By Nayan Saraf
Edited by Shulin V K Satoskar
Introduction
There have been many dramatic events in the history of the financial world which have subsequently changed the structure and practices across the world. These practices were mainly intended at getting ahead in the competitive world of trade. And when it comes to trade, all we can talk about is China. Perhaps, China is one of those countries which has tried every possible trade practice to be ahead of other countries. Some of these are unfair. These unfair practices are: Currency manipulation and currency devaluation. But before we go ahead and discuss the impacts of these unfair and regressive trade policies, we first need to understand currency manipulation.
What is Currency Manipulation?
Currency manipulation, also known as foreign exchange market intervention, or currency intervention, occurs when a government buys or sells foreign currency to push the exchange rate of its own currency away from equilibrium value or to prevent the exchange rate from moving towards its equilibrium value. This is basically an act of artificially inflating or deflating the fair value of the currency. In most cases, manipulation is illegal. Usually, the fair value is decided by the demand and supply of that currency in the market. But when a country manipulates its currency, the free market does not remain any free. In that case, the country with trade surplus doesn’t allow its currency to get appreciated, which in self-correcting phenomenon should do. Due to this process, the goods from that country would still cost less than those of other countries whose currencies would be wrongly inflated. This way, the country using currency manipulation attracts more exports and disturbs the free market.
How does China do Currency Manipulation?
Now suppose, a trade occurs between a US importer A and a Chinese exporter B. After the trade, importer A would transfer its money to the account of Chinese exporter B in dollars. Now, after receiving money in dollars, exporter B would go exchange the dollars in local currency Yuan. But instead of exchanging from its reserves, People’s Bank of China (Central Bank) exchanges it with newly created Yuan. This is equivalent to printing money. The Central Bank thus supplies more Yuan in the market. The Central Bank constantly prints new currency and uses it to buy U.S. dollars and U.S. government debt, thereby flooding the market with Chinese currency and increasing demand for American dollar. This way the supply of Yuan would be more than its demand and would result in lower prices of Yuan. On the other hand, the demand for dollar would be more than its supply and would result in an inflated dollar value.
Proof of China’s Currency Manipulation
We can observe it from the Figure 1 that from 2005-14, China’s export has grown by more than 300% which is 30% growth annually (on average). The monetary value of exports from 2005-14 has grown from $500 billion to $2.3 trillion. But in the same decade yuan depreciated by only 25%, i.e. from 8.26 CNY to 6.37 CNY for a unit dollar.
How is it possible?
It is only possible by manipulating the currency. In the same decade, the Central Bank has increased its Forex Reserve by more than 600% i.e. from $500 billion to $3.7 trillion (Figure 3). This is a clear sign of manipulating yuan by buying more dollars and supplying more Yuan. Figure 4 clearly indicates the increased money supply of Yuan, which is more than 700% in the same decade.
Why is China Devaluing its Currency?
The question which everybody is asking: why did the Chinese government devalue its currency in 2015? The answer is an interplay of many reasons. First, the global economic slowdown in US and Eurozone: The U.S. is slowly recovering from the global financial crisis of 2007-08, but the Eurozone is still in the vicious circle of recession. The export of Chinese goods has reduced due to low demand in US and Eurozone. Inflation in the second quarter of 2015 remained at 2% in the U.S., and abysmally low at 0.2% in Eurozone.
Second, the declining growth rate in China: It also resulted in this devaluation. China has realized that the currency manipulation is not yielding benefits as it did five years back. The exports are declining, which is also resulting in lower demand in the domestic market.
Third, the adoption of quantitative easing by Eurozone: Since the adoption of QE in March 2015, Euro has drastically depreciated against dollar. Now, Chinese government is worried that if this depreciation continues, then their goods would be less desirable in the Eurozone.
At the same time, Japanese government also adopted QE, which resulted in depreciation of yen. The fear of losing this competitive advantage over other countries has forced China to get into this currency war.
Impact on Chinese economy
The recent devaluation resulted in a crash of the Chinese stock markets. Despite the massive stimulus the government unleashed to prop them up the situation remains unchanged. The Shanghai index has fallen by nearly 40% from its mid-June peak. So is this the hour of China’s crisis? Not so likely. Stocks and economic fundamentals have little in common. When share prices nearly tripled in the year till June, it was not a sign of stunning improvement for Chinese growth prospects. China’s growth has been slow for a while but their stock market kept rising.
Furthermore, the property market of China is far larger than the equity market. Housing land accounts for a major chunk of the financial system and thus plays a much bigger role in spurring growth. House prices have risen up nationwide but this crisis has stopped overvaluing the property market. This stabilization has reduced the risk of property market crash – an event equivalent to that of a stock market crash in America.
Conclusion
This is not the first time that any country has devalued its currency. In 2010, the Japanese government moved to depress the value of yen. South Korea also has a habit of intervening in the valuation of its currency. Switzerland pegged its franc to the euro in the beginning of 2011. But a lesson that these countries have not learnt is that the fluctuation in currencies have global impacts.
Earlier this year, when Swiss Central Bank had unpegged their currency, the currency rose from pegged level of 1.12 Euro to 0.82 Euro in just one day. This is the highest appreciation of a currency in the history of the financial world in one day. The corresponding impact was that the Swiss market went down by 12% the same day. Many big hedge funds went bankrupt. And now, when China has devalued its currency, again, there is a market crash. This market crash is far bigger than the Swiss market crash. It eroded nearly $1 trillion of wealth in just one day.
China has always used these unfair practices just to get ahead in the world. But now, it should realize that this world is interconnected, and any volatility would cause global crisis. When China last devalued its currency in 1994, there was a financial crisis in Asian economies just after 3 years. Now again, we are at the verge of another financial crisis as the RBI governor, Raghuram Rajan, predicts. And its consequences would be far more fatal than 2007-08 global financial crisis.
References:
- http://www.reuters.com/article/2012/04/14/us-china-yuan-timeline-id
- http://www.usinflationcalculator.com/inflation/current-inflation-rates/
- http://www.tradingeconomics.com/euro-area/inflation-cpi
- http://www.economist.com/blogs/economist-explains/2015/01/economist-explains-13
- http://www.economist.com/news/briefing/21662581-stockmarket-turmoil-china-need-not-spelleconomic-doom-it-does-raise-questions-far?fsrc=scn/fb/te/pe/ed/takingatumble
About the author:
The author is a Banking and Financial Service student at TAPMI. His area of interest is mainly economics, banking, and risk management. He is on the editorial board of TJEF and also the member of Literary and Media Committee of TAPMI. You can contact him at nayan.bkfs17@tapmi.edu.in
Leave a comment