[fblike]
If extempers followed global economic news over the past week, they probably remember that China’s currency devaluation was a significant topic. On Tuesday, the People’s Bank of China (PBoC) announced more market-friendly reforms that will allow the nation’s currency, called the renminbi (RMB) or the yuan, to be managed less arbitrarily. The effect of this market-based move was a sudden decline in the value of the RMB, a currency that some market analysts argue has been overvalued for some time. The 1.9% decline versus the American dollar last Tuesday was welcomed by some economists, who say that it will provide a valuable market correction, but China also came under fire from American politicians and Western economists, who allege that China’s devaluation is designed to help boost the nation’s ailing exports. The move has provided ample fodder for Republican presidential frontrunner Donald Trump, who has made anti-China sentiment a large part of his campaign. In addition, China’s devaluation may contribute to more deflationary pressures in Western economies and complicate the Federal Reserve’s decision about whether to raise interest rates by the end of the year.
This topic brief will discuss the steps that China has taken to devalue its currency, analyze the reasons why the Chinese government would encourage a currency devaluation, and highlight how China’s currency devaluation could affect the global economy.
Readers are also encouraged to use the links below and in the related R&D to bolster their files about this topic.
What is China’s Currency Devaluation All About?
Prior to Tuesday, China was pegging its currency, the renminbi (RMB), to the dollar, although it has claimed that it is trying to float the RMB among a basket of other prominent international currencies. China has pursued this currency strategy in an effort to help its exports to the American market as the RMB is always pegged below the value of the U.S. dollar. What this means is that products that are placed in RMB are cheaper on the American market, whereas products that are priced in American dollars are more expensive in China. For example, let’s assume that China pegged six RMB to equal $1. This would mean that if a television made in China cost 12 RMB it could be sent to the U.S. and sold for $2. However, if an American company made a $12 television and sent it to China, it would cost 72 RMB. As you can see, Chinese companies would have a much easier time selling their products cheaply in the U.S., whereas American companies would be at a disadvantage in China. This is why China’s currency devaluation is significant because it has the potential to aid Chinese exporters by making the RMB worth less.
In addition to maintaining the currency peg, The Financial Times of London explains on August 11 that the People’s Bank of China (PBoC) used to conduct a “daily fix” before each trading day. The PBoC would set a midpoint for where it wanted the value of the RMB to be and then would allow investors to trade the currency within 2% of the established figure. The Los Angeles Times adds on August 12 that the PBoC manages the currency throughout the day by buying and selling RMB. Additionally, The Guardian explains on August 14 that these tight controls existed so that China could prevent sudden capital inflows and outflows that could lead to massive spikes or collapses in the value of the RMB. Extempers should remember that the Chinese government prioritizes sustained, controllable economic growth. The worst fear of Chinese officials is that the economy collapses or overheats, thereby creating massive job losses and possible political unrest that could threaten the rule of the Communist Party. Thus, strict control over the value of the RMB reflects these beliefs.
On Tuesday, China announced some changes in how the RMB would be valued. The 2% threshold for how far the currency will be permitted to rise and fall will remain, but instead of unilaterally deciding the midpoint of the RMB before the day’s trading begins, the PBoC will reportedly take into consideration other market sources. According to the Center for Strategic and International Studies on August 11, the PBoC will probably consult a small group of banks before setting the midpoint. Reuters explains on August 14 that under this new system the RMB could move as much as 10% a week versus the U.S. dollar and other currencies, but state intervention will likely keep such a wild swing from happening. It may seem curious that China is taking this step, but the International Monetary Fund (IMF) actually welcomed the move, saying that it shows how China is continuing to engage in much needed financial reforms.
Why Would China Devalue Its Currency?
There are several reasons why China announced last week’s currency reforms, the biggest of which might be a desire to boost the nation’s ailing exports. Newsweek explains on August 14 that since 2005 the RMB has appreciated (meaning that it has grown in value), largely due to the fact that the RMB is still largely tied to the value of the U.S. dollar. Over this time period, the U.S. dollar has continued to appreciate relative to other international currencies such as the European Union’s euro and the Japanese yen – in large part due to many of the economic problems that those areas are experiencing – so this means that the RMB has also increased in value. This has put China in a position where its exports are becoming more expensive on the international market and in fact, experts argue that the RMB was overvalued, with Bloomberg Business Week explaining on August 13 that the Royal Bank of Canada believed that the RMB was overvalued 15% before last Tuesday. The Chinese government likely wants to revive its exports as the economic growth of the last two decades was based on its manufacturing and export-oriented sectors. Part of the reason for the recent Chinese economic slowdown is owed to these segments of the economy performing poorly as Newsweek notes that Chinese exports to the European Union (EU) fell 12% over the last year and its overall exports have declined 8.3%. All of this contributes to a gross domestic product (GDP) of 7% and although this is a growth rate that many Western nations would kill for it is the slowest GDP growth rate for the nation in several years. Therefore, part of the aim of the recent devaluation may be due to the Chinese government’s drive to bolster exports and revive an ailing economy.
