Chinese Currency Devaluation Hits Global Economy By Shobhit Seth | January 25, 2016
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China has been devaluating its currency on occasion since August 2015. Given its greater role in the global economy, China’s surprise moves are having serious repercussions around the world. (For more, read: The Chinese Devaluation of the Yuan.)
Reasons For Yuan Devaluation
Developed economies took a long time to absorb the aftershocks of the global financial crisis of 2008, with their recoveries being slow. (For more, read: The 2007-08 Financial Crisis In Review.) Because these economies were major markets for Chinese exports, their sluggish recoveries led to declining production, reduced employment and falling incomes in China. In response, China decided to shift from being a manufacturing-based, export-driven economy to one built more on domestic consumption and a growing service sector.
However, such paradigm changes will take a long time to materialize and show results, and China still significantly depends on its exports. By devaluating its currency, China makes exports cheaper and gains a competitive advantage in the international markets. A weaker currency also makes China’s imports costlier, thus spurring production of substitute products at home and so aiding domestic industry.
Impact On Global Trade Market
Currency devaluation is nothing new. From the U.S. and the European Union to developing nations like India, countries have devaluated their respective currencies to help cushion their economies. That said, China’s devaluations could spell trouble for the global economy. Given that China is the world’s largest exporter and its second-largest economy, any change that such a large entity makes to the macroeconomic landscape will have serious repercussions.
With Chinese goods becoming cheaper, many small- to medium-sized export-driven economies may see their trade revenues reduced. And if these nations are debt-ridden and have a heavy dependence on exports, their economies could take a beating. For instance, Vietnam, Bangladesh and Indonesia greatly rely on their exports of footwear and textiles. They could be in serious trouble should China’s devaluations make its goods cheaper in the global marketplace.
Impact On Global Economy
In a bid to establish the yuan as an international currency, China has been liberalizing its currency system. For instance, it moved from its former dependence on the U.S. dollar to a weighted basket of different currencies belonging to its trading partner economies.
In December 2015, China succeeded in getting the renminbi included as the fifth currency in the IMF’s Special Drawing Rights (SDR) basket, which will be effective from October 2016. Along with generally adopted reserves of U.S. dollars and gold, SDR is an additional international reserve asset that IMF members can use to purchase domestic currency in foreign exchange markets in order to maintain exchange rates.
The Chinese renminbi has a weight of 10.92%, which is more than the weights of the Japanese yen (JPY) and U.K. pounds sterling (GBP), at 8.33% and 8.09%, respectively. With the renminbi recognized as an international reserve currency, its valuations could have major effects on holders, including nations and large organizations. The rate of borrowing funds from the IMF depends on the interest rate of the SDR, which will now include a Chinese instrument. As currency rates and interest rates are interlinked, the cost of borrowing from the IMF for its 188 member nations will in part hinge on China’s interest and currency rates. (For more, read: How Do Changes in National Interest Rates Affect a Currency’s Value and Exchange Rates?)
Zimbabwe recently added the Chinese yuan (CNY) to its legally approved currency list, which already included U.S. dollars (USD) and the South African rand (ZAR). Though this move was politically attributed to China canceling Zimbabwe’s $40 million debt, such developments indicate the growing influence of China at the global level.
Developments and Challenges
All present-day economic powerhouses have moved their currencies from domestic to international. With two versions of Chinese currencies already existing, the onshore (CNY) and the offshore (CNH), the next aim for Chinese authorities will be to keep their rates close.
Trading activity in renminbi has shown a significant rise in usage at the international level. It can now accommodate any large-value international transactions occurring even at the levels of organizations like the World Bank and the IMF. The ongoing integration of the Chinese currency should soon make it a freely usable currency, leading to more international transactions and making it competitive with the U.S. dollar.
As mentioned earlier, China’s falling exports and its efforts to move to a consumption-based economy has led it to devaluate its currency recently. The moves in some cases seemed driven by a clear motive. For instance, the surprise renminbi devaluation in August 2015 was accompanied by the announcement that 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.”
China’s transition to a domestic-consumption based economy could encounter some challenges. Despite the increasing international usage of CNY, which is meeting set standards for inclusion in the IMF SDR, the renminbi’s share in world currency trade remains lower. Though China has made significant, visible moves to open up its financial system (like removing the U.S. dollar peg), the process will take time to complete. (For more, read: Why China’s Currency Tangos With The USD.)
The Bottom Line
In the short term, Chinese policymakers will have to deal with reforming their exchange rate system, bringing its onshore and offshore currency rates to par, and demonstrating effectiveness in managing currency valuations (or devaluations) amid its ongoing economic slump.
In the longer run, the size of the Chinese economy makes it an eligible candidate for having a free market global reserve currency. As China takes center stage at a global level, it needs to balance its domestic priorities and global responsibilities. Until then, it will likely keep sending ripples across global financial systems, and rival economies should brace themselves for the after-effects. (For more, see: Chinese Yuan: A 360 Degree Analysis (CNY) and 4 Economic Challenges China Faces in 2016.)
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