The Chinese authorities made an exchange rate adjustment last week and the devaluation of its currency sent shivers across the world’s financial markets.
China had been averaging an annual growth rate of more than 10% since 1980 but in recent years, that trend has faltered. In 2015, the growth rate is projected to decline to 6.8%. Its current account surplus declined to 2% in 2014 from a peak of 10% in 2007. The latest IMF analysis—as of August 14 2015—suggests the Chinese economy is vulnerable to many factors; its augmented fiscal deficit is high at 10% of GDP while the country’s debt-to-GDP ratio has increased to 57%. Non-performing assets are rising too, constituting 5.4% of GDP, which could erode the safety buffers in the banking sector. In July, the authorities responded to this situation with a range of measures in the equity markets but these may not yield long lasting results.
The yuan devaluation is significant because of the central role rapid export growth has played in the Chinese miracle of the past two decades. China’s share of world exports increased from 2% in 1990 to 13% in 2013, with its growth largely coming at the expense of advanced economies. As if that were not impressive enough, China’s market share is also characterised by depth—as illustrated by the fact that it accounts for 56% of global computer equipment exports and 65% of global plastic toy exports.
The recent devaluation of the renminbi (RMB) is the product of various factors, including the slow-down in the Chinese economy and exports. The devaluation will likely boost labor intensive exports like furniture, footwear, apparel and plastic toys – items where China made its mark, initially.
It can also be argued that the devaluation marks the beginning of China’s movement towards a floating exchange rate. If China has to claim a place in the basket of currencies for IMF special drawing rights, then it has to have a currency which is more flexible than at present. To make the RMB freely usable requires a certain level of capital account convertibility (CAC), something the Chinese have been discussing since 1993. When China adopted current account convertibility in 1996, it had announced its resolve to achieve CAC. Similarly, in 2003, 2011 and 2013 the resolve was mentioned and has been implemented in phases, though hindered by the 2008 crisis. In April 2015, People’s Bank of China governor Zhou Xiaochuan told the IMF that Beijing plans to launch a series of reforms to make the renminbi a freely usable currency.
In theoretical terms, China does not have the luxury of enjoying increasing capital flows, an independent monetary policy and a tightly managed exchange rate all at the same time. This is the ‘impossible trinity’—if China wants to retain the independence of its monetary policy and the free movement of capital, it will have to move away from a fixed exchange rate regime.
There is, of course, the very real danger that a Chinese devaluation could trigger a currency war amongst competing emerging economies, with other countries forced to devalue their currencies in order to retain their export markets. However, in view of the size of its international reserves—estimated at nearly US$4 trillion—any do-or-die currency war will only ensure China’s rising supremacy. Thus, devaluation at this juncture seems to be the most appropriate strategy for China.
Indeed, given that China’s currency had appreciated nearly 10% over the past year, impacting its exports and reserves accumulation, more spurts of devaluation should not be ruled out. This is because the current devaluation of nearly 4% may not be sufficient to edge out competition in the export market.
Implications for India
The Chinese devaluation has immense implications for India, especially for its banking and exports sectors, and for the government’s fiscal policy.
First, the uncertainty brought in by China’s initial devaluation on two consecutive days followed by a small appreciation on August 14 will add to the already increasing uncertainty about the timing of US Federal Reserve’s monetary policy. Commercial banks which lend against exports would now need to factor uncertainty in the Chinese market, in addition to evaluating their clients and the commodities they trade in.
Second, the vulnerable sectors where banking sector non-performing assets are high in India include steel and textiles. With the RMB losing value, the price of Chinese steel will decline further, and the Indian government may have to dynamically adjust import barriers upwards, or provide a subsidy to domestic manufacturers—thereby putting pressure on the fisc. As for textiles, exporters from India would probably seek support to compete with products from China.
Even as they protect the competitiveness of the country, our policy makers need to be alert to measures Beijing may implement to match or counter the steps India takes to carve out a greater role for the rupee in international trade and expand India’s presence in international markets and institutions.
Charan Singh is RBI Chair Professor in Economics, IIM Bangalore. Views are personal