China recently devalued its yuan by about 1.9 percent, marking the largest drop in two decades. The devaluation came as a surprise to many markets and central bankers. While the move may be unanticipated, it is justified. The market rate for the yuan has moved away from the midpoint, or the fixing point, for this major currency which clearly has shown that it is overvalued and should be adjusted. Moreover, China wants the yuan to be one of the elite currencies that make up the International Monetary Fund’s currency, known as the Special Drawing Rights. The IMF wants China to make its currency more market-determined.
How can we rationalize this surprise inside China? The yuan had appreciated against the dollar by 30 percent since 2005, and by more than 12 percent last month. It is justified on the basis of the divergence between market rate and the fixed rate for the yuan. Thus, the devaluation looks good because it may make China like a free market. It is part of a processed called quantitative easing that other regions including the United States, the Eurozone and Japan followed before to stimulate economic growth. The People’s Bank of China has reduced interest rate four times in the last few years, but this policy did not bear good fruit. It reduced the reserve requirement, and this tool did not help much. The current policy is to devalue the currency. They are all part of QE. China also tried fiscal policy but that did not help much. All these polices indicate that China needs to substantially reform its economy.
Outside of China, the IMF applauded the devaluations and considered it a “welcome” step towards making the yuan more market-based. The major international organization is preparing the yuan as one of the elite currencies in the world, and thus the devaluation of the yuan in honor of market forces pleases the IMF. The U.S. lawmakers will see it as a currency manipulation to give China more comparative trade advantage over other countries, including the United States.
The devaluation is intended to energize China’s export sector at a time when its economic growth is slowing down below 7 percent. It may hamper China’s effort to restructure the economy away from depending on exports and towards domestic consumption. The export sector is still important in the Chinese economy, accounting for about 25 percent but is still less than the 30-35 percent it had last decade. While this devaluation should help the Chinese exports and economic growth modestly due to the reduced share of exports in gross domestic product, it is in this sense a setback to China’s macroencomic reforms. On the other hand, it is welcomed by the IMF since it makes the exchange rate look more market dependent.
The devaluation has economic and political ripples that have resonated around the globe, given the importance of the Chinese economy as the second in the world after that of the United States. Brazil, Russia, India, China and South Africa, the five major emerging national economies that are often referred to the BRICS, depend on exports as a major thrust of their economic growth. Retaliatory devaluation should come from Brazil and others in the BRICS and Indonesia and South Korea among others in Asia who are not members of the BRICS. They should devalue their currencies to stay as competitive as China. The Philippines responded immediately by expanding the exchange rate band for its currency. These actions will create chain reactions around the world and depreciate against the dollar, which in turn should depress commodity prices including oil prices. Commodity-exporting countries, which are mostly emerging market economies, should be negatively affected by the expected plunge of their goods. This in turn should push down global inflation, which makes it harder for the United States to hike short-term interest rates in September.
If you are a currency trader or a central banker, what have you learned from this surprise devaluation? Currency traders and central bankers should watch the diversion between the market rate and the fixed rate. If the divergence comes close to 2 percent, get set for a yuan depreciation. This advice is supported by the government’s recent statement that it will base its future official rates more closely on transactions taking place in the exchange market. I hope this policy is not asymmetric, in the sense that the governmnet will be willing to let the yuan appreciate by 2 percent if the deviation warrants it and the currency becomes undervalued. If that happens, we have a symmetric exchange rate policy that inches closer to a market-based intervention policy. Once this happens, the yuan will become a major currency touching shoulders with the dollar, euro, yen and the British pound, the elites of the SDR.