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2015

Author: Rohit Kaul (9987237425)


College: Sydenham Institute of
Management Studies, Research and
Entrepreneurship Education (SIMSREE)

9/10/2015

Yuan Devaluation: Will it lead to a global currency war and world economic meltdown

Contents
I.

INTRODUCTION ........................................................................................................................ 2

II.

CHINAS CURRENCY SYSTEM .............................................................................................. 3

III. REASONS FOR YUAN DEVALUATION ................................................................................ 4


IV. IMPACT OF YUAN DEVALUATION ON MAJOR GLOBAL CURRENCIES &
ECONOMIES AROUND THE GLOBE.................................................................................... 5
a)

Impact on the US: ..................................................................................................................... 5

b)

Impact on the European Union: .............................................................................................. 6

c)

Impact on Russia: ..................................................................................................................... 8

d)

Impact on African nations: ...................................................................................................... 8

e)

Impact on India: ........................................................................................................................ 9

f)

Impact on Brazil: .................................................................................................................... 10

g)

Impact on Asian economies:................................................................................................... 10

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Yuan Devaluation: Will it lead to a global currency war and world economic meltdown

I.

INTRODUCTION

On August 11 2015, the Peoples bank of China (PBOC) devalued the Chinese Yuan
by about 1.9% below its previous days close. It sent ripples around the globe as the world
started to believe that Asias largest economy is going through one of the toughest phases in
its turbulent history a slowing economy ailed by reduced manufacturing output in the last
quarter. In order to resurrect its dwindling economy and bring it back on track, the Chinese
central bank had to resort to the age old technique of depreciating the value of its own currency
a process called as devaluation.
Such a devaluation followed months and months of the Yuan appreciating along with
the US dollar, making Chinese exports expensive. This would make the situation politically
dangerous for the ruling communist party of China (CPC) as it could lead to loss of millions of
jobs in the Chinese domestic sector causing wide outrage against the government. There were
other reasons as well attributed to, as to, why the PBOC had to come up with such a drastic
measure, which would be discussed in detail here, but it is evident that the Chinese authorities
alongside the central bank would not hesitate to take such steps in the future if need be.

Figure 1: Graph showing vs USD


As depicted in the figure above the Yuan depreciated from 6.23 /$ to almost 6.4 /$
on August 11 before settling down to 6.35 /$ later. It was the single biggest day fall in a decade
for the Chinese currency. So much so that the Peoples bank of China had to start selling dollars
when the currency had depreciated to 6.4 /$ to arrest the slide of the Yuan. The reason for
selling dollars was because of the huge capital outflows that were taking place to depreciate
the Yuan, as the PBOC kept printing new money and increasing the supply of Yuan in the
international markets to reduce the value of its currency. The PBOC in all had to offload $93.9
billion taking their reserves down from $3.65 billion to $3.56 billion by the end of August to
stabilize the Yuan. Let us now look into what system China follows for determining its
currency value.
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Yuan Devaluation: Will it lead to a global currency war and world economic meltdown

Figure 2: China Foreign Exchange Reserves Change ($billions)

II.

Source: Bloomberg

CHINAS CURRENCY SYSTEM

China uses a Managed float exchange regime. This means that the currency is
normally pegged to a reference rate that is set by the Peoples bank of China (which is now
the US dollar). It is float because it is allowed to fluctuate 2% above or below this
reference rate based on previous days trading. Thus it allows for the currency to fluctuate
based on the market forces of demand and supply for the Chinese Yuan but only up to a
certain extent. The US and the European Union have been long pressurizing the Chinese to
make their currency fully market driven i.e. float type of currency as it eliminates excessive
intervention and manipulation of the currency by the central bank.
Chinas leadership has since long, urged the IMF to include the Yuan in a basket of
global reserve currencies comprising the US Dollar, Euro, Yen and the Pound thus giving
it special drawing rights. For that, China needs to change its currency regime from
Managed float currency to fully float, that is, a currency whose value is wholly determined
by the demand and supply forces of the market with minimal intervention from the central
bank. However, following the recent stunt, the US and EU has lost faith in Chinas
willingness to allow its currency to become free floating and thus be counted amongst the
reserve currencies.

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Yuan Devaluation: Will it lead to a global currency war and world economic meltdown

III.

