China's balancing act

China's balancing act

Tweaking the currency

China’s strategy to depreciate Yuan can be considered a sensible bet, with an objective to handle its dwindling economy.

In the past few years, currencies of most of the nations have been weakening against the US dollar.

However, China’s currency Yuan was constantly getting stronger. Riding on China’s strong export performance; Yuan appreciated by more than 40 per cent, between 2005 and 2013.

Breaking this trend in the last one year China has amazed the world by depreciating its currency by nearly 3 per cent in the last one year.

It is believed that in the coming months Yuan may depreciate further.
Today, in most of the countries the exchange rate of a currency vis a vis foreign currencies is determined by market forces, however in China it is still more or less administered, that is, fixed or managed by the Chinese government and the People’s Bank of China (PBOC).

One can say that exchange rate of Yuan cannot vary against their will. Policy of strong Yuan paid rich dividends to China, with constantly rising export incomes and foreign exchange reserves.
Though speculators used to speculate on Yuan.
That speculation was unidirectional, that is, only on upward movement of Yuan.
However in the past one year PBOC first allowed speculation within the range of 1 per cent and the same has now been increased by 2 per cent.

It is now clear that the Chinese government and PBOC have finally decided to devalue Yuan.
Why is devaluation being done? In the last more than two decades, China has experienced huge growth in GDP and per capita income.
China’s average GDP growth rate has been around 10 per cent in the decade preceding 2009. However this year’s expected growth is merely between 7 and 7.5 per cent. 
Today China is amidst high inflation and interest rates. Both these factors are responsible for rising costs in China, making Chinese products less competitive in the world.
Earlier Chinese Yuan continued to gain strength riding on competitiveness of Chinese goods, owing to low cost with continuous support from Chinese government.

This turned China into manufacturing hub of the world and therefore rising export earnings and bulging foreign exchange reserves made Yuan gain strength year after year, without any loss of export market.
In recent years, currencies of India, Brazil, South Africa and many other developing countries have depreciated significantly, making Chinese products less competitive in international markets.
As a result, growth of exports from China has slackened in the past couple of years. The fact that Chinese economy has started slowing down, is revealed from the data published by international agencies.

 It is notable that the Markit/HSBC Services Purchasing Managers’ Index (PMI), which focuses more on the private sector, fell to an eight-month low of 48.0 in March.
The index has been below the level of 50, since January, indicating a contraction this year.
Financial crisis
Many companies in China are passing through a severe financial crisis and it seems that unlike earlier days, Chinese government is in no mood to rescue them.

Some time ago, China's largest solar company Suntech defaulted in payment of debts and later faced insolvency, the Chinese government did not try to save the company.

 Downgrading by rating agencies of Chinese major electronic and many other companies, point toward the financial crisis.

Debt equity ratio in these companies is on rise and in future situation may worsen further, it is believed.
Generally, other things equal, countries usually strive to strengthen their currencies as value of their currency reflects their economic strength. Riding on lower rate of inflation and subsidised exports, China continued to dump Chinese goods worldwide.

Now due to the fact that China too is facing the heat of inflation and constrained by resources, Chinese government is no longer in position to subsidise exports.
Chinese goods are losing competitiveness very fast.
On the other hand, appreciating Chinese Yuan is adding to the woes of Chinese policy makers.
Since, except Russia, currencies of the remaining countries of the world, have depreciated significantly in the recent past, their goods are getting relatively cheaper in the USA and Europe.
Apparently stiff competition from other countries is making Chinese policy makers to rethink about valuation of Yuan.
India’s rupee has weakened considerably in recent times.
Exchange rate, which was Rupees 54.4 per dollar in March 2013, went up to Rupees 68.84 per dollar in August 2013.

Although the rupee has strengthened recently, but it is still weaker by 11 percent, from the March 2013 level.

Brazil, South Africa, Argentina and other Latin American countries’ currencies are also weaker than before.

A few years ago, China's currency was strengthening, along with rapidly growing GDP.
But now with slowing down of Chinese economy in general and the deteriorating condition of Chinese companies in particular, China’s government was forced to devalue its currency.
At this point, the Chinese government probably would not want any domestic troubles including massive labour unrest, with the spread of crisis.

Normally, when currency devalues, country runs the risk of inflation, due to costlier imports.

However, situation of China is different from the rest of the world. China does not import many goods from rest of the world except raw materials, while imports of India and other developing countries have been high and rising.
Therefore if currencies of these countries depreciate, they run the risk of getting caught into inflationary spiral.
However, same problem does not occur in China, as their economy is more export oriented than imports.
Therefore, it may be mixed destiny for the rest of the world; Chinese strategy to depreciate Yuan can be considered a sensible bet, with an objective to handle their dwindling economy.