SLATE. All you wanted to know about yuan devaluation

Last year, the yuan devaluation scare first surfaced when the Peoples Bank of China adjusted the yuan reference rate lower by 1.9 per cent on August 11 and said that it was a one-time adjustment before moving to a mechanism that makes the currency better linked with market forces.

Last week, the scare resurfaced when the reference rate was moved 0.5 per cent lower by the Chinese central bank. It once again panicked global markets that China was going to value yuan sharply lower to make its exports more competitive.

There is a common misconception that the Peoples Bank of China has moved the reference rate lower only on these two occasions. But after August 11, 2015, the reference rate of the yuan is daily being set after taking into account the previous day’s close, the movement of other major currencies, and the demand and supply conditions in the foreign exchange market. The currency is then allowed to move 2 per cent on either side of the reference rate in a session. So while in some sessions the reference rate has been moved lower (devaluation), in others it has been moved higher (revaluation).

Devaluation of a currency occurs when the government moves the value of the currency lower against other currencies in a fixed exchange rate system. Now China did have a fixed exchange rate system prior to last August. But since then it is moving to a quasi-floating exchange rate, but this is determined by the market forces. The central bank, of course, steps in to intervene in the forex market to ensure that the currency does not move more than 2 per cent on either side of the reference rate.

The Chinese government wants to make the yuan one of the reserve currencies of the world and had been wanting the yuan to be included in IMF’s SDR basket. The move to market-link the yuan reference rate was aimed at appeasing the IMF. Last November, the yuan has been included in the SDR basket. Weak macro data and continued foreign outflows from China had made the yuan traded in offshore market move lower over the past month. The sharp adjustment to the yuan reference rate last Monday was an effort to align the onshore and offshore rates of the Chinese currency.

With China emerging as a major force in global trade, the value of yuan affects almost all economies. Commodity prices have already crashed over the last two years due to slowing demand from China. With the yuan getting further devalued, the commodities exported out of China will move further lower.

This will hurt all commodity producers and will stall their growth further. Falling commodity prices will also cause deflation across the globe. Competitive devaluation of other currencies could begin, weakening other currencies weaken. This will create a fresh set of problems for a global economy.

India should mainly benefit from a fall in yuan value since India runs a trade deficit with China. Cheaper Chinese imports will, therefore, help us. But if you have invested in stocks of tyres, tiles, power equipment manufacturers, you need to watch out as these manufacturers can be hard-hit due to competition from cheaper imports from China. Besides commodity producers will suffer due to falling realisation.

No getting away from China in 2016 too.

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