On August 11th, People's Bank of China (PBOC) has shocked the markets by devaluing yuan to 6.23 against the U.S. dollar. For many investors, this was a surprising move that has raised a red flag for the growth prospects of the Chinese economy, whereas several markets around the world came under extreme pressure. Furthermore, fears for a regional currency war have mounted as, following China’s move, many markets in the Southeast Asia have collapsed.
Why China Devalued Its National Currency
From 1994 to 2005, the yuan was pegged to the U.S dollar at 8.28 yuan per U.S. dollar. In July 2005, following pressures from its major trading partners, the Chinese government decided to internationalize the national currency by allowing it to enter a managed free-float system around a fixed rate determined by the movements of major world currencies, including the U.S dollar. From 2005 to 2008, the yuan appreciated by 21% at 6.83 to the U.S dollar. In July 2008, the declining global demand for Chinese products due to the global financial crisis led PBC to halt the yuan’s appreciation. On June 2010, China reentered the game, pushing the yuan up, leading to a cumulative appreciation of 12% to 6.11 by December 2013. Although it is hard to accurately calculate the exact percentage of undervaluation over the past two decades, it is certain that the currency is substantially undervalued.
PBOC’s move to set the official rate at 6.23 yuan per U.S. dollar has rattled investors, reigniting a narrative on whether China is providing an unfair advantage to its businesses. The move is widely viewed as an effort to keep the yuan at low levels in order to boost the competitiveness of the Chinese exports in the global marketplace. In fact, China is pegging the yuan against the greenback at artificially low levels, while it allows fluctuations within a range of 2% on either side of the reference rate. By allowing its currency to float freely, China accumulates U.S dollars by selling yuan. As of September 2015, China’s foreign exchange reserves is $3.51 trillion, down from $4 trillion in June 2014. However, the cut in foreign exchange reserves was made to support the devaluing yuan. In addition, the PBOC’s move indicates a shift in the Bank’s monetary policy, suggesting that China may be seeking a more market-oriented approach for its national currency in order to make its economy more responsive to global market forces.
Markets Respond To Yuan Devaluation
The yuan has already declined by 5% in the global foreign exchange markets. Following the PBOC’s decision, Vietnam, China’s major trading partner, has decided to widen the dong’s (VND) trading band to 2% from 1%, allowing its national currency to trade in a range of VND 21,240 and VND 22,106 against the U.S. dollar. According to The State Bank of Vietnam, the decision is within a series of “comprehensive measures and policies to ensure stability of the dong and the currency market.”
Furthermore, in response to China’s move, Indonesian Rupiah (IDR) hit a 17-year low, declining by 0.44%. The Singapore Dollar (SGD) hit its five-year low, declining by 1.3%, Malaysian Ringgit (MYR) dropped by 0.7%, and the Thai Baht (THB) fell 0.8%, hitting its six-year lows. Similarly, Australian dollar (AUD) and New Zealand dollar (NZD) hit their six-year lows.
Global markets were also sent into a spin. The ASX 200 index declined to 5,001.3 points, down by 4.09%. The Shanghai composite index fell to 3,209 points, down by 8.5%, while the Nikkei slumped by 4.61%. The Dow Jones fell down to 588 points. NASDAQ and S&P entered a correction phase, down by 10% from their peaks. FTSE 100 suffered its bigger losses in the last six years and the European stock markets suffered their worst tumble since 2011.
Struggling Economic Activity In Emerging Markets
China’s slowdown is expected to have an impact on the output growth of the emerging markets, mainly due to declining commodity prices and depreciating currencies. Additionally, Russia and Brazil endure high inflationary pressures which cause their currencies to depreciate against the currencies of developed economies, causing a further decline in commodity prices. Meanwhile, job cuts continue to impede consumer confidence and economic sentiment in these economies. The IMF has lowered its forecast of global growth to 3.1% for 2015, 0.2% down from its July estimates and to 3.6% for 2016.
Conclusively, China’s yuan devaluation happens on top of a sharp slowdown in the world’s second-biggest economy, while slumping commodities are hurting the emerging economies. The PBOC’s move has also raised political concerns in the United States, following China’s threats to displace exports from Asian and emerging market competitors. The yuan devaluation in not without implications and risks triggering capital outflows.