Chinese Yuan Devaluation and Its Effects

Sep 20, 2021 07:17 PM ET
Chinese Yuan Devaluation and Its Effects

Foreign currency markets trade dollars and yuan; while doing so, the PBOC, the central bank of China, keeps some dollars in foreign exchange reserves and regulates them by buying and selling dollars depending on China's economic needs. 

Because the PBOC is hoarding dollars, the dollar's value is increasing as its supply diminishes. The PBOC achieves the opposite result when it sells dollars.

The PBOC does not keep money in reserves, and it's critical to know that. It invests the money it makes in buying United States Treasuries, which are considered safe-haven assets since they earn a return above keeping cash.

The devalued yuan in relation to the USD has repercussions not only for commerce between the US and China but also for other competitors in the global marketplace. For example, because the yuan is devalued exclusively against the USD, US corn exports will decline, whereas Brazilian corn exports to China will increase.

The same goes for Chinese goods, which might supplant Mexican exports as the yuan is cheaper to purchase compared to the peso.

What are the effects of yuan devaluation?

A weakened yuan makes Chinese goods more attractive on the global market because they become comparatively cheaper.

It is thought by the Americans to be a method of neutralizing the impact of import tariffs imposed on Chinese goods arriving in the US.

Despite the boost to worldwide consumers (who will get lower prices for Chinese goods), there are several risks to this move.

The market decides the currency value in countries like the United States and other developed countries. The US government has little control over how much the dollar is worth; the value of the dollar is determined by supply and demand.

China decided to pursue a different strategy. For decades, the central bank used its reserves to hold one USD at an exchange rate of 8.2 yuan. China has been actively managing the currency's value during the last ten years by pegging it to selected currencies and manipulating the exchange rate.

China abandoned a stable currency exchange rate and decided to tie the yuan to these currencies, which included the USD, EUR, JPY, KRW, GBP, Russian ruble, and Thai baht.

A managed float called a “dirty float” where Chinese monetary officials established a band of only 0.3 percent to be determined by demand and supply forces and the maximum and minimum decided by the officials. This form of controlled float, however, is prone to frequent misalignment because of the way it is constructed.

Despite there being a number of other factors that affect the US-China bilateral trade deficit, the undervalued yuan is commonly regarded as one of the main ones.

There is a need for a solution to be found because of its impacts on manufacturing, consumption, and commerce. Although differing conclusions have been reached about the precise extent of the yuan's undervaluation, there is universal agreement that the yuan is undervalued. 

Recently, the US Congress has proposed numerous laws to address the difficulties resulting from this undervaluation. There is a strong argument for and against revaluation, and both sides are angry and quite ready to retaliate.

What techniques does China use to depreciate its currency?

One must go through a number of obstacles in order to get the yuan to exchange it for USD, including getting the permission of the government, which decides how freely it can move against the US dollar.

The PBOC does not enjoy the same independence as the central banks of other countries and is often accused of meddling whenever it makes significant adjustments to exchange rates.

Devaluation of the Chinese yuan and the impact on Forex

A trader can make a profit by using short-term and long-term market signals when devaluation news hits the markets. Many historical currency debasements and the resulting crises have been due to government interventions and monetary devaluations.

Conventional currency exchange rates between China and the United States are expressed in terms of USDCNY, which represents how many yuan are required to purchase one US dollar.

Lower USDCNY exchange rate numbers signify a stronger Chinese currency. The lower rate means fewer yuans are needed to purchase one US dollar.

Why does currency manipulation stir up so much debate?

Currency manipulation — such as China's currency devaluation, for example — is regarded as having a detrimental effect on international trade, as it gives unfair advantages to exporters.

Countries rely on being able to control their currency supply to inflate or deflate their exchange rate. It may be intended to help with exports, avoiding inflation, or keeping out foreign cash.

China's ability to move the yuan value is limited, but this doesn't necessarily help matters. For example, when China's economy is weak and the US economy is booming, the yuan is under pressure. Under such circumstances, China can let market forces pull the value of the yuan down without having to interfere.

Also, as the US economy gains strength, the US Federal Reserve has greater room to maneuver in combating the problems that arise when China maintains a weak yuan.

In summary

It is crucial to have in mind that in the past, a wide variety of governments had unsuccessfully attempted numerous interventions and devaluations on numerous currencies. Currency markets are generally quite liquid, which leads to plenty of speculators that have no intention of holding on to a currency for an extended period of time. 

This is why short-term speculators (as opposed to long-term investors) exist. Therefore, the volatility of currency like the Chinese yuan is also strongly influenced by bigger market factors such as interest rates and market trends.

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