GP Insights

GP Insights # 123, 10 August 2019

China: Devaluation of Yuan towards a currency confrontation
Harini Madhusudhan

What happened?

As a response to the announcement by Trump government to raise tariffs by 10 percent for an additional $300 billion of Chinese exports, Beijing took a political decision to drop the value of Renminbi below 7. This sent shockers across the financial markets around the world. 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. US Treasury officially named China a “Currency Manipulator,” though the naming is mostly symbolic, it opens an opportunity for the US to take this case to the IMF to ‘eliminate any unfair advantage China's currency moves have given the country.’

POBC claims that the purpose of the devaluation is to allow the market to be more instrumental in determining the yuan’s value. 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," reported a market analysis platform.

What is the background?

Since 2005, China’s currency has appreciated 33% against the U.S. dollar. Previously in August 2015, the People’s Bank of China (PBOC) had surprised the markets with upto three devaluations consecutively of the yuan renminbi or yuan (CNY) which knocked over 3% off its value. After a decade of steady appreciation against the US dollar, investors had become accustomed to the stability and growing strength of the yuan. While a somewhat insignificant change for Forex markets, the drop which amounted to 4% over the subsequent two days has rattled investors.

The second arrangement of “truce” between the two leaders along the sidelines of G20 summits in Argentina and Japan have both failed in a similar way. The trade war has taken various forms over the past months it has moved from export restrictions and tariffs to technology, MNCs and 5G, and it is moving towards the currency.

What does it mean?

China’s is using the currency valuation as a double-edged sword which could easily hurt both the US and China economies and simultaneously hurt the world markets to a great extent. However, according to various experts, the drop is technically not strong enough to give China a comparative advantage over the US; but just enough to nudge the US. Also, do exchange rate-cuts make an impact on the trade patterns today, like it did in the past? Not really, the economy is extensively diversified now.

It seems like China chose this option over the choice to ban rare earth’ exports to the US. Since the trade war began, China is also said to have been keeping the value of Renminbi artificially high; this drop could be an attempt to readjust the differences. The immediate effects will be of advantage to the Chinese exporters and will halt the imports to China. Quoting a report from China, “Exchange rate cuts have muted effects on the trade balance in the short term,” it is safe to say that this will correct the imbalances.

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