The Concept of Currency Devaluation & The Chinese Move: Part #2

This theme has been covered in 2 parts. Read the Part #1, here.



 

Before, we proceed to understand the current move, let’s put some light on the background:

During 1997, most of East Asian countries witnessed financial crisis. This led China to devalue its currency in order to encourage its exports.

During 2005-06, China had come back to market-determined exchange rates , but later shifted to managed exchange rates.

Now, let’s take a look at how the recent events unfolded

Currently, Chinese economy is witnessing slowdown, due to dip in exports.
Do keep in mind, that China is export-oriented economy, unlike US which is more of consumption-based economy.


Now, let’s explore the Chinese move.

Technically, it is depreciation because China has allowed market forces to operate in determining the exchange rates. This is the reason, you may find at times, newspaper writing depreciation.

Now, the obvious question, why is it called devaluation ?

Because, Central Bank of China determines when the market forces will play their role.

Basically, before the this move, Chinese currency was a managed exchange rates, i.e. Central Bank decided the exchange rates.

As China knew that its currency will depreciate due to economic slowdown, so it allowed market forces to operate, i.e. China withdrew from currency exchange market.

Now, let’s dive deep into the issue.

Few questions, which may surface into your mind, that China could have simply devalued its currency. Why does it want market forces to play a role in determining the exchange rate.

What are the intentions behind such a move ?

Since Chinese economy is heavily dependent on exports, therefore China wanted to make its exports cheaper & thereby boost its exports.

China has been demanding from long time, that its currency Yuan, be made a global reserve currency at IMF.

Now, why would IMF reject such a demand?

Actually, IMF is a vocal supporter of free market economy, but, Chinese currency was managed by its Central Bank. Therefore, IMF rejected the demand to include Yuan in SDR.

This was the reason Chinese central bank allowed market forces to play their role.

Lets understand, Why would China want Yuan to be included in IMF.

  1. When a currency becomes part of SDR, then every country’s Central Bank would hold those currencies as part of their FOREX.
  2. This makes a Yuan a hard currency.
  3. Politically, a country has a major role to play in IMF, once its currency becomes part of SDR.

Now let’s come to India, the biggest question, what will be the impact on India.

  • We are losing out in export markets with respect to China, as some common exports on which we are competing with China such as textile are facing the heat.
  • As Chinese products will become cheaper in India too, the industries aligned to domestic markets, will also face the pressure.
  • The indirect impact is that many FPI’s are moving out of India, to China and US.

Published with inputs from Pushpendra

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