On Aug. 11, the yuan started to plummet in value against the US dollar, sliding from 6.2066 yuan per US dollar to 6.3982 by Aug. 13. Global financial markets were severely shaken.
The currencies of many Asian countries and developing economies were — at the time of writing — continuing to depreciate. Examples include Taiwan, Singapore, Malaysia, Thailand, South Korea, the Philippines, Russia, Australia, New Zealand, Indonesia and India. The weakening of the yuan appears to have sparked a currency war.
Close inspection of the economic situation of these nations reveals that all are facing difficulties of differing levels of magnitude. The situation has come about mainly due to a steady decline in exports over the past six months in addition to depressed GDP growth. However, this time the panacea of devaluation seems to be having no effect.
This is because each country is engaging simultaneously in currency devaluation, thus the comparative benefit is being canceled out. In addition, the global economy is shrinking, which means that there is insufficient effective demand.
The US economy is still in the process of a slow recovery and cannot provide the vast demand that it once did. The Chinese economy is in trouble: Consequently, demand for raw materials, bulk goods and energy has weakened, which has resulted in global oversupplies and falling prices.
Needless to say, China’s industrial transformation and Beijing’s strategy of import substitution — replacing imported goods with domestic production — has forced out exports from Taiwan, Japan and South Korea, and played a key role in these changes. Aside from this, the global electronics market has gradually become saturated, resulting in sluggish demand. The market pressure is felt most keenly in nations such as Taiwan, Japan, South Korea and China, where producers are geared toward electronics exports.
Under these conditions, currency devaluation would not be able to solve the problems. However, all it needs is for one nation to devalue and others are forced to follow suit. It looks like it is set to be incredibly difficult to regain control of the situation.
Chinese officials have explained the devaluation of the yuan as the result of a process of market reform to convert the yuan to a floating exchange rate. In fact, from January last year up until June, net capital outflows from China amounted to approximately US$720 billion.
In addition, the foreign reserves held by the People’s Bank of China decreased from US$3.99 trillion to US$3.69 trillion during the 12-month period starting June last year. Viewed purely from the perspective of market supply and demand, a devaluation was perfectly understandable.
Will the yuan continue to depreciate? Financial analysts have said that because the yuan’s value is pegged to the US dollar, it is estimated to have been overvalued by as much as 30 percent. If China really does liberalize its currency exchange market to reflect actual supply and demand, there is quite a lot of room for further depreciation.
However, China is experiencing slow economic growth: Exports declined by a significant 8.9 percent in July. Taken together with the bursting of China’s stock market bubble in the latter half of June and other events, Western observers have interpreted the depreciation of its currency as the result of manipulation by the Chinese central bank. Although the IMF expressed pleasure in the marketization of the yuan exchange rate, it nevertheless decided to postpone its decision on whether to include the yuan as a Special Drawing Rights currency until September next year. This shows that the IMF is adopting a wait-and-see approach.
During the latest devaluation, there was quite a large discrepancy between the yuan-US dollar exchange rate in offshore markets and China’s domestic money market. On Aug. 11 the discrepancy rose to a high of 1,140 base points — 11.4 percent — before falling to 400 and then 300 base points. This clearly demonstrates the discrepancy between the Chinese central bank-controlled domestic foreign exchange market and that of overseas markets. In fact, each of Beijing’s three former strategies — pegging the yuan against the US dollar, restricting capital outflows and implementing domestic currency controls — contained gaps and omissions.
Capital controls were unable to prevent the flow of funds in and out of China, the domestic interest rate of the yuan was higher than in offshore markets and the backwash of capital made it harder for the central bank to control the currency. As for the dollar peg, the Aug. 11 depreciation gave the yuan a degree of room to maneuver.
However, the discrepancy with offshore markets still left a a fairly large space for investors to engage in interest arbitrage. From this, it can be seen that the longer Beijing delays financial reform, the greater the price China will have to pay in the long run.
It looks as if the global economy has already become trapped in a vicious circle from which no county is immune. The earthquake caused by China’s devaluation is serious indeed.
Norman Yin is a professor of financial studies at National Chengchi University.
Translated by Edward Jones
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