Another reason for China’s decision is that it wants the RMB to become part of the IMF’s special drawing rights (SDR) basket of currencies. SDR currencies are used as the primary funds of the IMF and national governments can exchange them for hard money that is denominated in one of the four currencies that have SDR status: the U.S. dollar, the euro, the British pound sterling, and the Japanese yen. Chinese policymakers have been meeting with the IMF to try to get the RMB listed. If it succeeded, China could eventually get more nations to use RMBs as part of their foreign reserves and this is part of a long-term effort by the Chinese to obtain a more prominent role in international markets. Zero Hedge, a financial blog, explains on August 13 that the reason for the U.S. dollar’s prominence on international markets is that it is a global reserve currency that nearly all central banks have as part of their foreign reserves. The dollar is also used as a primary currency in global trade, evidenced by the fact that oil is priced in American dollars. Eventually, China would like to make a push for the RMB to be seen on the dollar’s level and it shares some of the same sentiments as other nations such as Russia that wish for the U.S. dollar to be potentially replaced by other currencies. To get to this point, though, the RMB has to have wider use and it needs the sanction of other financial officials at the IMF. If the perception still exists that the RMB is centrally managed and is not allowed to be freely traded, the chances of the IMF granting the RMB SDR rights is out of the question. The Guardian writes on August 12 that the IMF will make its SDR decision about the RMB next September, so China’s recent moves that appear market-friendly may be designed to win over skeptical IMF officials.
The Guardian article previously cited alleges that China’s devaluation decision may also be motivated by trying to prevent a continued appreciation of its currency if the U.S. Federal Reserve decides to raise interest rates. If the Federal Reserve does what many economists expect it to do and raises interest rates in September, the U.S. dollar would experience more appreciation on the global market as investors would seek out higher returns by placing funds into dollar assets. The Hill writes on August 12 that the U.S. dollar has been weak since the 2008 financial crisis and in fact, the last time that interest rates were raised was 2006. After the 2008 crash, the Federal Reserve cut interest rates to the bone and its quantitative easing program flooded the markets with U.S. dollars. This had the effect of keeping the value of the dollar artificially low and developing nations alleged that the U.S. was engaging in a currency war. China realizes that U.S. monetary decisions can impact other parts of the world and when a rate increase does occur, international observers warn that a capital flight could take place out of the developing world. The Washington Post points out on August 12 that if China continues to stubbornly peg the RMB to the dollar that it could be in for significant pain as the RMB would have to appreciate. It explains that since investors expect the Federal Reserve to raise interest rates, the U.S. dollar has been rising in value and the Chinese RMB has ended up rising 9.2% versus the euro and 57.8% versus the Japanese yen. Therefore, China may be trying to decouple the RMB from the dollar before the Federal Reserve raises interest rates and the RMB appreciates too much.
The Devaluation’s Impact on the Global Economy
One of the concerns of China’s currency devaluation is that it may spark a currency war, especially among its neighbors in East and Southeast Asia. In the 1930s, governments attempted to remedy the economic problems created by the Great Depression by erecting prohibitive trade barriers and devaluing their currencies relative to each other, which ended with a general freezing of the international financial system and more prolonged agony. The New York Times explains on August 13 that now that China is moving to devalue its currency other nations such as South Korea, Indonesia, and others may devalue their currencies so that they remain competitive against Chinese exporters. CNN adds on August 12 that countries that are competing against China in consumer electronics, smartphones, and other goods will also feel pressure as their ability to sell in foreign markets could be negatively affected by the devaluation. There are some troubling signs that more devaluations could come as all major currencies in China’s neighborhood weakened against the U.S. dollar on Tuesday with New Zealand, Taiwan, South Korea, Singapore, and Australia all seeing their currencies decline in value. If all of this produces a more anxious trade environment in Asia it could harm the prospects of the Trans-Pacific Partnership (TTP) as it could inhibit cooperation among nations that are suddenly trying to outrace each other and China.
China’s devaluation is likely to complicate monetary policy in the Western world as well, especially because the Federal Reserve and the Bank of England appear poised to raise interest rates. The Bloomberg Business Week article cited earlier notes that the Federal Reserve has sounded the alarm about how an appreciating U.S. dollar could harm exports, and it also notes that a 10% appreciation of the dollar relative to other international currencies produces a 0.7% decline in GDP over a two year period. Additionally, a 5% decline in the RMB will likely lead to a 2.6% appreciation for the dollar, thereby creating headaches for American exporters and potentially making it harder for the U.S. economy to continue to recover from the 2008 financial crisis. The Federal Reserve has enough headaches trying to figure out what to do with interest rates due to the fact that labor force participation rates remain at historic lows, wage growth has remained stagnant despite signs of an economic recovery, and there are questions about whether the unemployment rate is credible. The Guardian from August 12 that was cited earlier in this brief points out that China’s devaluation may bring more deflationary pressure to Western economies as goods will continue to be cheap for consumers. This would ward off some of the inflationary pressures that would usually lead to a substantial change in monetary policy. Bloomberg Business Week concludes that if the dollar appreciates significantly following an interest rate hike in September, the Fed may have to put off another interest rate increase until early 2016, so extempers should continue to watch how the Fed handles monetary policy in light of China’s devaluation.
