Yuan Devaluation Analysis

2015

Author: Rohit Kaul (9987237425) College: Sydenham Institute of Management Studies, Research and Entrepreneurship Education (SIMSREE)

9/10/2015

“Yuan Devaluation: Will it lead to a global ‘currency war’ and world economic meltdown”

Contents I.

INTRODUCTION ........................................................................................................................ 2

II.

CHINA’S CURRENCY SYSTEM .............................................................................................. 3

III. REASONS FOR YUAN DEVALUATION ................................................................................ 4 IV. IMPACT OF YUAN DEVALUATION ON MAJOR GLOBAL CURRENCIES & ECONOMIES AROUND THE GLOBE.................................................................................... 5 a)

Impact on the US: ..................................................................................................................... 5

b)

Impact on the European Union: .............................................................................................. 6

c)

Impact on Russia: ..................................................................................................................... 8

d)

Impact on African nations: ...................................................................................................... 8

e)

Impact on India: ........................................................................................................................ 9

f)

Impact on Brazil: .................................................................................................................... 10

g)

Impact on Asian economies:................................................................................................... 10

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I.

INTRODUCTION

On August 11 2015, the People’s bank of China (PBOC) devalued the Chinese Yuan by about 1.9% below its previous day’s close. It sent ripples around the globe as the world started to believe that Asia’s largest economy is going through one of the toughest phases in its turbulent history – a slowing economy ailed by reduced manufacturing output in the last quarter. In order to resurrect its dwindling economy and bring it back on track, the Chinese central bank had to resort to the age old technique of depreciating the value of its own currency – a process called as “devaluation”. Such a devaluation followed months and months of the Yuan appreciating along with the US dollar, making Chinese exports expensive. This would make the situation politically dangerous for the ruling communist party of China (CPC) as it could lead to loss of millions of jobs in the Chinese domestic sector causing wide outrage against the government. There were other reasons as well attributed to, as to, why the PBOC had to come up with such a drastic measure, which would be discussed in detail here, but it is evident that the Chinese authorities alongside the central bank would not hesitate to take such steps in the future if need be.

Figure 1: Graph showing ¥ vs USD As depicted in the figure above the Yuan depreciated from 6.23 ¥/$ to almost 6.4 ¥/$ on August 11 before settling down to 6.35 ¥/$ later. It was the single biggest day fall in a decade for the Chinese currency. So much so that the People’s bank of China had to start selling dollars when the currency had depreciated to 6.4 ¥/$ to arrest the slide of the Yuan. The reason for selling dollars was because of the huge capital outflows that were taking place to depreciate the Yuan, as the PBOC kept printing new money and increasing the supply of Yuan in the international markets to reduce the value of its currency. The PBOC in all had to offload $93.9 billion taking their reserves down from $3.65 billion to $3.56 billion by the end of August to stabilize the Yuan. Let us now look into what system China follows for determining its currency value. P a g e 2 | 11

“Yuan Devaluation: Will it lead to a global ‘currency war’ and world economic meltdown”

Figure 2: China Foreign Exchange Reserves Change ($billions)

II.

Source: Bloomberg

CHINA’S CURRENCY SYSTEM

China uses a ‘Managed float exchange regime’. This means that the currency is normally pegged to a reference rate that is set by the People’s bank of China (which is now the US dollar). It is ‘float’ because it is allowed to fluctuate 2% above or below this reference rate based on previous day’s trading. Thus it allows for the currency to fluctuate based on the market forces of demand and supply for the Chinese Yuan but only up to a certain extent. The US and the European Union have been long pressurizing the Chinese to make their currency fully market driven i.e. float type of currency as it eliminates excessive intervention and manipulation of the currency by the central bank. China’s leadership has since long, urged the IMF to include the Yuan in a basket of global reserve currencies comprising the US Dollar, Euro, Yen and the Pound thus giving it ‘special drawing rights’. For that, China needs to change its currency regime from ‘Managed float’ currency to fully float, that is, a currency whose value is wholly determined by the demand and supply forces of the market with minimal intervention from the central bank. However, following the recent stunt, the US and EU has lost faith in China’s willingness to allow its currency to become free floating and thus be counted amongst the reserve currencies.

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III.

