The general brouhaha around the Yuan devaluation, with cries of how China is escalating the currency war and trying to boost its exports, may have some truth it. But such generalised sweeping arguments, often tends to sweep under the carpet some nuanced understanding of what China is actually trying to achieve. This understanding may be essential to estimate how the Chinese authorities may behave to boost economic growth so that the economic underperformance does not escalate into political turbulence. As such, my conjecture is that ‘Yuan Devaluation’ is a by-product of a desperate Chinese attempt to get entry into IMF’s special drawing rights (SDR) basket. Hence, the devaluation by the People’s Bank of China (PBOC) was only a sideshow with the real objective being to make the Yuan (CNY) more market dependent. Last week, the PBOC actually raised the value of CNY against USD by 0.05% to give some credence to its claims of the CNY being market determined.
While it continues to remain the largest non-US owner of US government securities ($1.2 trillion of total US debt of $10 trillion), China wants to reduce its dependence on USD. The reduced dependence on USD is not only expected to benefit its international trade but over a long period of time PBOC wants to have a more direct say in global financial markets on the lines of the US Fed. On a lighter note, it will be embarrassing to label China, publicly, as a currency manipulator, if it becomes part of SDR basket under the broad assumption that the current currencies are not ‘technically’ manipulated even when unconventional monetary policies are used.
China possibly believes that the first step towards that goal is to get the CNY included as a fifth currency in SDR basket alongside the existing four namely USD, Pound, Euro and Yen. Of course, mere inclusion in the SDR basket need not imply that global financial markets and governments would rush in to trade in CNY. The SDR basket gets reviewed every five years. For a currency to be included in the SDR there are two key criteria a) Export criterion and b) Free usability. The IMF states that both the conditions must be met.
China met the export criterion even in 2010 when the last SDR review was held. However, it is the free usability criteria where China struggles. At this juncture it may be worthwhile to state that IMF's definition of 'free usability’, does not disqualify the Yuan despite its capital controls. Free usability is determined by actual international usage and trading of the currency in market exchanges. As per the latest data from Bank of International Settlements, with respect to factors used to determine free usability, currencies such as Swiss franc, Australian dollar and Canadian dollar are ahead of the Yuan.
Of course, Yuan has made significant progress on free usability metrics is last five years. In fact Christine Lagarde, MD, IMF commented in April that Yuan’s inclusion in SDR basket is not a question of ‘if’ but when. As per original plans the reviewed SDR basket was expected to be launched on 1 January 2016. Thus when around 4th August,2015 an IMF staff paper suggested that the current basket be extended by nine months till 1st September 2016, a lot of China watchers interpreted it as, IMF providing the countries and markets more time to adjust in case the Yuan is added to SDR. Some others interpreted it as IMF providing more time to China to make Yuan more ‘market determined’.
Damn if you do & damn if you don’t
Chinese authorities would have more than a prior intimation of the economic data that was released on 12th August 2015, by the National Bureau of Statistics. It showed critical drivers of the economy such as growth in value-added industrial, fixed asset investment in non-rural areas and retail sales while continuing to remain in positive territory has inched down for the month of July, 2015. With economic fundamentals including export cooling on one hand, the Chinese QE initiative is not exactly working wonders.
As highlighted in the previous article, stock market performance has become a barometer for the success or failure of Chinese leadership. Hence, unwinding the QE, for which the IMF expressed its concern, was out of question. So the PBOC choose to make Yuan rates more market determined. It would not only re-establish China’s commitment to reforms but also strengthen its case for inclusion in the SDR basket. The timing of the move, which would cause yuan to devalue and arguably benefit exports, would have made it a relatively easy sell in the politburo.
The move to make yuan more market determined won nuanced praise from the IMF but then it unruffled the markets at large which focused more on the devaluation per se and not so much on the desperation behind the move.
Desperate measures and its dangers
From early July to August 2015, the frequency and intensity with which China is taking critical decisions needs to be carefully analysed. The inertia of a moderating economy is unlikely to be reversed in a quarter or two. With global trade mirroring stuttering global economic growth, it is unlikely that exports will pull any country out of its troubles.
So what may China do next? Will it unleash a sharp intense period of dumping products on its Asian neighbors which may destabilise their local manufacturing for a period of three-to-six months? Will it undercut the Asian banking system by extending super cheap credit to businesses in neighboring countries and affect bank lending growth in those countries?
India is currently worried about how China will compete on exports? Really! A 2.5% devaluation of Yuan tends to add to export competitiveness of a nation only in excel sheets during college courses of macro-economy. Actual export trade volumes are often subject to long-term trade contracts and these do not get affected by weekly or monthly fluctuations in currency prices. If export volumes are shrinking post-2008, it is because of an almost secular fall in global demand. The bigger worry for India is, whether its economy is prepared for these other onslaughts which may happen in the future?