The Impact of China Devaluing the Yuan in 2015

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The Impact of China Devaluing the Yuan in 2015

On August 11, 2015, the People’s Bank of China (PBOC) startled markets by devaluing the Chinese yuan renminbi (CNY) three times in a row, taking over 3% off its value. China’s currency has strengthened 33% versus the US dollar since 2005.

The initial devaluation was the largest single decline in 20 years. The decision came as a surprise, and many assumed it was a desperate effort by China to promote exports in order to maintain an economy that was developing at its weakest pace in decades. The PBOC, on the other hand, stated that the devaluation was part of its reforms to shift the country toward a more market-oriented economy. The decision has far-reaching consequences across the globe.

Key Takeaways

  • Investors had become used to the yuan’s stability and rising strength after a decade of steady rise versus the US dollar.
  • Since taking office in March 2013, China’s President Xi Jinping has emphasized the government’s commitment to reforming the Chinese economy in a more market-oriented manner.
  • Despite the IMF reaction, many questioned China’s adherence to free-market ideals, claiming that the new currency rate regime amounted to a controlled float.
  • The negative effect of currency depreciation on ties with the United States also contributed to China being classified as a currency manipulator for a short period in 2019 and early 2020.

Surprised Markets

Investors had become used to the yuan’s stability and rising strength after a decade of steady rise versus the US dollar. By stock market standards, the decrease, which totaled 4% over the next two days, was minor. However, many speculators in the foreign currency (FX) markets use excessive leverage.

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Stock markets in the United States, Europe, and Latin America all plummeted as a result of the yuan depreciation. Most currencies were also affected. Some speculated that the change was an effort to make exports seem more appealing, even as China’s economy stagnated. However, the PBOC said that the devaluation was prompted by other causes.

Effect on the IMF

When he initially took office in March 2013, Chinese President Xi Jinping declared the government’s commitment to reforming China’s economy in a more market-oriented manner. That made the POBC’s assertion that the devaluation was intended to enable the market to have a larger role in establishing the yuan’s value more credible.

Following the announcement of the depreciation, the PBOC said that as a consequence of this “one-time depreciation,” the “yuan’s central parity rate would correspond more closely with the previous day’s closing market prices.” It was also intended to “give markets a larger role in establishing the renminbi exchange rate with the objective of facilitating further currency reform.”

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At the time, Cornell University Professor Eswar Prasad said that the decision was also compatible with China’s “modest but steady” market-oriented changes. Currency depreciation was one of many monetary policy instruments used by the PBOC in 2015, which also included interest rate decreases and stricter financial market regulation.

Another reason for China’s decision to weaken the yuan was the country’s desire to be included in the International Monetary Fund’s (IMF) special drawing rights (SDR) basket of reserve currencies. The SDR is a kind of international reserve asset that IMF members may use to buy domestic currency in foreign exchange markets in order to keep exchange rates stable. Every five years, the IMF revalues the currency composition of its SDR basket. The yuan was rejected in 2010 because it was not readily used. The IMF supported the depreciation, bolstered by the allegation that it was carried out in the name of market-oriented reforms. As a result, the yuan was included to the SDR in 2016.

The Chinese renminbi had a weight of 10.92% in the basket, which was higher than the weights of the Japanese yen (JPY) and the British pound sterling (GBP), which were 8.33% and 8.09%, respectively. The IMF’s borrowing rate is determined by the SDR’s interest rate. Because currency and interest rates are linked, the cost of borrowing from the IMF for its member countries would now be determined in part by China’s interest and currency rates.

Skeptical Views

Despite the IMF’s reaction, many questioned China’s adherence to free-market principles, claiming that the new currency rate regime amounted to a controlled float. Some said that the depreciation was merely another intervention, and that the PBOC will continue to constantly monitor and manipulate the yuan’s value.

Furthermore, the devaluation came only days after statistics revealed a steep drop in China’s exports—down 8.3% year on year in July 2015. This demonstrated that the government’s interest rate cuts and fiscal stimulus had not been as successful as predicted. As a result, detractors dismissed the argument for market-oriented change. Instead, they saw the depreciation as a frantic effort to jump-start China’s lethargic economy and protect exports from sliding further.

China’s economy is mainly reliant on exports. The Asian behemoth cut the price of its exports and acquired a competitive edge in foreign markets by weakening its currency. A weakening currency also made China’s imports more expensive, stimulating local manufacturing of replacement items to assist domestic firms.

