China’s devaluation of its currency and after its aftermath By Dr. Bobby Srinivasan and Dr. Sudhakar Balachandran

September 3, 2015 | Posted by bobbysrinivasan << back to blog

To shore up the flagging exports, China took an unusual step to devalue its currency – Chinese Yuan by approximately 4%. This led to the other country’s currencies in the region namely Vietnamese Dong, Malaysian Ringgit, Korean Won, Singapore Dollar and Indonesian Rupiah were marked down in value against the dollar. Why did China do this? What did they plan to achieve is a moot question which is being discussed by a student and his professor.

Student: Professor, I read in the papers that Chinese economy grew at an annual rate of 7% during the first half of this financial year. Why would they rush to reduce the value of their currency against the dollar?

Professor: While the official figure stands at 7% some analysts reckon that the real growth is anywhere between 5 to 6%. There are widespread suggestions that further stimulus may be needed to prevent the slowdown.

Student: Can devaluing a currency help the economic growth?

Professor: It is again widely believed that lower the value of a currency, its competitiveness improves. With this action Chinese products could be approximately 5% cheaper which may help to boost the demand. Yet an export revival would boost the growth marginally. Study show that export contributed on an average only 3% in the gross domestic product from 2004-14. Meanwhile investment contributed on an average 52%.

Student: Professor, it is quite revealing as to how China has achieved this astonishing growth. Then what exactly is the problem with China.

Professor: China invested very very heavily in infrastructure. Currently due to global economic slowdown these facilities are grossly under utilised. Because of this, commodities demands have fallen and the producers are cutting back on their output and also reducing additional investment in new capacity.

Student: What then is the rationale for devaluation?

Professor: It is employment scenario in China. In the past even though the economy had been decelerating, the unemployment didn’t pose a challenge. Now it is the labour demand index has hit 49.3 last month down from an average of 67.8 in the last six months. China has other serious internal problem. China’s economy wide debt was $7 trillion US in 2007. It has touched $28 trillion in June 2014, a staggering $21 trillion additional debt. Now time has come not to reflate the economy by lowering interest rates. If they did the debt problem will overwhelm them.

Student: Professor, I am looking for an answer. I am not able to comprehend your analysis and the data that you provide.

Professor: In simple terms, China is joining the rest of the world in deflation. In China the wholesale prices have fallen nearly 40%. The China’s debt to GDP has increased this year even though new borrowing has slowed down significantly. In summary China faces deflation. My fear is that it may face the same fate of Japan which is in deflation for nearly 2 decades.

Student: Are you then saying that China will not be the driver for the future economic growth.

Professor: Precisely, the world is heading towards a deflation where consumption will take the worst hit. All commodity prices like Aluminium, Copper, Zinc, Iron ore, Gold, Oil and Silver are all in many years low. It is because the demand has disappeared.

Student: Professor, I am worried. Is India likely to face the same fate?

Professor: Indian economy is 85% locally driven; our global trade is only 2%. We are also at a very low level of GDP compared to the rest of the developed world. My feeling is that exports may be affected but the internal demand will always drive the economy.

Student: Thanks Professor for such an illuminating lecture.

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