too.

Moreover, another reason for the PBoC’s surprise move on the yuan is that China’s authorities have long wanted the yuan to gain a coveted status as a global reserve currency. The devaluation could help the yuan gain inclusion in the International Monetary Fund’s Special Drawing Rights (SDR) basket of currencies. If included, the yuan would be among the currencies loaned to sovereign borrowers by the IMF in times of distress. Inclusion in the SDR basket is unlikely to help China financially. Rather, the status is one Beijing desires largely for reasons of vanity, marking it out as one of the world’s most important countries.

By J Bren

 



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