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Devaluation to give China a global edge

China had been averaging an annual growth rate of more than 10 per cent since 1980.

Devaluation to give China a global edge

Devaluation of renminbi is a strategy to aid China’s pursuit of the status of a superpower



Charan Singh

China had been averaging an annual growth rate of more than 10 per cent since 1980. In recent years, the growth rate declined significantly to around 7 per cent.  In 2015, it is projected to decline further to 6.8 per cent. China’s economy is vulnerable to many factors as augmented fiscal deficit is high at 10 per cent of the GDP and debt to GDP ratio has increased to nearly 60 per cent. 

The credit to GDP ratio has also increased, especially in sectors involving social financing.  The steep rise in corporate investment during the last few years is mainly due to credit. Efficiency of investment has been declining along with corporate sector profitability. The housing sector, an important source of growth and employment, is suffering from considerable over-supply of nearly three years,especially in smaller cities.

The equity market in China has been a major concern.  The rapid rise of the market by nearly 150 per cent since mid-2014 raised concerns about price volatility and possible implications for broader financial stability.  The rise was worrisome because of a dismal global market trend and the slowdown of the Chinese economy itself. Markets dropped by 30 per cent in less than three weeks in July, 2015. The authorities restored orderly conditions by providing liquidity; reducing selling pressure by a six-month ban on sales by large shareholders; and suspending new initial public offerings.

China had experienced rapid export growth in the past two decades.  Its export market share rose from 2 per cent in 1990 to 13 per cent in 2013, at the expense of advanced economies. That  China's market share has depth is proved by by the fact that 56 per cent of global computer equipment exports and 65 per cent of global plastic toy exports are from China.  Further, China has at least 10 per cent of global market share in one-third of all category exports. Production of sophisticated inputs within the country rather than importing them, has ensured decline of import intensity. In some labour-intensive commodities, in which it made its export mark initially, China has been losing competiveness. This includes furniture, footwear, apparel and plastic toys.  

Reforms on exchange rates initially started on July 21, 2005, when the People's Bank of China (PBC) announced that the exchange rate of the renminbi against the US dollar would be revalued upward by about 2.1 per cent (from RMB 8.28/US$ to RMB 8.11/US$) and the exchange rate regime would move to a managed float in which renminbi's value will be set with reference to a basket of currencies. The basket included the US dollar, Euro, Japanese yen, and Korean won as main currencies; and the UK pound, the Thai baht, and the Russian rouble amongst other currencies. 

In recent years, the International Monetary Fund (IMF) has been advising Chinese authorities to open the economy and promote rebalancing to address vulnerabilities. Measures include shift to a more market-determined financial system and monetary policy framework, including interest rate liberalisation; reforming state-owned enterprises; strengthening the fiscal framework and adopting floating exchange rates. 

Theoretically, there are many options for transiting into a flexible rate and China needs to adopt a tailor-made one.  Some options are: Expanding the band around a central rate, something which China was practising, though very gradually since 2005.  Now, it is probably adopting the other strategy to adjust the central parity rate. The authorities have the discretion to regularly intervene in the market to adjust a band around the new central parity rate.  A rule-based system of making adjustments to avoid political pressure would be useful. Some transparency is required in the exchange rate policy pursued by the market to avoid speculation by the market.

The devaluation of the currency by the Chinese could be for various reasons, including slow-down in the economy and exports. Along with the growth rate, the current account surplus was also declining in the foreign exchange reserves built painstakingly since 2003. 

Housing prices have been moderating and as capital formation in real estate accounts for about 9 per cent of the GDP, this could impact the consumption pattern in case of a housing market crash. Due to a slow growth in advanced economies, China's export can suffer, resulting in lower capacity utilisation and fall in profitability, rising unemployment and diminished ability to service credit borrowed from banks.  A deterioration in asset quality could slow down investment and growth further.  

Devaluation was the correct strategy to boost the economy in such circumstances. China accounts for nearly one-sixth of world exports. Devaluation can help gain some more market as Chinese goods would be further cheaper in the world market.  Cheaper Chinese exports can create more market share in the existing market and find new markets for its cheaper commodities.  

China's currency has appreciated nearly 10 per cent in the last one year, impacting its exports and reserves accumulation. The current devaluation has only been in the range of 4 per cent. Therefore, to edge out competition in the export market it would not be difficult to imagine that more spurts of devaluation can be expected.  

While initiating these reforms, including technology-related and productivity-enhancing, employment is expected to suffer. So far, state-owned enterprises have been employing and retaining a large number of workers. China has to prepare for a shift in the employment pattern, to reform them.  Giving a boost to exports though devaluation could be a well-thought-of strategy in the present context of economic development.

China is pursuing the objective of being a world super power and undertaking substantial reforms in the economy.  To stake a claim to the basket of currencies for special drawing rights of the IMF, it has to have a more flexible currency. The market should be playing a more decisive role in the economy.  The devaluation by China can be considered as beginning of an era towards a floating exchange rate.  

If China has to independently frame its monetary policy, a tightly managed exchange rate is not feasible.  It could be considered a clever of strategy in the present uncertain times when the world is waiting for the US to raise interest rates.  Devaluation can trigger a currency war amongst competing emerging countries to devalue currencies to retain  export markets.  

The currency war would have a negative impact on different economies as they need to subsidise goods and services. Exports would be supported by subsidies at the cost of other sectors in the economy.  China has substantial international reserves to withstand the currency war, unlike any other emerging country in the world.  

It has been subsidising its exports in the past and can continue to do so.  In this competitive world of dog-eat-dog, a beggar-thy-neighbour policy, that emerges because of the currency war, will ensure China’s supremacy. Devaluation at this juncture appears the most appropriate strategy for China. 

The writer is the RBI Chair, Professor Economics at IIM Bangalore

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