Fears of currency war overstated

The past week's turmoil in global and especially Asian currency markets reflects investors' and some politicians' misunderstanding of the Chinese yuan devaluation. In some quarters, there has been an overreaction to the impact of the move.

What is happening is not indicative of an emerging markets "currency war", as many have surmised. Instead, it was an intervention to let the yuan move in tandem with the market.

First, some background.

China's currency has been tightly linked to the US dollar for many years, meaning that it rises when the dollar rises, and falls when the dollar falls.

In the past couple of years, the dollar has soared on the back of stronger economic growth in the United States than in its trading partners, and in anticipation of the US Fed's long-promised interest-rate increase. Both these developments raise the relative returns to investments in US dollar assets, drawing capital away from other countries.

The strengthening US dollar means that other currencies have weakened against it and the dollar-pegged Chinese yuan.

In the stagnating Japanese and European economies, belated monetary stimulus in the form of government bond-buying or "quantitative easing" on top of near-zero interest rates, have had the effect of weakening the yen and euro, thus cheapening and increasing exports from Japan and Europe and restoring some economic growth there.

Since 2013, China has been experiencing slowing economic growth, in part because its policymakers seek to "rebalance" the now-middle-income economy away from past over-reliance on investment by state-owned enterprises (often into unproductive activities) and exports, towards more consumption which would increase the welfare of the Chinese people.

Slower growth in China means falling demand for and hence import of raw materials and energy from commodity-exporting countries like Canada, Australia, Brazil, Indonesia and many other developing economies. This further depresses the currencies of these countries, already suffering from an outflow of capital to the higher-growth, soon-to-be-higher- interest-rate US.

Taken together, these developments caused China's currency to strengthen by some 30 per cent as other countries' currencies weakened against the soaring US dollar to which the yuan was pegged.

In May this year, the International Monetary Fund (IMF) pronounced the yuan "no longer undervalued". The yuan continued to rise even as Chinese growth slowed, capital flight increased, and most recently, its stock markets tumbled.


In these circumstances, the fact that the Chinese monetary authorities did not re-peg or devalue the increasingly overvalued yuan before last week, and by a greater percentage, is testimony to their political determination to keep the yuan strong as part of their hope to transform it into an international reserve currency like the dollar, euro, yen and pound sterling.

But part of this transformation also requires that the currency's value be determined by market forces, rather than government fiat. In recent weeks, market forces have been pushing the yuan down below its daily trading floor. If the yuan were freely floating like many other currencies, it would likely have drifted even further downward.

Bear in mind that the yuan doesn't trade freely. It is pegged to the US dollar. The People's Bank of China, the central bank, sets a daily target figure for the yuan and allows trading within a tight band of 2 per cent above or below it.

On Aug 11, the central bank set the target 1.9 per cent below the previous day's level, the biggest one-day change within a decade. The yuan's value fell correspondingly. On Aug 12, it set the rate another 1.6 per cent lower, sparking another round of devaluation.

The bank also changed the way the yuan's target value is set, saying it will be more responsive to market forces, and be based on the previous day's closing value.

Given the circumstances, the move last week was a response to market forces: the equivalent of loosening the screws to allow the yuan to float down in response to market forces, which was what happened.

The Chinese monetary authorities have argued that their move was in tandem with market forces, and the International Monetary Fund has validated this.

Another thing the Chinese authorities did was to intervene in the market to stem a further slide on the yuan after the devaluation. It did so by entering the market to buy yuan with some of their copious foreign exchange reserves.

In so doing, they were acting like many other countries with "managed float" regimes (including Singapore), where daily buying and selling of currencies is done to moderate exchange rate fluctuations.


So why the outcry, particularly in the US, that China is "manipulating" its currency to gain an unfair competitive edge for its exports in world markets?

One reason is that we are once again in the "silly season" of US presidential election politics where China provides a convenient whipping boy for candidates anxious to show off their nationalist credentials.

But a more important reason is probably the lack of understanding on the part not only of politicians, but also of the public and even business leaders, of the complexities involved in currency movements.

