Take-Away lessons from China’s move to devalue Yuan

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On August 5, 2019, the People’s Bank of China set the yuan’s daily reference rate below 7 per dollar for the first time in over a decade. This, in response to new tariffs of 10% on $300 billion worth of Chinese imports imposed by the Trump administration, set to go into effect September 1st, 2019. It is the latest salvo in the U.S. China trade war, but certainly not the first time China has devalued its currency.

On August 11, 2015, the People’s Bank of China (PBOC) surprised markets with three consecutive devaluations of the yuan renminbi or yuan (CNY), knocking over 3% off its value. Since 2005, China’s currency had appreciated 33% against the U.S. dollar, and the first devaluation marked the most significant single drop in 20 years. While the move was unexpected and believed by many to be a desperate attempt by China to boost exports in support of an economy that was growing at its slowest rate in a quarter century, the PBOC claimed that the devaluation was part of its reforms to move towards a more market-oriented economy. The move had substantial repercussions worldwide.

After a decade of a steady appreciation against the US dollar, investors had become accustomed to the stability and growing strength of the yuan. Thus, while a somewhat insignificant change for Forex markets, the drop – which amounted to 4% over the subsequent two days – rattled investors.

U.S. stock markets and indexes, including the Dow Jones Industrial Average (DJIA), the S&P 500, and European and Latin American markets fell in response. Most currencies also reeled. While some argued that the move signaled an attempt to make exports look more attractive, even as the Chinese economy’s expansion slowed, the PBOC indicated that other factors motivated the devaluation.

Key Takeaways

  • After a decade of a steady appreciation against the US dollar, investors had become accustomed to the stability and growing strength of the yuan.
  • China’s President Xi Jinping had pledged the government’s commitment to reform China’s economy in a more market-oriented direction since he first took office in March 2013.
  • Despite the IMF response, many doubted China’s commitment to free-market values arguing that the new exchange rate policy was still akin to a “managed float.”

Effect on the IMF

China’s President Xi Jinping had pledged the government’s commitment to reform China’s economy in a more market-oriented direction since he first took office in March 2013. That made the POBC’s claim that the purpose of the devaluation was to allow the market to be more instrumental in determining the yuan’s value more believable. The devaluation announcement came with official statements from the PBOC that as a result of this “one-off depreciation,” the “yuan’s central parity rate will align more closely with the previous day’s closing spot rates,” which was aimed at “giving markets a greater role in determining the renminbi exchange rate with the goal of enabling deeper currency reform.”

At the time, a professor at Cornell University indicated that the move was also consistent with China’s “slow but steady” market-oriented reforms. The currency devaluation was one of many monetary policy tools the PBOC employed in 2015, which included interest rate cuts and tighter financial market regulation.

There was also another motive for China’s decision to devalue the yuan – China’s determination to be included in the International Monetary Fund’s (IMF) special drawing rights (SDR) basket of reserve currencies. The SDR is an international reserve asset that IMF members can use to purchase domestic currency in foreign exchange markets to maintain exchange rates. The IMF re-evaluates the currency composition of its SDR basket every five years. In 2010, the yuan was rejected on the basis that it was not “freely usable.” But the devaluation, supported by the claim that it was done in the name of market-oriented reforms, was welcomed by the IMF, and the yuan did become part of the SDR in 2016.

Within the basket, the Chinese renminbi had a weight of 10.92%, which is more than the weights of the Japanese yen (JPY) and U.K. pound sterling (GBP), at 8.33% and 8.09%, respectively. The rate of borrowing funds from the IMF depends on the interest rate of the SDR. As currency rates and interest rates are interlinked, the cost of borrowing from the IMF for its 188 member nations would now hinge in part on China’s interest and currency rates.

Although a lower-valued yuan does would give China somewhat of a competitive advantage, trade wise, the move was not totally counter market fundamentals. Over the past 20 years, the yuan had been appreciating relative to nearly every other major currency including the U.S. dollar. Essentially, China’s policy allowed the market to determine the direction of the yuan’s movement while restricting the rate at which it is appreciated. But, as China’s economy had slowed significantly in the years prior to the devaluation while the U.S. economy had improved. A continued rise in the yuan’s value no longer aligned with market fundamentals.

Understanding the market fundamentals clarifies that the small devaluation by the PBOC was a necessary adjustment rather than a beggar-thy-neighbor manipulation of the exchange rate. While many American politicians grumbled, China was actually doing what the U.S. has prodded it to do for years—allow the market to determine the yuan’s value. While the drop in the value of the yuan was the largest in two decades, the currency remained stronger than it had been in the previous year in trade-weighted terms.

The Bottom Line

Despite being critiqued for exchange-rate manipulation, China had good reason to devalue the yuan in 2015. With slower exports and a stronger U.S. dollar, allowing the yuan to depreciate was consistent with market fundamentals and the desire of the nation’s leaders to shift to domestic consumption and service-based economy. While fears of further devaluations continued on the international investment scene for another year, they faded as China’s economy and foreign exchange reserves strengthened in 2017. However, China’s moves will continue to send ripples across global financial systems, and rival economies should brace themselves for the after-effects.

 

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