Yuan and dollar: A case of an exchange rate diplomacy

Perhaps, only a sage meditating in a remote place would not have noticed devaluation of the Chinese Yuan (CNY). Why a minor devaluation of Yuan, of about 2%, has made so much of news? Why it is so significant? These questions can only be answered if we understand the position of China in global political and economic matters.

Having transformed itself from an impoverished communist state to an economic superpower, China has leapfrogged Japan to become the world’s third largest economy, and, now it targets to eclipse USA as world largest economy by 2025. China’s rise as an economic and political superpower is significant for two reasons- it represents China’s increased assertion as an alternative pole to USA in a unipolar world (especially after disintegration of erstwhile USSR), and, secondly, rapid growing Chinese economy has provided much needed fuel to the global economy. China has used an astute economic diplomacy to expand its domain of influence in every part of the world. It has aligned most of its policies, if not all, to this end.

Exchange rate of yuan, especially with US dollar serves as a critical input to the Chinese export oriented growth model. In 1998 (as a response to East Asian crisis) China pegged its currency to Dollar at around 8.2 Yuan per Dollar. Many countries mainly USA, maintained that Yuan was undervalued and it was hurting their trade interest. Undervaluation of Yuan was a part of Chinese strategy to expand its export and it helped it to amass huge foreign exchange reserves and especially the US Dollar.  In July 2015, Chinese foreign exchange reserves stood at US Dollar 3.5 trillion.

It is important to note that an overvalued Yuan undermines the interest of those who export to China, as their exports become costlier in China and it also hurt foreign firms in China when they remit profit (Profit in Yuan translates into fewer Dollars). In 2005, China decided to unpeg Yuan and allow appreciation of its currency. Between 2005-2008 Yuan appreciated by 21%. On the concern of impact of global recession on its export oriented economy, the Peoples Bank decided to peg its currency again in 2008 at 6.8 Yuan per Dollar. In 2010, when the world economy started to rebound, there was pressure on China to let Yuan’s exchange rate become more flexible (means, be more market determined). In fact, for Obama administration an upsurge in its exports to China was critical to the recovery of US economy and other associated objectives, and, for this, it was important that China allows its currency to adjust to market rate. Although, China is known for not bending to global pressures, it decided to relent once more due to two reasons- one is related to its desire to take over the global leadership position and second reason was related to its domestic needs. China recognised its position as economic leader would depend on its policies that strengthens its linkages with other countries especially in East Asia. An undervalued Yuan would hurt these countries’ exports to China and may adversely affect their balance of payment positions, which may in turn be counterproductive to China’s own economic interest. On domestic front China was grappling with double digit inflation and an overvalued Yuan was not helping in fighting inflation and strengthen the domestic demand base. In 2010, China let Yuan appreciate, albeit very marginally by 2.5%. This small appreciation of Yuan was not enough to serve US interest and also overall global interest.

Lately, rapidly growing Chinese economy has slowed down from a level of 9.4% average annual growth rate for 13 years since 2000 to about 7% in last 5 years. There is a growing feeling among experts that current growth rate would be much less than official figure of 6% and things have only started to worsen.  There are two main reasons for this slowdown- steep fall in the manufacturing activity (which is at its lowest levels since 2009) due to sluggish exports and plunging consumer demand, but, the main villain is underlying structural issues. China has been facing the heat of its policy to peg Yuan with Dollar as a tool of exchange rate stability with US Dollar.

A stable currency is an important element of its strategy to get Yuan join the elite club of currency constituting international reserves (SDR) held by IMF.  Policy to peg Yuan with Dollar, in my opinion, has also contributed to the current slowdown. Since 2014, Dollar has appreciated significantly vis a vis a weaker Euro and this has made Yuan also to appreciate.  Chinese decision to devalue the Yuan was triggered by the need to stimulate demand for its exports. Very small devaluation may not work to promote its exports of goods but it has definitely exported the fear of currency war and downturn. The fear of down turn is real. As I am writing this article, global stock markets are tumbling and panicked. Signs of worry are real.  Here, I am reminded of a quote that I read somewhere but which actually belongs to Dante-   “From the little spark may burst a mighty flame”.  A very small devaluation of Yuan has brought disproportionately large shocks throughout the world.

Contributed by 

Sanjeev Mehta


Royal Thimphu College

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