Sunday, 16 August 2015

Yuan, where are you going?



Recent economic news has centred on the same few topics; Greece, Greece, Greece and interest rates. Yet last week the world woke up to a new story; the devaluation of the Chinese yuan! Why did the depreciation send shock waves around the world and prompt such a huge global response?

The People's Bank of China has now allowed market forces to have a greater role in determining the value of the renminbi. Supply and demand can affect the value of a currency. Here there is an extension in supply of the RMB which causes the exchange rate to fall to R2 from R1. This results in a depreciation of the RMB.
Every country has a central bank responsible for issuing money and setting short term interest rates. In the United Kingdom this is the Bank of England whilst in the United States of America it is the Federal Reserve and the Reserve Bank of India in India. Beginning Tuesday the People’s Bank of China let the yuan devalue by 1.9% and this continued for a couple of days. So why did they do this?

China is a major exporting nation; so the 8.3% fall in exports in June was a big shock. Devaluing the yuan enables people abroad to buy more Chinese goods for the same amount of their currency. Theoretically, this move should boost the volume of Chinese exports. Perhaps the central bankers are looking for an export-led recovery following the economic slowdown in China! Yet I feel the stronger reason for devaluation is to show the world that China can be more dependent on the market. Previously the renminbi (another name for the yuan) was pegged to the US dollar. This is because China wants to become one of the International Monetary Fund’s (IMF) Special Drawing Rights currencies. As a consequence of this more countries would have the renminbi in their reserves.

What were the economic effects for countries that already have strong ties with China? Neighbouring countries, such as Vietnam and even India, also experienced devaluation in their currencies. This happened so that their exports would still remain competitive against China’s. Commodities saw a huge depreciation as China is a large consumer of raw materials and makes up a lot of the market demand. Goods such as metals are priced in dollars; therefore it is more expensive for Chinese manufacturers to import them. Similarly, costs of production are now increasing for Chinese airlines since crude oil, the core ingredient for aviation fuel, is traded in US dollars.

There are still ramifications for those in the West. UK retailers, especially those of luxury goods, have a big market in China. With many consumers priced out of buying the latest fashions it’s likely that there could be losses for companies like Burberry. For consumers in the USA and the UK, cheaper Chinese goods could reduce inflationary pressures and keep interest rates at their current levels for longer.

My opinion is that this devaluation and further devaluations, if any, will not have too adverse effects on economies of the UK and the US. This is because the manufacturing sector in these countries is very small relative to the whole economy. Even if they do increase manufacturing, it wouldn’t be in cheap goods that China is focused on. If they were competitors, greater unemployment could have been the issue but this isn’t the case. I also feel there is more for China to do in order to be accepted as an SDR currency. The move to make the value of the yuan dependent on market forces, such as taking into account FX demand, is a good one. To further improve their cause with the IMF, China could relax some capital controls e.g. relax the amount of bureaucracy ‘enjoyed’ by foreign investors. In doing so, China could also make itself attractive to investors in general.

Will this move kill two pigeons with one stone; stabilise economic growth and enable China to join a currency club? We’ll have to wait and see.

N.B:

A special thank you to Grishma Shanbhag for her advice and tips, my blog is even better for it!

Photo source: www.cmsfx.com

The renminbi (RMB)  is the name of the currency used in China while the yuan is one unit of it.