REASONS FOR YUAN DEVALUATION

Figure 3: vs $ trend and trading band


banks

As can be seen from Figure


2,
Chinas
foreign
exchange reserves have
swelled, almost tripled, in
the last decade as they have
looked to slow the
appreciating Yuan (see
figure 3). Thus in effect it
was selling Yuan to buy
more dollars to arrest the
upsurge of Yuan. However,
to ensure that such an
influx of Yuan doesnt
cause a surge in inflation, it
raised its reserve ratios for the

By doing this, China wanted to keep its exports competitive, as China is primarily
an export driven economy. Its exports have fallen by about 1.4% in dollar terms over the
last year, with overseas shipments down by almost 5.5%. This amidst a falling domestic
consumption demand has triggered the Peoples Bank of China to devalue the Yuan to give
a boost to the Chinese domestic market. By increasing the supply of Yuan in the local as
well as international markets (either by printing more Yuan or selling off existing Yuan),
it has put more money in the hands of people thus encouraging them to spend more and
thus prop up consumption. To combat the resulting fear of inflation, it has put a tab on the
reserve ratio requirements for the banks as discussed earlier.
Apart from the purposeful devaluation, the market believes that the Yuan is
overvalued at its current levels. That has also caused capital outflows from the Chinese
market. With the US Federal bank announcing that it will raise interest rates soon for the
first time post 2006, there are concerns that there would be even more money flowing out
of the Chinese markets and into the US market causing the Yuan to depreciate even further.
This would be detrimental for the likes of the US and the European Union which import
vast quantities of goods from China and even compete with their Chinese counterparts in
other countries. It would make Chinese exports very competitive and kill competition from
the US and European companies. Thus the US Fed is apprehensive of raising the interest
rates come October, especially now that the Yuan has already shown signs of weakness and
any further bouts of downturns in the Yuan would spell trouble for the American economy.
Third reason as to why China possibly devalued their Yuan could be to raise their
inflation rate.

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Yuan Devaluation: Will it lead to a global currency war and world economic meltdown

Figure 4: China Inflation Rate

Source: http://www.tradingeconomics.com/china/inflation-cpi

The manufacturing Purchasing Managers Index, which is a gauge of the manufacturing


activity in China fell to a 6 year low of 47.1 in August symbolizing a contraction in
manufacturing economy. By devaluing their currency, China wanted to drive demand in their
economy which had staggered in the past year. The CPI numbers post the devaluation rose to
2% immediately. By doing this, China effectively exported their deflation to the US and the
European Union thus causing concerns for those countries. There are many reasons to support
this claim. China in the recent past, have reduced the supply of pork meat thus causing poultry
prices to increase. Food constitutes a large percentage of the CPI index thus causing
inflationary pressures.

IV.

IMPACT OF YUAN DEVALUATION ON MAJOR GLOBAL CURRENCIES


& ECONOMIES AROUND THE GLOBE

a) Impact on the US:


Major source of concern for the US has been the strong US dollar which has squeezed
their exports. It has, however, helped curb inflation below the 2% target set by the Fed.
The Fed ever since the end of the quantitative easing rounds, has been looking to raise
interest rates and bring the economy back on parity. However, that is now expected to
be put on a hold after the Yuan devaluation, as such a move would further add to the
upward pressure on the US dollar as it would lead to more capital inflows into the US
economy thus further hurting exports.
The Bank of International Settlements (BIS) has said that Chinese companies
have borrowed about $1 trillion abroad, up from $200 billion in 2009. With the Fed
planning to raise interest rates, the cost of such borrowing would go up risking default
for many of these Chinese companies. As a retaliatory measure, the only way China
could stop Fed from doing that was to devalue its currency, thus stopping the Fed from
raising interest rates and further strengthening the dollar thus hurting US exports as
stated earlier. Due to muted inflation rate, Fed could delay the interest rate hike. The
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Yuan Devaluation: Will it lead to a global currency war and world economic meltdown

