What China’s yuan devaluation means?

China has shocked the world by suddenly devaluing its currency – renminbi – in two successive days by nearly two per cent on Tuesday and again by 1.6 <g data-gr-id="74">per cent</g> on Wednesday.  This has set in motion a huge adjustment in financial and commodity markets across the world. This is the biggest yuan loss since 1994.

The immediate effect is that the US dollar has become the supreme currency, which has gained against all major currencies. From Australia and New Zealand dollars to the Euro and yen all are losing and depreciating against the greenback.

With the whopping devaluation, European companies which had banked on sales in China are seeing the red. Their share prices have dropped across <g data-gr-id="80">bourses</g> and equity prices of some of the biggest European companies have fallen.

For India, it has resulted in a fall in exchange rate of the rupee for no weakness in the Indian economy. Rupee is racing towards 64 to the dollar and maybe even lower. It will push up import costs. But at the same time with Chinese currency being cheaper, the competition in international markets will become keen. It will make for far fierce competition from China in the major export markets around the world. Besides, China’s imports should also go down, which means India’s exports to that country might further fall. As such, India currently has huge current account deficit with China, meaning that we are importing more from China than we are able to export to that country. As a result, India runs a major trade deficit with China adding up to around $40 billion annually. We must watch out and devise ways of meeting the Chinese threat now that a currency war is expected in Asia.

Economists believe that the Chinese move to gain competitiveness through devaluation will lead to 

currency wars across geographies. European countries were trying to regain their exports through a softer euro. Asian countries would equally try the same medicine. Hence, this will be a war to the bottom, felt Stephen Roach, professor of economics at Yale University.

These effects apart, the devaluations are leaving wider footprint. China being a resources guzzler for its massive manufacturing sector, mining companies have been particularly hit. BHP Billiton is down, commodity markets are down, mining sectors affected as China has been the biggest user of commodities and metals. Why is China doing this? First, the cut in the yuan exchange rate may have been prompted by overall trade figures of China. The latest figures indicated that China’s exports have dropped by eight <g data-gr-id="92">per cent</g> in July compared with a year back and this was hurting the Chinese domestic economy.

With fall in exports, entire segments of Chinese industries are facing glut. Their products are not selling overseas and China is stuck with excess production capacity. Falling exports will further deepen the slow down of the Chinese economy and the country is trying to overcome through devaluation of its currency. It is feared that Chinese domestic growth rate will be drastically cut this year and China should grow by below five per cent. China, the move confirms, is slowing down faster than anticipated, experts now fear.

Secondly, China is recalibrating its method of exchange rate management. It is trying to place a mechanism for making its exchange rate more responsive to market forces. This is in response to recent criticism of IMF on this score. A question is naturally cropping up how this will go down with China’s efforts to make renminbi accepted more widely as a reserve currency. China had asked IMF to include the renminbi as a reserve currency in its special drawing rights.

SDR is a currency basket with IMF in which funds are extended to countries for crisis management. It requires that these currencies should be readily exchangeable and used for making payments and purchases. <g data-gr-id="77">Thus</g> they must be stable and be freely traded.

The devaluations can have favourable impact so long as China’s currency remains range bound. If it devalues deeply, then the central bank will have to re-enter and seek to fix rates around its desired levels. If it settles at reasonable levels, without intervention, then the central bank can let the more <g data-gr-id="76">market friendly</g> mechanism remain in place. The fact remains that here we are entering a more uncertain territory. The future course will also be influenced by what is happening in the real economy. There is fear that China’s economy is slowing down faster than the authorities could stomach. Housing markets are falling, so also industrial production and exports. If these trends are not reversed, then the pressure on the political authorities will mount.

This is the time for China transiting from a <g data-gr-id="71">command oriented</g> economy to a more <g data-gr-id="72">market based</g> one. From being <g data-gr-id="85">a investment</g> and exports oriented economy to more consumption oriented ones. But many of the steps taken are contradictory. For example, for a consumption based economy to emerge a stronger currency should be the tool.

Devaluations should make Chinese spend less and imports should come down. It is not clear which way China is veering. But in any case, this will leave its impact globally.