First, the 2 to 3 per cent yuan depreciation is small, certainly against its prior 30 per cent appreciation. Second, a weaker currency does not automatically mean cheaper and more exports that would benefit China.

For one thing, exports usually include imported components (like raw materials), and the cost of those in domestic currency rises when the currency weakens.

For another, businesses which have borrowed abroad (for example, because of lower US dollar interest rates) are now faced with higher debt repayment burdens, which also raise their costs and shrink their margins. And, any stronger demand for exports could raise domestic inflation, especially where labour is scarce.

Many of China's exports are complementary rather than competitive with those of other countries, being part of regionally or globally integrated manufacturing supply chains.

Just because the Chinese portion of what goes into exports are slightly cheaper due to a lower yuan, does not mean that Chinese exports will increase in volume greatly. Exports don't just depend on relative prices. They depend also on foreign demand, which is in turn dependent on foreign income growth.

Will a weaker yuan - and stronger dollar - boost Chinese exports to the United States?

Consider that a stronger US dollar makes US exports more expensive abroad, and imports cheaper within the US. This hurts demand for US multinationals' goods. A strong US dollar also means foreign profits translate into fewer US dollars when repatriated, hitting bottom lines. Meanwhile, US companies lose market share to European and Japanese competitors whose currencies, the euro and yen, are falling more than the yuan.

It is thus not at all clear that a weak yuan will result in a boost in Chinese exports to the United States, if US income growth cannot support that surge in demand.

In contrast, many US companies import parts and components from China, so they may even benefit as these get cheaper due to a weaker yuan. For some companies like car assemblers, strong growth in the US market has outweighed the negative effects of the strong dollar, just as slowing growth in China has cut demand for the products they manufacture there for the Chinese market.


South-east Asia is not as fortunate.

In this region, foreign exchange earnings from commodity exports have fallen due to slower Chinese demand in recent years (including from slower Chinese export growth partly from the strong yuan).

Their currencies weakened significantly before the yuan devaluation, due to outflows of capital responding to anticipated better investment returns in the US. Weaker currencies increased import and foreign debt repayment costs.

But the monetary authorities have been reluctant to raise interest rates to support currencies and reduce the risk of imported inflation, because this would further slow domestic growth.

A weaker yuan might also reduce Chinese investment in the region and divert labour-intensive export manufacturing back to China. Going forward, the best outcome for the Chinese, US, South-east Asian and world economies is for China to continue to liberalise its financial system and currency as its officials have reiterated it is determined to, and for the US Fed to finally raise interest rates.

Both actions will reduce the uncertainty which is currently spooking investors and roiling markets. The Fed at least has been transparent about what it intends to do and why (but not when or at what pace).

The problem with China is the lack of trust by both domestic and foreign investors that the government will indeed continue to pursue necessary market- oriented economic reforms despite slowing growth and domestic political resistance.

Its recent role in both fuelling the stock market bubble (on the heels of prior credit and property bubbles), and intervening to prevent its deflation, has cast doubt on the extent to which "market fundamentals" will be allowed to determine the currency's value as well.

Ironically, capital market actors base their "market-driven" investment decisions on governments' policy credibility, which can only be earned by observed actions.

And that supposed "currency war"? Europe, Japan and other Asian countries did not engineer depreciation in their currencies to give their exports a competitive edge in global markets, though for some, that might have been an (intended or unintended) effect of domestic monetary stimulus, and for others, of US monetary tightening.

Given how delayed, and small, the yuan devaluation has been to date, and the long-term goal of a strong and stable currency, it is highly unlikely that China devalued to spur a currency war, or that other countries will deliberately imitate it.

Most already have floating currencies, and in this ever-more-integrated world economy, competitive devaluations will not only "beggar our neighbours", but ourselves as well.


The writer is professor of strategy at the Stephen M. Ross School of Business, University of Michigan, in the United States.

This article was first published on August 19, 2015.
Get a copy of The Straits Times or go to straitstimes.com for more stories.