Fed has currently kept the interest rate hovering between 0.0% - 0.25%. It is 0.08% as
of now. Although there have been no inflationary pressures in the US economy, the Fed
needs to hike the interest rate soon enough flush some liquidity out of the market.
Besides there are various U.S multinationals that have significant operations in
China like Apple Inc. The iPhone maker would witness increased cost of manufacturing
iPhones and iPads in the domestic market in China as most of its manufacturing and
assembly arrangements in China are denominated in U.S dollars.
China has almost always had a trade surplus with the U.S. Because of this, it
has managed to accumulate a lot of US dollar reserves along with other foreign
exchange reserves of other countries (due to a current account surplus). The PBOC
needed to invest the surplus dollars it had acquired someplace, where it could get a
reasonable rate of return. Since central banks are generally highly conservative in their
strategies with PBOC being no exception, it decided to invest in highly liquid securities
of the U.S Treasury. Hence China acquired large obligations of U.S dollar denominated
debt which has kept on growing with time. Currently in 2015, China holds more than
$3.1 trillion in foreign exchange reserves of which $1.2 trillion are held in U.S
government obligations. The U.S has urged China to increase the value of Yuan to
reduce the trade deficit it has with China thus slowing down the dollar denominated
debt it holds with the U.S. China on the other hand, is using the devaluation tool as a
leash to hold the U.S from raising interest rates in the near future which would cause
huge capital outflows from the slowing Chinese market.
The perceived threat of China holding such large US dollar denominated debt
can be seen with the help of an example. Lets consider we are still under the Bretton
Woods system. If China felt it wanted to redeem some of its US debt, say in 2008, then
$100 billion of redemption at $1000 per ounce would have equalled 2840 metric tonnes
of Gold. That would have been about 35% of the total Gold reserves held by the U.S.
A full redemption of US government treasuries would have thus completely wiped off
all the Gold reserves from the US and left China with about 9000 metric tonnes of Gold.
The Idea of the Gold standard at that time was to force nations to get their finances in
order before they run out of Gold. It proved to be a warning signal. However, with such
a system not in place currently, the American people are unaware of the deteriorating
conditions existing in their economy right now.
b) Impact on the European Union:
The strong exchange rate since last year has been a drag on Chinese exports to the EU.
Exports to the European Union have fallen by almost 12% from July 2014 to July 2015.
By devaluing the Yuan, China expects value of its exports to the EU to rise. However,
this could prove detrimental to countries like Greece, Spain, Portugal, Italy and other
peripheral countries which are already battling a slowing economy, lower wages and
dwindling profits. By devaluing Yuan, China would export their deflation to such
countries adding to the woes of an existing deflationary European environment.
Countries like Greece which have started to implement austerity measures and are
already facing low wages, unemployment and low consumer demand would simply be
blown away if a large devaluation occurs. It would put more pressure on countries like
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Yuan Devaluation: Will it lead to a global currency war and world economic meltdown

Germany & France which bear a large burden of their debts on their books and they in
turn would have to write off debts which would go unpaid.
Table 1. EU-28 main export partners, 2014 (billion EUR)
Country
USA

Exports
311

Share in Exports
18.3%

Cumulative Export
18.3%

China

165

9.7%

27.9%

Switzerland

140

8.2%

36.2%

Russia

103

6.1%

42.2%

Turkey

75

4.4%

46.6%

Japan

53

3.1%

49.8%

Norway

50

2.0%

52.7%

Source: http://trade.ec.europa.eu/doclib/docs/2006/september/tradoc_122532.pdf

For most of the European luxury brands like BMW, Prada, Coach, Tiffany &
Co., the devaluation spells doom. For one, China is the second largest luxury market in
the world after the US. Post the devaluation, the foreign brands are likely to get costlier
in the Chinese domestic market hurting their sales there. However, the bigger worry is
Chinese spending outside of China which accounts for more than 50% of the revenues
of the luxury brands from Chinese consumers. Chinese tourism to places like Germany,
France and other European nations, where they prefer buying alligator skin-handbags
and gold watches, would go down causing large revenue loss.
China is also the second biggest buyer of European goods in general, accounting
for nearly 14% of European exports. Sectors with maximum exposure are basic
resources, personal and household goods, autos, technology and the auto sector. In the
telecom sector in China for example, State owned Huawei is on a fierce competition
with Swedens Ericsson and devaluation could swing the pendulum the way of Chinese
companies like Huawei and ZTE.
Table 2. Chinas main export partners, 2015

A weak Euro, however, isnt in Chinas interest.


If the European turmoil leaves countries like
Greece, Portugal out of EU, they would resort to
their own weakened currencies and since they
form an important part of Chinas exports, it
Source: http://www.tradingeconomics.com/china/exports would hurt Chinas trade surplus a lot. China
has a strategic interest in Europe and has adopted a quid pro quo approach. It has bought
European sovereign debt and has shared the debt burden with Germany and France. Thus in
the event of the PIGS nations going bankrupt, China would be affected drastically. In return
for these risks, China has sought foreign investment in sensitive sectors in the European
economy like infrastructure, hi-tech technology and permission to purchase advanced weapons
technology originally reserved only for NATO allies.
Country
United States
European Union
ASEAN
Japan

