Yuan Devaluation: Is a Currency War on the Horizon?

By John Yang By John Yang

After decades of the renminbi’s so-called domestic devaluation strategy and appreciation overseas, suddenly in August 2015 the currency began to slump, and reached a level that is regarded as “depreciation” for the first time in several years. As a matter of fact, when the Central Bank of China (PBoC) announced an adjustment of the renminbi’s median price formation mechanism against the US dollar, the exchange rate was significantly devaluated by over a thousand points in the next two days, and the median rate of the renminbi against the US dollar was devaluated by almost 4%. The unexpected renminbi devaluation has shaken global markets, Asia Pacific stock markets, foreign exchange markets, and resulted in volatility in international commodity markets.

It is for this reason that some observers believe the renminbi’s “proactive” devaluation over these two days could trigger a new “currency war”. But is that really the case?

It is worth noting that Vietnam was the first nation to take immediate action on the renminbi’s sudden devaluation. Vietnam’s Central Bank announced on 12 August that the Vietnamese dong’s everyday trading range would be expanded. The dong can now float within a range of 2% of the median rate designated by the Central Bank, whereas the previous range was just 1%. Korean officials also announced plans to reinforce control of the financial market; Indonesian officials said they would do anything to protect the rupia.

At the same time, it is generally understood that the depreciation of the renminbi will likely promote China’s economy, and at some point also offset the impact of the dollar’s appreciation. Currency devaluation in emerging economies will soon become more common as Asian currencies remain low, and Korea, Thailand and Malaysia will all take a hit.

According to Morgan Stanley, the largest victim of China’s currency policy changes will be countries who export goods to China or compete with China on exports, along with those who face deflation and at the same time have excess production. Korea, Singapore and Thailand all fall into this category.

The question is, if the renminbi’s devaluation maintains momentum, is a “currency war” really imminent?

Let’s first look at the origin of the term “currency war”.

“Currency war” was a term first used by Brazil’s Finance Minister Gido Mantega, who, in a 27 September 2010 speech said: “We are in a worldwide currency war, currencies are depreciating all over the world and this poses a threat to us because it devalues our competitiveness.” He also urged the Brazilian government to take immediate action to prevent Brazil’s real from appreciating excessively.

In actual fact, Mr. Mantega was only openly raising an issue that had been worrying every other nation. And nowadays, developed countries such as the United States and Japan are implementing loosened currency policies to stimulate their slowing economies, which has resulted in the devaluation of their currencies. Due to low returns on investment in these developed countries, a lot of speculative investment has been rushing to developing nations, which has only put more pressure on their currencies to appreciate. On the other hand, these nations have also faced difficult choices regarding intervening in the exchange market. And, all of a sudden, the whole world was at the edge of a “currency war”.

Chairman of the international monetary fund (IMF), Mr. Dominique Strauss-Kahn, who is responsible for regulating world economic and financial order, warned that if exchange rates are used to solve domestic problems, there will be risk of an exchange rate war.

British media has taken a cautious stance on this so-called “currency war”. The Guardian previously reported that, according to the latest data indicating falling exports and the slowing manufacturing sector, the PoBC allegedly allowed the renminbi’s median rate to devaluate by almost 2%, hoping to lower China’s export prices and decrease the cost of loans. PoBC claimed that this currency depreciation was only a “one-off”, and is the lowest within the renminbi and the US dollar’s median rate in the past three years. Reports said that this decision will have a significant impact on markets in the Asia Pacific region: “Investors worry that the demand of the world’s second largest economy will slide for a long time.” Stock markets in the Asia Pacific area have consequently fallen overall but Hong Kong’s Hang Seng Index instead rose by 0.72%.

The Guardian claimed that PoBC’s decision illustrates Chinese leaders’ concerns about the economy, and concerns over the renminbi’s strengthening position against the yen and euro reducing China’s competitiveness, reporting, “But this will possibly cause other countries’ Central Banks to devalue their currencies, because others will also have to retain their competitiveness again China.” The report claimed that another possibility is that the United States will criticize China for manipulating its currency.

