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Yuan Direction – Currency Wars and China’s Game Plan

Currency wars are hitting the headlines daily.   

As at the time of writing, the Kazakhstan currency, the tenge (no, I didn’t know it either) has been allowed to ‘free float’. The oil-dependent country has been battered by low commodity prices and weak demand from its main export markets in Russia and it has decided that the market should set what level the currency should trade atWell, the market has voted and the tenge has fallen 23% in value against the US dollar just today. 

This follows in the footsteps of Vietnam which has twice widened the trading band for its currency, the dongagainst the US dollar since 11 August. Other countries are also seeing their currencies weaken including the South African rand, which is at its lowest against the dollar since 2001, and the Malaysian ringgit and Indonesian rupiah which are both at 17-year lows against the mighty US dollar. 

So, what’s going on? 

Well, the big summer headline grabber was China’s move to allow the currency (the yuan) to devalue against the US dollar by 2%, the largest single day drop in modern history.   

The consensus in much of the reporting was that this was due to the weakening state of the economy. Many analysts, including ourselves, monitor some of the ‘real’ indicators of economic activity such as electricity usage and rail traffic and note persistent weakness in these indicators over recent months. 

Trading Places 

Just prior to the devaluation, China announced a very weak set of export data.  Overall exports fell 8.3% from the same month a year earlier and this would appear to have led to the decision to let the currency fall.  By reducing the value of your currency, the relative price of your exports fall and this should serve to boost demand, so the theory goes. 

However, a new study of 46 countries, including China, by the World Bank* found that currency devaluations are only half as effective for boosting exports as they were back in the mid-1990’s.  More complicated supply chains and logistics mean that it matters more about the combined effect of higher import costs combined with lower export prices when looking at the effect on trade. 

By way of example, the Financial Times cites a note by the investment bank Brown Brothers Harriman that “pointed out that the Japanese yen had fallen by more than 17% against the dollar in the past year and yet Japan’s exports in the three months to June posted the biggest quarterly decline in five years”.   

Maybe the theory needs updating. 

Certainly China will be aware that this is not a cure-all remedy.  They will know that if they spark a currency war and all the other currencies devalue too, they will be back at square one.  So, what is China’s central bank trying to achieve? 

Reserve Game 

Well, firstly, China’s currency has been too strong against those of its trading partners.  The yuan has risen over 10% against the currencies with which it trades over the last year.  Indeed, the 2% devaluation in August only unwound the rise it had had in the previous 10 days. 

Secondly, and more importantly, there may be a longer game being played by China.  As the Economist recently pointed out**, later this year the International Monetary Fund (IMF) will decide whether to include the yuan in the select group that make up the ‘global reserve currencies’.  Achieving this status would go a long way to advancing China’s role on the global economic stage and be a major stepping stone to reducing the need for the US dollar ‘peg’ for its currency.  

However, the IMF recently indicated that the yuan is too heavily controlled…. which brings us back to why China may be letting the market have a greater say in the setting of the value of the currency today. 

We may never know for sure what the motives for China’s recent currency devaluation are.  What we do know, is that the country fought for 15 years to eventually join the World Trade Organisation in 2001.  They take a patient, long-term approach to building global influence and having their currency as a global unit of value would certainly be a major cornerstone in that strategy. 

 

*Depreciations without exports ? Global value chains and the exchange rate elasticity of exports (English). Ahmed, Swarnali; Appendino, Maximiliano Andres; Ruta, Michele. Policy Research Working Paper 7390. August 2015. World Bank. 

**The battle of midpoint: China initiates market reforms of its currency, then backtracks, Aug 15th 2015, print edition