REASONS FOR YUAN DEVALUATION

Figure 3: ¥ vs $ trend and trading band banks

As can be seen from Figure 2, China’s foreign exchange reserves have swelled, almost tripled, in the last decade as they have looked to slow the appreciating Yuan (see figure 3). Thus in effect it was selling Yuan to buy more dollars to arrest the upsurge of Yuan. However, to ensure that such an influx of Yuan doesn’t cause a surge in inflation, it raised its reserve ratios for the

By doing this, China wanted to keep its exports competitive, as China is primarily an export driven economy. Its exports have fallen by about 1.4% in dollar terms over the last year, with overseas shipments down by almost 5.5%. This amidst a falling domestic consumption demand has triggered the People’s Bank of China to devalue the Yuan to give a boost to the Chinese domestic market. By increasing the supply of Yuan in the local as well as international markets (either by printing more Yuan or selling off existing Yuan), it has put more money in the hands of people thus encouraging them to spend more and thus prop up consumption. To combat the resulting fear of inflation, it has put a tab on the reserve ratio requirements for the banks as discussed earlier. Apart from the ‘purposeful’ devaluation, the market believes that the Yuan is overvalued at its current levels. That has also caused capital outflows from the Chinese market. With the US Federal bank announcing that it will raise interest rates soon for the first time post 2006, there are concerns that there would be even more money flowing out of the Chinese markets and into the US market causing the Yuan to depreciate even further. This would be detrimental for the likes of the US and the European Union which import vast quantities of goods from China and even compete with their Chinese counterparts in other countries. It would make Chinese exports very competitive and kill competition from the US and European companies. Thus the US Fed is apprehensive of raising the interest rates come October, especially now that the Yuan has already shown signs of weakness and any further bouts of downturns in the Yuan would spell trouble for the American economy. Third reason as to why China possibly devalued their Yuan could be to raise their inflation rate.

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Figure 4: China Inflation Rate

Source: http://www.tradingeconomics.com/china/inflation-cpi

The manufacturing Purchasing Managers’ Index, which is a gauge of the manufacturing activity in China fell to a 6 year low of 47.1 in August symbolizing a contraction in manufacturing economy. By devaluing their currency, China wanted to drive demand in their economy which had staggered in the past year. The CPI numbers post the devaluation rose to 2% immediately. By doing this, China effectively ‘exported their deflation’ to the US and the European Union thus causing concerns for those countries. There are many reasons to support this claim. China in the recent past, have reduced the supply of pork meat thus causing poultry prices to increase. Food constitutes a large percentage of the CPI index thus causing inflationary pressures.

IV.

IMPACT OF YUAN DEVALUATION ON MAJOR GLOBAL CURRENCIES & ECONOMIES AROUND THE GLOBE

a) Impact on the US: Major source of concern for the US has been the strong US dollar which has squeezed their exports. It has, however, helped curb inflation below the 2% target set by the Fed. The Fed ever since the end of the quantitative easing rounds, has been looking to raise interest rates and bring the economy back on parity. However, that is now expected to be put on a hold after the Yuan devaluation, as such a move would further add to the upward pressure on the US dollar as it would lead to more capital inflows into the US economy thus further hurting exports. The Bank of International Settlements (BIS) has said that Chinese companies have borrowed about $1 trillion abroad, up from $200 billion in 2009. With the Fed planning to raise interest rates, the cost of such borrowing would go up risking default for many of these Chinese companies. As a retaliatory measure, the only way China could stop Fed from doing that was to devalue its currency, thus stopping the Fed from raising interest rates and further strengthening the dollar – thus hurting US exports as stated earlier. Due to muted inflation rate, Fed could delay the interest rate hike. The P a g e 5 | 11

