China’s Currency Devaluation: What You Need To Know

by Aleksandra Saga, CBC News

China’s central bank is allowing its tightly controlled currency, the yuan, also known as the renminbi, to fall in value.

The People’s Bank of China allowed the yuan to fall to a four-year low on Wednesday, after it devalued the national currency by almost two per cent the day prior.

The move signals a shift in the bank’s monetary policy, financial analysists say, one that may indicate the country is moving towards a more market-oriented approach for its currency, which Beijing has been hinting at.

Here’s what you need to know about this recent devaluation of the yuan.

Why did the government do this?

Despite the Chinese economy being the second largest in the world, after the U.S., it has been underperforming for the past year or so, says Loren Brandt, a professor at the University of Toronto’s department of economics. So it clearly felt it had to do something to get exports moving again.

“This is kind of a normal course of action” that is seen in most weak economies, Brandt says. “Their exchange rate adjusts and it provides a margin with which to try to help the economy recover.”

In 2014, China’s economic growth fell to 7.4 per cent, a noted drop off from years of double-digit growth.

In July, exports fell by 8.3 per cent and the country’s manufacturers are seeing their fourth year of price deflation, Reuters reports.

What’s more, Chinese investors were dismayed this summer when the Shanghai Stock Exchange fell steeply, losing 30 per cent of its value in June, and then plunged more than eight per cent in one day.

China’s slowed economy makes this type of action unsurprising to Brandt, who says it was a question of when, not if, the government would intervene.

Has China tried anything else?

The Chinese government has already taken several steps to remedy its economic downturn, says Peter Dungan, an economics professor at the University of Toronto’s Rotman School of Management.

“This is not just one thing, one time.”

The central bank lowered interest rates a number of times since November 2014. Most recently, in June, it cut the rate for both one-year loans by commercial banks and for one-year deposits by 25 basis points.

The bank also lowered reserve requirement ratios for small businesses. A few months prior, it had done the same for banks to free up more of their money for lending.

How can the bank do this?

Currency exchange rates are determined one of two ways, Dugan says.

Most countries, like Canada, have a floating exchange rate that’s determined by market forces. The government has some ability to indirectly influence the exchange rate. For example, the Bank of Canada can help push the Canadian dollar down by lowering its benchmark lending rate.

A small number of nations, like China, have an exchange rate that is “fixed in some way or other by the authorities.” The Hong Kong dollar and the Danish krone are also at least somewhat fixed rates.

In China, the bank determines the yuan’s exchange rate based on its own basket of foreign currencies, which economists tend to believe is primarily made up of the U.S. dollar.

Generally, the central bank allows the yuan to move two per cent above or below the rate it sets for that day, which it calls the daily fixing. But more often of late it has been following a strong-yuan policy, designed to encourage more imports and consumer spending.

Tuesday’s move was described by the bank as following more supply and demand forces, which at least some outside bankers saw as a good thing.

The yuan dropped 1.9 per cent Tuesday and then a further 1.6 per cent Wednesday. Some suggest it could drop by as much as 10 per cent over the next little while.

What impact will it have?

The intended effect of the lowered exchange rate is to boost exports from the country, Brandt says, to make Chinese exports less expensive and thus, more desirable.

Local Chinese businesses could also benefit as imported goods could prove too costly for most consumers.

However, Brandt says, “in the short run, it’s very difficult to say” if the strategy will work for China.

One of the concerns is that China now appears to be entering the currency wars and that others may follow suit, perhaps by using other monetary tools like lending rates to attempt to influence their currencies, as the Bank of Canada did earlier this year, which led to the falling dollar.

“If one country goes ahead and devalues their currency, then everyone feels like they need to devalue their currency even more to remain competitive with them,” says Brandt.

In some ways, China is coming late to this game. Japan embarked on the devaluation of its yen two years ago, using U.S.-style quantitative easing to drive down its value, and Britian and the European Central Bank have also deployed monetary polices, as recently as the spring, aimed at bringing down the value of the pound and euro as well.

Is China moving towards a market-based rate?

The central bank’s move to let its rate fall is “revolutionary,” says Donald Brean, a finance and business economics professor at the Rotman School of Management, as it is “moving more towards market signals.”

The move hints at the beginnings of reform where eventually the exchange rate could be set solely by market forces, like in Canada, rather than a combination of that and government intervention, Brandt says. “Time will tell.”

Will the yuan become a global currency?

A market-based rate is the track China needs to be on to achieve its goal of the yuan becoming a global currency, says Farrokh Zandi, an economics professor at York University’s Schulich School of Business in Toronto.

China wants the International Monetary Fund to include its currency in the Special Drawing Rights, a basket of reserve currencies it uses to lend to sovereign borrowers and which includes the U.S. dollar, the Japanese yen, the European Union euro and the British pound.

The IMF has insisted that China needs to have a floating exchange rate to be admitted into the pool of currencies in the SDR.

China’s move to devalue its currency “is perhaps a step in the right direction” to meet those conditions, Zandi says.


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