It should be noted, though, that China’s currency devaluation, which had the effect of lowering the value of the RMB by 4.4% versus the dollar, is not going to suddenly boost China’s exports, though, especially relative to other nations. The Center for Strategic and International Studies explains that Chinese goods are already competitively priced without help from a cheaper currency and it has to pay for imported components, which will actually be more expensive now that the RMB is depreciating. Chinese products will still have to be purchased by consumers as well and that is something that is a problem everywhere because global demand is still relatively weak. China may run into some political headwinds over its decision, though, which could generate more protectionist sentiment among the American population. Reuters reports on August 11 that Republican presidential frontrunner Donald Trump, who has made China a focal point of his campaign, blasted the devaluation by saying that it was “devastating” for the U.S. economy and reiterating his belief that the Chinese are “just destroying us (the United States).” Members of Congress also expressed hostile opinions about the devaluation, saying that the move showed that China was a “serial currency manipulator” and that the move merits economic countermeasures. Considering that Chinese President Xi Jinping is set to visit Capitol Hill next month the timing of the currency devaluation could be politically explosive.
With regards to the Chinese economy, the currency devaluation will have mixed results. On the one hand, China is hoping that the devaluation can bolster exports and can win the IMF’s favor. It is likely betting that it can sell the devaluation as a market-friendly correction and thus ward off charges that it is manipulating its currency, as Foreign Policy discusses on August 13. However, the currency devaluation could have some negative effects on the Chinese economy. First, the sudden depreciation shows some international observers that China cannot be trusted on being transparent on economic decisions as there was little indication that it was going to pursue alterations in its currency policy. Zero Hedge notes that China’s credibility was undermined in markets last week when it promised not to continue devaluing the RMB after Tuesday, but did so on Wednesday and Thursday, producing a 6% decline in the RMB’s value in less than thirty-six hours. The Economist explains on August 11 that China is asking a lot of itself as it is trying to adjust its economy to a consumption model, trying to rein in real estate and equity speculation, reduce volatility while opening itself up more to international markets, and expand its financial sector without overheating the economy. There are some fears that China’s devaluation shows that its existing actions in these areas, especially shifting the economy to a consumption model, are not working and that it is trying to actually go back to what worked in the past. Thus, the devaluation might be taken as evidence that China is regressing from its willingness to make adjustments to its economic model. Furthermore, The New York Times writes on August 11 that the devaluation could be harmful for Chinese companies that have debts in dollars. In fact, The Financial Times of London explains that China’s national airlines lost 9% of their value due to the fact the devaluation will inflate the cost of oil since that commodity is priced in U.S. dollars. The corporate debt issue is something that extempers should monitor closely as The New York Times from August 13 points out that Chinese companies have $1.6 trillion in foreign debt obligations. A sharp decrease in the value of the RMB could make these debts harder to repay and create more problems for the Chinese economy in the future. Lastly, there is the obvious question of whether Chinese officials will actually allow the RMB to appreciate. It is one thing to sell your reforms as market friendly and economically justified if they devalue your currency and appear to give you a trade advantage, but it is quite another when those reforms might go the other direction. The Atlantic explains on August 13 that the U.S. cannot complain if the market pulls down China’s currency, but Bloomberg notes on August 11 that complaints could fly if market forces pull the RMB up and Chinese officials intervene. This might be a situation that the IMF monitors before granting the RMB SDR status. Remember, when China had a 1929-style stock market crash several weeks ago they spent more than $100 billion bailing out the market and threatened to throw some investors in jail for selling their holdings. This strong-handed approach is too typical of the Chinese market and is an image that China needs to shed.
China’s recent devaluation is not going to suddenly alter the global economy, but it does have the potential over the long-term to swing some factors against the nation’s economic interests. The move, if it continues to lead to a substantial fall in the value of the RMB, could make China bashing a popular issue in the 2016 presidential election. It could also complicate the ability of Western central banks to raise interest rates if deflationary pressure continues to be brought to bear on consumer prices. And finally, China’s ability to show that it really is using the market to determine the value of the RMB will affect the IMF’s willingness to give it SDR rights. The currency devaluation is a market correction that China probably needs, but its ability to show the world that it can be trusted on monetary policy will be placed under a microscope. It cannot fail this examination if it wishes for the RMB to be treated as the international reserve currency of the future.