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Fed has currently kept the interest rate hovering between 0.0% - 0.25%. It is 0.08% as of now. Although there have been no inflationary pressures in the US economy, the Fed needs to hike the interest rate soon enough flush some liquidity out of the market. Besides there are various U.S multinationals that have significant operations in China like Apple Inc. The iPhone maker would witness increased cost of manufacturing iPhones and iPads in the domestic market in China as most of its manufacturing and assembly arrangements in China are denominated in U.S dollars. China has almost always had a trade surplus with the U.S. Because of this, it has managed to accumulate a lot of US dollar reserves along with other foreign exchange reserves of other countries (due to a current account surplus). The PBOC needed to invest the surplus dollars it had acquired someplace, where it could get a reasonable rate of return. Since central banks are generally highly conservative in their strategies with PBOC being no exception, it decided to invest in highly liquid securities of the U.S Treasury. Hence China acquired large obligations of U.S dollar denominated debt which has kept on growing with time. Currently in 2015, China holds more than $3.1 trillion in foreign exchange reserves of which $1.2 trillion are held in U.S government obligations. The U.S has urged China to increase the value of Yuan to reduce the trade deficit it has with China thus slowing down the dollar denominated debt it holds with the U.S. China on the other hand, is using the devaluation tool as a leash to hold the U.S from raising interest rates in the near future which would cause huge capital outflows from the slowing Chinese market. The perceived threat of China holding such large US dollar denominated debt can be seen with the help of an example. Let’s consider we are still under the Bretton Woods system. If China felt it wanted to redeem some of its US debt, say in 2008, then $100 billion of redemption at $1000 per ounce would have equalled 2840 metric tonnes of Gold. That would have been about 35% of the total Gold reserves held by the U.S. A full redemption of US government treasuries would have thus completely wiped off all the Gold reserves from the US and left China with about 9000 metric tonnes of Gold. The Idea of the Gold standard at that time was to force nations to get their finances in order before they run out of Gold. It proved to be a warning signal. However, with such a system not in place currently, the American people are unaware of the deteriorating conditions existing in their economy right now. b) Impact on the European Union: The strong exchange rate since last year has been a drag on Chinese exports to the EU. Exports to the European Union have fallen by almost 12% from July 2014 to July 2015. By devaluing the Yuan, China expects value of its exports to the EU to rise. However, this could prove detrimental to countries like Greece, Spain, Portugal, Italy and other peripheral countries which are already battling a slowing economy, lower wages and dwindling profits. By devaluing Yuan, China would ‘export their deflation’ to such countries adding to the woes of an existing deflationary European environment. Countries like Greece which have started to implement austerity measures and are already facing low wages, unemployment and low consumer demand would simply be blown away if a large devaluation occurs. It would put more pressure on countries like P a g e 6 | 11

“Yuan Devaluation: Will it lead to a global ‘currency war’ and world economic meltdown”

Germany & France which bear a large burden of their debts on their books and they in turn would have to write off debts which would go unpaid. Table 1. EU-28 main export partners, 2014 (billion EUR) Country USA

Exports 311

Share in Exports 18.3%

Cumulative Export 18.3%

China

165

9.7%

27.9%

Switzerland

140

8.2%

36.2%

Russia

103

6.1%

42.2%

Turkey

75

4.4%

46.6%

Japan

53

3.1%

49.8%

Norway

50

2.0%

52.7%

Source: http://trade.ec.europa.eu/doclib/docs/2006/september/tradoc_122532.pdf

For most of the European luxury brands like BMW, Prada, Coach, Tiffany & Co., the devaluation spells doom. For one, China is the second largest luxury market in the world after the US. Post the devaluation, the foreign brands are likely to get costlier in the Chinese domestic market hurting their sales there. However, the bigger worry is Chinese spending outside of China which accounts for more than 50% of the revenues of the luxury brands from Chinese consumers. Chinese tourism to places like Germany, France and other European nations, where they prefer buying alligator skin-handbags and gold watches, would go down causing large revenue loss. China is also the second biggest buyer of European goods in general, accounting for nearly 14% of European exports. Sectors with maximum exposure are basic resources, personal and household goods, autos, technology and the auto sector. In the telecom sector in China for example, State owned Huawei is on a fierce competition with Sweden’s Ericsson and devaluation could swing the pendulum the way of Chinese companies like Huawei and ZTE. Table 2. China’s main export partners, 2015

A weak Euro, however, isn’t in China’s interest. If the European turmoil leaves countries like Greece, Portugal out of EU, they would resort to their own weakened currencies and since they form an important part of China’s exports, it Source: http://www.tradingeconomics.com/china/exports would hurt China’s trade surplus a lot. China has a strategic interest in Europe and has adopted a quid pro quo approach. It has bought European sovereign debt and has shared the debt burden with Germany and France. Thus in the event of the PIGS nations going bankrupt, China would be affected drastically. In return for these risks, China has sought foreign investment in sensitive sectors in the European economy like infrastructure, hi-tech technology and permission to purchase advanced weapons technology originally reserved only for NATO allies. Country United States European Union ASEAN Japan