% Exports
17%
16%
10%
7%

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Yuan Devaluation: Will it lead to a global currency war and world economic meltdown

c) Impact on Russia:
Beijings sudden devaluation of their currency sent oil prices tumbling down, to $43 a
barrel, the lowest level seen in the last six years. It was bad news for Russia as it derives
nearly 68% of its export revenues from the sale of oil and gas. The Russian Rouble
which is closely tied to the performance of the countrys energy exports thus
depreciated, and is now at nearly 64 roubles/dollar. For Russia, a devaluing Yuan
alongside a strong dollar is a worrying sign as their cost of dollar denominated debt
would rise leading to cost of obtaining more dollars even more expensive.
d) Impact on African nations:
Most of the African commodities in countries like Nigeria and Kenya are still priced
in American dollars. Off late though, China has emerged as the largest trading partner
for many African countries. To make buying and selling of goods easier, Nigeria in
2011, pledged to keep 5-10% of its foreign exchange reserves as Yuan. They also
believed that it would act as a hedge for its local currency, Naira, against the backdrop
of volatile oil prices set in dollars. Later Kenya, which is a major trade partner in Africa
with China, announced plans to set up a clearing house for the Chinese currency.
However, with the American dollar strengthening against the Yuan, African exports
like platinum, copper and coal could become expensive for the Chinese counterparts.
Countries in Africa having
sizable exports to China also
include South Africa which
exports Gold and wine,
Angola which exports oil and
Zambia which exports copper.
These currencies have already
depreciated following the
Yuan devaluation. The cost
competitive nature of Chinese
products in these markets has
eroded competition from the
African counterparts. For
some countries like Ethiopia,
Mozambique,
Yuan
devaluation is a blessing as it
reduces their cost of importing
Figure 5: Africas total World trade
heavy machinery, electrical lines and bulldozers. Consumers and retailers in general also get
access to cheaper goods.
Some of the steps that the African economies could take is allowing their currencies to
depreciate thus gaining a competitive advantage over the Chinese exporters. They should also
look to diversify their economies away from commodities in the event of a global commodity
crisis.
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Yuan Devaluation: Will it lead to a global currency war and world economic meltdown

e) Impact on India:
Figure 6: Commodity Prices trend of 5 years

Impact on the Indian economy as a


consequence
of
the
Yuan
devaluation is complex. The rupee
fell by about 1.5% following the
Chinese devaluation and has fallen
by about 6% from the start of the
year. It was because of the general
sell off of the emerging market
currencies that has taken place post
the devaluation. Part of the
devaluation has also been due to the
fears of the US Fed hike that could
further weaken the currency, hence
forcing to RBI to raise interest rates
in India i.e. resorting to a
contractionary monetary policy and
taking away 18 months of solid hard
won macro-economic stability. India
imports a lot of goods from its eastern neighbour. The import bill from China was about
$60 billion in 2014. The devaluation of Yuan thus brings good news to many importers
from India especially the electronic and electrical component manufacturing
companies. However, India competes with China in many sectors like Chemicals and
textile manufacturing and post devaluation Chinese goods might become more
competitive than Indian goods in world markets. That could be a huge problem for the
export industry in India as exports have declined continuously over the past 7 months.
Also with RMB devaluing, price of Chinese steel will decline. Thus the
government will have to step in and apply import barriers to prevent Chinese steel from
entering into the Indian market or support domestic manufacturers via subsidies (which
would put pressure on the fiscal deficit.
A Bank of America report suggests that a 1% drop in decreases the commodity
prices by nearly 0.4-0.5%. This is because China is a large commodity importer and
with slowing demand of commodities there, prices of commodities are languishing at
their lowest levels since 2009. A weak Yuan adds to the woes of commodities even
further. This would be good news for India as India is a net importer of commodities
and low commodity prices would help to lower its import bill thus improving its trade
deficit.

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Yuan Devaluation: Will it lead to a global currency war and world economic meltdown

f) Impact on Brazil:
Probably the biggest impact of a Yuan devaluation would be on the South American
behemoth. Brazil relies on 18% of its export revenues from China. Its export items
include commodities like iron and copper ore, oil, soy bean, corn, beef, food products
and lubricants. Will falling commodity prices and weakening Yuan, Brazils export
revenues would go down. An economy set to contract by 2.4% in 2015, with a 10%
inflation rate and a home currency having lost 20% of its value since Jan 2015 this
would spell disaster for Brazil. Brazils GDP in 2014 was $3.073 trillion and exports
were $225 billion i.e. exports accounted for nearly 7% of its GDP and China accounts
for 18% of that 7% i.e. 1.26% of Brazils GDP!

Table 3. Major export partners of Brazil


Country
China
U.S
Argentina

Exports (billion USD)


40.5
24.75
18

% of exports
18%
11%
8%

Source: http://www.tradingeconomics.com/brazil/exports

g) Impact on Asian economies:


The Yuan devaluation meant that other Asian countries also had to devalue their
currency in order to maintain their cost competitiveness in the export markets. In fact,
even before the devaluation, owing to the slowdown in the Chinese economy, there
was decreased demand for many products from these nations causing prices to fall
down.
Figure 7: Asian currency % change post devaluation

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To summarise the risks associated and the corresponding actions that could be taken by
these Asian economies to subvert the crisis

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