The US government was especially enraged because many US lawmakers had claimed for years that China had intentionally maintained its yuan cheap at the detriment of American exporters. Some speculated that China’s yuan depreciation was the start of a currency war that would exacerbate trade tensions.

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Consistent with Market Fundamentals

Although a lower-valued yuan would provide China a trade advantage, the decision was not entirely contrary to market fundamentals.

The yuan has appreciated in value compared to practically every other major currency, including the US dollar, during the last 20 years. Essentially, China’s strategy enabled the market to decide the yuan’s direction while limiting the pace at which it appreciated. However, prior to the devaluation, China’s economy had slowed dramatically. The US economy, on the other hand, had recovered. The yuan’s continuous increase in value is no longer consistent with market fundamentals.

Understanding market fundamentals reveals that the PBOC’s little devaluation was a necessary adjustment rather than a beggar-thy-neighbor exchange rate manipulation. While many American lawmakers moaned, China was really doing what the US has been urging it to do for years: letting the market decide the value of the yuan. While the yuan’s value fell by the most in two decades, the currency remained stronger in trade-weighted terms than it had been the previous year.

Impact on Global Trade Markets

Currency depreciation is not a new phenomenon. Many countries, from the European Union to emerging nations, have periodically depreciated their currencies to assist cushion their economies. However, China’s devaluations may be detrimental to the global economy. Given that China is the world’s biggest exporter and second-largest economy, every alteration to the macroeconomic environment made by such a massive institution has major ramifications.

Many small and medium-sized export-driven countries may suffer lower trade income as Chinese products become more affordable. If these countries are in debt and rely heavily on exports, their economy may suffer. Vietnam, Bangladesh, and Indonesia, for example, depend heavily on footwear and textile exports. These nations may suffer if China’s devaluations make their exports less expensive in the global market.

Impact on India

A weakening Chinese yuan has various consequences for the Indian economy. Demand for dollars increased globally as a consequence of China’s decision to allow the yuan to weaken versus the dollar. This included India, where investors preferred the safety of the dollar over the rupee. The Indian rupee promptly fell to a two-year low versus the US dollar and stayed there during the second half of 2015. The potential of rising emerging market risk as a result of the yuan depreciation boosted volatility in Indian bond markets, causing the rupee to fall further.

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A falling rupee would normally benefit local Indian producers by making their goods more inexpensive to overseas purchasers. However, in the context of a weakening yuan and declining Chinese demand, a more competitive rupee is unlikely to compensate for decreased demand in the future.

Furthermore, China and India compete in a variety of sectors such as textiles, garments, chemicals, and metals. For Indian exporters, a weaker yuan meant greater competition and lower profits. It also meant that Chinese manufacturers could dump items into the Indian market, undercutting indigenous firms. Between 2008 and 2009 and 2014 and 2015, India’s trade imbalance with China almost doubled.

China, being the world’s biggest energy user, has a huge impact on crude oil pricing. The PBOC’s move to weaken the yuan communicated to investors that Chinese demand for the commodity, which was already declining, would deteriorate further. After China depreciated its yuan in mid-August, the global benchmark Brent crude plunged more than 20%.

Each $1 decrease in oil prices resulted in a $1 billion reduction in India’s oil import bill, which amounted at $139 billion in fiscal year 2015. Falling commodity prices, on the other hand, made it far more difficult for Indian manufacturers to stay competitive.

Charges of Currency Manipulation

Between 2015 and 2019, the Chinese yuan usually fell against the US dollar, prompting accusations of currency manipulation. On August 5, 2019, the US Treasury Department formally designated China as a currency manipulator. This was the first time the United States has done so since 1984. However, the United States removed the currency manipulator designation in early 2020. “China has made enforceable pledges to abstain from competitive devaluation, while enhancing openness and accountability,” said then-US Treasury Secretary Steven Mnuchin.

Yuan: Dollar Historical Chart.

The Bottom Line

The growth of the US dollar was China’s key argument for weakening the yuan in 2015. Other factors were the country’s goal to transition to a service-based economy and domestic consumption. While worries of more devaluations persisted on the international investment scene for another year, they dissipated in 2017 as China’s economy and foreign currency reserves improved. The negative effect of currency depreciation on ties with the United States also contributed to China being classified as a currency manipulator for a short period in 2019 and early 2020.

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