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Desperate Measures in Desperate Times – PBoC Devaluing Yuan

Avanish Verma & Mukul Shashtry

It is rumored that the Chinese Central Bank (People’s Bank of China – PboC) is on its way for 10pc fall in Yuan. Though PBoC has dismissed saying it has devalued its currency for the first time in over 20 years. Interesting the rate of Yuan is not market determined but is pegged at Dollar by the PBoC. Though PBoC has reiterated several times that China has strong economic fundamentals and deep foreign reserves but it looks their conduct reeks of desperation.

August 11, depreciation of Yuan to Dollar is a mixture of both outward looking and Inward looking review of Chinese currency policy. It is no hidden fact that after witnessing a neck-breaking double digit growth for last three decades, Chinese economy is going through a rough patch, probably the worst in last three decades.

How does PBoC devalue Yuan?

Before deliberating further as to the devaluation of Yuan, let us in brief have a look as to how PBoC devalues Yuan. Chinese currency had been pegged at against US dollar, one of the prime reasons why it was not getting international status at par with Pound, Euro or Dollar. On 21st July 2005 this peg was finally lifted which saw immediate one off revaluation of Yuan to 8.11 per dollar from 8.27 per dollar. However, China manages the exchange rate of Yuan through an official midpoint of a basket of currencies and it allows variance of 2% each day. The basket is dominated by US Dollar, Euro, Yen, Won and to lesser extent Pound, Thai Baht, Ruble, Australian, Canadian and Singaporean Dollars. On August 11, 2015 PBoC changed the methodology for setting the ‘reference rate’ i.e. the rate at which Yuan is pegged against Dollar. Further, PBoC prints more Yuan and buys Dollar and also ensures that Yuan trades within 2pc range.

Impact of Devaluation

The Chinese`s yuan relation to USD cannot be viewed in isolation and is a derivate of complex relation between Chinese and US economy. While undervalued Chinese economy not only offers export advantage to China thereby lowering cost of living in US, it also offers US Government huge funds to gap its budget deficits. Such devaluation has played a major role in China holding almost one fifth of US treasuries.

What happened on 11th Aug?

Before a modification in currency policy on 11th August 15’, China kept Yuan`s trading value within a predefined band (+/-2%) around a particular reference value. However, with a intent to allow market forces drive Yuan value, PBoC modified the reference value to previous day`s closing value at Forex markets. This led to an immediate correction and devaluation of Yuan to $0.156633 within two days (largest devaluation in history of Chinese currency).

The prime drivers for such change in policy are deeply engraved than obvious peripheral reasons of encouraging growth, reviving the stock market after recent disarray and fighting possible domestic unemployment. China have been long demanding inclusion of Yuan into reserve currency and have special drawing rights. However IMF has indicated that Yuan is still not freely tradeable and lacks market driven interest rate. With decision on inclusion of yuan to reserve currency expected in next few months, China wants to relinquish the global image of yuan being steered by government controls. The recent modification of currency policy is a step in this direction. Further, a back of envelop calculation tells that though 10 basis point drop in value of Yuan can boost export growth by 1% point with some lag, but it also triggers capital flight in much higher proportion. Some economist estimates it to be as high as $40 billion.

Impact on Indian Segment

The devaluation of Yuan and sluggish Chinese economy may have a twofold impact on Indian Economy. While the direct positive impact would be availability of cheaper Mobiles, Electronics and toys the domestic metal, rubber & tyre Industry would be negatively impacted directly and may spell dooms for the already struggling steel sector in particular. The recent alacrity of 2.5% hike in import duty hike by Government is being seen as a panic reaction to save the domestic metal manufacturers. Such small hikes may not be enough to deject Chinese exporters to dump goods in Indian market

Devaluation of Yuan would add to volatility on depreciating rupee thereby destabilizing the stock market further. Also such downward pressure on rupee would lead to higher import prices and inflation. Any measures by RBI to curtail inflation through higher interest rate would jeopardize the economic development further.

Further, with higher interest rates prevalent in India, Indian exporters may turn hog tie in the global market enhancing the current account deficit for the country. Also sluggish domestic demand in Chinese market owing to slowing economy shrinks the potential market for Indian export segment. China constitutes the fifth largest export segment for Indian Exporters.

However, not all seems gloomy, slump in Chinese economy has led to lower demand of crude oil for world`s second largest economy. This shall inturn put downward pressure on global crude prices leading to cheaper oil import bill for India. Also India can draw heart from fact that other currencies have depreciated much more. This could be also be another opportunity for India to ease on self-imposed bullion import precincts. The devaluation of yuan and associated instability has also opened doors for foreign investors to look at India as an alternate attractive segment to invest in. Therefore, if Indian reform bills which are pending can be cleared, some stability is assured in Indian market the global investors will head India’s way with much higher confidence.

About the Authors: Both Avanish and Mukul are alumni of IIM Ahmedabad. Avanish holds over eight years of experience in energy sector,  while working with large multinational corporations. Mukul brings over a decade of experience working with Reserve Bank of India, National Law University, and Rajasthan High Court.

Avanish Verma Avanish Verma Mukul Shashty Mukul Shashtri

Disclaimer: The opinions expressed within this article are the personal opinions of the authors. The facts and opinions appearing in the article do not reflect the views of The Indian Iris and The Indian Iris does not assume any responsibility or liability for the same.

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