Yuan devaluation: Will China fall victim to its own manoeuvre?

• Yuan was devalued by 0.36% in just first week of August against the US Dollar, prompting fears of the trade war leading to a currency war.
• This would make Chinese exports competitive, but could add to the hardships for its consumers and households.
• Many of China’s biggest enterprises have borrowed heavily in dollars, and a weaker yuan would greatly increase the cost of servicing this external debt.
• In the long run, China would certainly find this approach unsustainable, and policy makers on both sides would be hoping for a resolution of the US-China trade war soon.

TPCI-IBT-Business-Perspectives

Recently the Chinese yuan breached the seven-to-one level against the dollar for the first time since the global financial crisis of 2008. The People’s Bank of China, which had maintained this level consistently till now, deliberately devalued the Chinese currency after the latest tariff threats issued from the USA side as a retaliation move. This was followed by the US labelling China as a ‘currency manipulator’.

The act marks a shift of focus in the current trade tensions between the US and China away from what was seen as a “tariff war” to a potential “currency war“. And this spells greater uncertainties not only for those trading in Chinese and US currencies or their stocks (which is over 60% of global financial investors), but also for capital flows between emerging markets that tend to peg the value of their own currencies to the dollar.

Economic theory says that a lower exchange rate tends to benefit exporters at the expense of importers, and vice versa, which is known as the J-Curve concept. Thus, when an economy deliberately keeps its currency exchange rate below the level that it would be if its exchange rate were floating, it faces the risk of being accused of manipulating its currency to fetch an unfair trade advantage. Since countries are obliged to respond to unfair competition by imposing barriers to trade, currency alteration is discouraged by international bodies such as the IMF.

Value of Yuan against Dollar

Source: https://ycharts.com/indicators/chinese_yuan_to_us_dollar_exchange_rate, figures depict one-month movement

The move has possibly negative implications on other fronts for China. With inflation on food already reaching at 7%, more import restrictions or tariffs will add to hardships on households and consumers. Devaluing the yuan may further add to the risk and make China’s financial system volatile and uncertain. China’s whopping domestic debt has already compelled the central bank to augment its money supply at a rate of 8% to 10% a year, a relatively high pace that typically enervates the exchange rate.

To guard against the expectation of a weakening currency, the central bank of China has strategized and spent years establishing the reputation of the yuan, which has been built on the tacit assumption that it would not fall below 7 yuan to the dollar. This impression is crucial for the yuan because the currency does not have a significant and liquid market, where participants can hedge against various risks at a relatively low price.

Since, China remains a major exporter, the yuan’s devaluation may well tempt and incentivise other countries either to devalue their currencies by expanding money supplies or by cutting interest rates to be competitive. Such a response may provide impetus to financial uncertainties at global platform which is a sign of worry.

It seems unlikely, therefore, that China is about to declare all out currency war. The yuan was already close to the symbolic level of 7 yuan per US dollar. By setting their daily benchmark rate for the currency at a smidgen below 7 yuan to the dollar, the Chinese authorities have created room for currency traders to push the market rate temporarily above that mark, an effective devaluation.

Since devaluation would also carry significant risks for China, the country’s policymakers and leaders will be hesitant to continue this manoeuvre for a longer tenure. Many of China’s biggest corporates have borrowed heavily in dollars, and a weaker yuan would greatly increase the cost of servicing this external debt and increasing the opportunity cost of paying pack. Worse, the prospect of devaluation could spark massive capital flight from China as anxious companies and individuals seek to shield the value of their assets.

The Chinese consumer is certainly losing out. A weaker currency drives up import prices and constrains living standards. Commodity imports in particular will be hit the most in terms of paying the bills. Since they are priced in dollars, surged commodity prices will pressure input costs, weaken corporate margins and slow government spending.

A feebler yuan also poses a risk to Chinese corporate non-financial debt issued in US dollars, which is close to US$ 850[1] billion and has tripled since 2014. Meanwhile, banks have also issued US$ 670 billion of dollar debt. Together, this debt load is over 11% of GDP.  Defaults are rising and expected to top the record stress levels set in 2018.

Regardless of the immediate winners or losers, in the long run, currency wars are zero sum games. US trade friction with China is the greatest risk to global growth and continued provocations could prematurely deliver a recession. It’s a high stakes game for both: China wants continued access to US markets and technology. Trump wants to get re-elected next year, and evidence of competent economic stewardship is critical to his appeal.

Any waiting game or procrastination gets catastrophic as economic and market confidence can swiftly erode and plummet, leaving little scope for catch-up political action to shift the momentum. The recommended or pragmatic path is that a market scares or a pickup in Chinese defaults force some agreement that in turn dials back the geopolitical risks.

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