On the eve of China broadening the scope of its Quantitative Easing Monetary Policy, the United States continues to place increasing pressure on renminbi appreciation. After the US Congress approved the “Exchange Rate Reform to Promote Fair
Trade” Act, Treasury Secretary Timothy Geithner said that exchange rates have become a “core challenge” in the world economy, and he criticized China’s undervaluing of the renminbi of bringing about dangerous global trends. He is likely to discuss the issue of currency undervaluation during the IMF’s annual conference.

On the issue of rebalancing the world’s economy, the United States criticizes China’s currency’s low exchange rate and reliance on exports to the United States, accumulating a large amount of capital in “unfair” trade, which is not good for the world’s economic rebalance. On the issue of international institutional reforms and expanding emerging nations’ share in the IMF, Geithner said that emerging nations should allow for flexible exchange rates in return for their voice in the IMF. He then implied that whether the United States will support China in playing a more important role in the IMF depends on if China’s market-oriented exchange rate policies can show “more progress”.

To summarize, a “currency war” may already be a very real possibility, but in today’s world of complex economic relationships, it wouldn’t be easy to provoke a “currency-devaluation war” similar to the Arms Race. The British Financial Times issued a Q&A including its readers’ commonly-asked questions, a summary of which is below:

Why choose now to depreciate the currency?

One obvious catalyst is the slowing economy. In the first and second quarters of 2015, China’s economy grew at an annual rate of 7 percent, the slowest pace in six years. Data at the weekend showed that exports have tumbled by 8.3 percent year-on-year in July, far worse than expectations for a 1.5 percent decline. A weaker currency should help make Chinese exports competitive.

So China is trying to spur on exports? Isn’t that a currency war?

Not necessarily. The stated purpose for the move was market reform. The central bank said this was a one-time move to enhance the “market-orientation” of the renminbi. Previously, the PBoC would set the currency wherever it liked. Now it will give markets a voice: the daily exchange rate will refer to the closing rate of the interbank foreign exchange market on the previous day.

Is there pressure for market reform?

Before the end of the year the International Monetary Fund will decide whether to include the renminbi in its special drawing rights, a global reserve asset comprising the dollar, euro, pound and yen. Inclusion would mean endorsing the renminbi as a formal reserve currency.

Last week the IMF recognized China’s progress on financial reform but called on authorities to take further steps to increase foreign access to its onshore stock and bond markets. The IMF only conducts a review of the SDR once every five years, so the PBoC could be stepping up its efforts to liberalize the currency as part of its quest to internationalize use of the renminbi.

What are the risks?

Investors have been pushing for the renminbi to weaken and if they are allowed to determine where the fix is, it is possible the currency could depreciate quickly. Stuart Allsopp, head of country risk at BMI Research, a unit of Fitch, warns that investors could now see the renminbi as a one-way bet “and start to position against the currency, raising the prospect of more substantial [renminbi] weakness and more economic uncertainty”.

And yes, of course, people who are very cautious about the renminbi’s devaluation are everywhere, including India’s treasury secretary Rajiv Mehrishi who thinks that the renminbi’s devaluation will directly impact India’s FDI and its exports. Another Indian finance official also said it’s a mistake for India not to reduce its interest because high interest harms India, and the rupee’s high exchange rate against other currencies is not necessarily a good thing.

The Indian rupee is the only regional currency with small decreases, mainly due to India’s strong economic performance which attracts a great deal of overseas investment. In comparison, Malaysia’s ringgit has tumbled 13% against the US dollar, with the Korean won dropping 7%, and the yen 4%.

“It’s like a group of people are jogging: everyone must keep at the same pace, and thus when they reach the finish line everyone can be at the same time,” an insider from India said. “We must carefully balance the rupee in order to prevent a negative impact from outside, and at the same time avoid triggering serious inflation domestically.”

From my point of view, it isn’t necessary to be wary of China’s currency policies. “China is trying keep to pace with everyone else instead of leading the group to devalue its currency,” Barclays Singapore’s Forex and interest rate director Mitul Kotecha said. “And up until now, Asian currencies have not shown significant adjustment upon China’s devaluation, nor have they shown any sensitivity, but this will change.” And what change we are expecting? Let’s wait and see.


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