% Exports 17% 16% 10% 7%

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c) Impact on Russia: Beijing’s sudden devaluation of their currency sent oil prices tumbling down, to $43 a barrel, the lowest level seen in the last six years. It was bad news for Russia as it derives nearly 68% of its export revenues from the sale of oil and gas. The Russian Rouble which is closely tied to the performance of the country’s energy exports thus depreciated, and is now at nearly 64 roubles/dollar. For Russia, a devaluing Yuan alongside a strong dollar is a worrying sign as their cost of dollar denominated debt would rise leading to cost of obtaining more dollars even more expensive. d) Impact on African nations: Most of the African commodities in countries like Nigeria and Kenya are still priced in American dollars. Off late though, China has emerged as the largest trading partner for many African countries. To make buying and selling of goods easier, Nigeria in 2011, pledged to keep 5-10% of its foreign exchange reserves as Yuan. They also believed that it would act as a hedge for its local currency, Naira, against the backdrop of volatile oil prices set in dollars. Later Kenya, which is a major trade partner in Africa with China, announced plans to set up a clearing house for the Chinese currency. However, with the American dollar strengthening against the Yuan, African exports like platinum, copper and coal could become expensive for the Chinese counterparts. Countries in Africa having sizable exports to China also include South Africa which exports Gold and wine, Angola which exports oil and Zambia which exports copper. These currencies have already depreciated following the Yuan devaluation. The cost competitive nature of Chinese products in these markets has eroded competition from the African counterparts. For some countries like Ethiopia, Mozambique, Yuan devaluation is a blessing as it reduces their cost of importing Figure 5: Africa’s total World trade heavy machinery, electrical lines and bulldozers. Consumers and retailers in general also get access to cheaper goods. Some of the steps that the African economies could take is allowing their currencies to depreciate thus gaining a competitive advantage over the Chinese exporters. They should also look to diversify their economies away from commodities in the event of a global commodity crisis. P a g e 8 | 11

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e) Impact on India: Figure 6: Commodity Prices trend of 5 years

Impact on the Indian economy as a consequence of the Yuan devaluation is complex. The rupee fell by about 1.5% following the Chinese devaluation and has fallen by about 6% from the start of the year. It was because of the general sell off of the emerging market currencies that has taken place post the devaluation. Part of the devaluation has also been due to the fears of the US Fed hike that could further weaken the currency, hence forcing to RBI to raise interest rates in India i.e. resorting to a contractionary monetary policy and taking away 18 months of solid hard won macro-economic stability. India imports a lot of goods from its eastern neighbour. The import bill from China was about $60 billion in 2014. The devaluation of Yuan thus brings good news to many importers from India especially the electronic and electrical component manufacturing companies. However, India competes with China in many sectors like Chemicals and textile manufacturing and post devaluation Chinese goods might become more competitive than Indian goods in world markets. That could be a huge problem for the export industry in India as exports have declined continuously over the past 7 months. Also with RMB devaluing, price of Chinese steel will decline. Thus the government will have to step in and apply import barriers to prevent Chinese steel from entering into the Indian market or support domestic manufacturers via subsidies (which would put pressure on the fiscal deficit. A Bank of America report suggests that a 1% drop in ¥ decreases the commodity prices by nearly 0.4-0.5%. This is because China is a large commodity importer and with slowing demand of commodities there, prices of commodities are languishing at their lowest levels since 2009. A weak Yuan adds to the woes of commodities even further. This would be good news for India as India is a net importer of commodities and low commodity prices would help to lower its import bill thus improving its trade deficit.

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f) Impact on Brazil: Probably the biggest impact of a Yuan devaluation would be on the South American behemoth. Brazil relies on 18% of its export revenues from China. Its export items include commodities like iron and copper ore, oil, soy bean, corn, beef, food products and lubricants. Will falling commodity prices and weakening Yuan, Brazil’s export revenues would go down. An economy set to contract by 2.4% in 2015, with a 10% inflation rate and a home currency having lost 20% of its value since Jan 2015 – this would spell disaster for Brazil. Brazil’s GDP in 2014 was $3.073 trillion and exports were $225 billion i.e. exports accounted for nearly 7% of its GDP and China accounts for 18% of that 7% i.e. 1.26% of Brazil’s GDP!

Table 3. Major export partners of Brazil Country China U.S Argentina

Exports (billion USD) 40.5 24.75 18

% of exports 18% 11% 8%

Source: http://www.tradingeconomics.com/brazil/exports

g) Impact on Asian economies: The Yuan devaluation meant that other Asian countries also had to devalue their currency in order to maintain their cost competitiveness in the export markets. In fact, even before the devaluation, owing to the slowdown in the Chinese economy, there was decreased demand for many products from these nations causing prices to fall down. Figure 7: Asian currency % change post devaluation

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To summarise the risks associated and the corresponding actions that could be taken by these Asian economies to subvert the crisis –

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