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The Global War In Currency Escalates As China Devalues Yuan

170px-Billets_de_5000This week saw an escalation in the global currency war when China decided to embark on a major devaluation. The immediate result was a 1.8% drop in the yuan on Tuesday against the American dollar and 2.2% in relation to the Euro. It was the largest single day plunge for the currency in decades. On Wednesday, Chinese authorities allowed the yuan to drop even further, bringing the total depreciation equal to about 4% against the dollar. A third cut will be coming on Thursday. The consequences of this action will reverberate throughout not only China, but the entire world economy.

As the global economy continues to slow, it has put pressure on the leading nations of the world to embark on policies that will enhance growth. As always the bankers and politicians would prefer to enact a plan of action, that causes the least amount of controversy among the electorate. Therefore, monetary policy is a favorite tool that can be used in trying to stimulate more growth. As a result within the past year, the Euro has dropped about 18% against the United States Dollar (USD) and the yen close to 22%.

China chose devaluation as a measure to maintain growth and employment, which has rapidly declined over the past year. The Chinese government is determined to maintain a rate of economic expansion of at least 7%. The survival of the Communist Party at the pinnacle of Chinese politics will be in question, if it can no longer deliver jobs and economic prosperity in the worlds second largest economy.

Shanghai Stock Exchange

Shanghai Stock Exchange

The rate of growth as reported by officials in China managed a 7% level for the first half of 2015. There is a suspicion among a number of analysts, that the Chinese government has inflated a number of statistics to maintain the stated objective. What has been clear given the nearly 30% loss in the Chinese stock market and the declining demand for Chinese exports, is the economy was due to slow even further for the rest of this year.

A secondary goal of the leaders in China is to have the yuan internationally known as the renminbi, to become a major world currency. This can be facilitated better if the Chinese are allowed to make their money a world reserve currency alongside the USD, the Euro, British pound, Swiss franc, Japanese yen, as well as the Australian and Canadian dollars. The IMF (International Monetary Fund) is due to make this decision in October of this year, but it seems that this determination may be well be postponed, rather than wait for another 5 years as has been traditionally done.

On October 15, 2013, the British Chancellor of the Exchequer George Osborne announces that the pound sterling and the renminbi will be traded directly in London and Shangha

On October 15, 2013, the British Chancellor of the Exchequer George Osborne announces that the pound sterling and the renminbi will be traded directly in London and Shangha

The actions taken by the Chinese this week is also a step in making their currency fully convertible. The central bank of China (PBOC) has traditionally kept the yuan overvalued, by maintaining a tight range in the band of allowed trading. The Chinese have decided that growth is more important, than keeping an artificially higher rate for their currency. By loosening central control over the valuation of the yuan, the Chinese are also seeking to promote their case to allow reserve status in the near future.

China is entering a period that promises the slowest domestic growth in 25 years. The previous model for economic expansion was heavy internal investment on infrastructure and a continuous expansion of low cost exports. Chinese goods as a result have flooded global markets for years. In addition in changing world trade patterns, it also creating a massive demand of commodities and raw materials to keep Chinese factories humming.

Factory near Yangtze River

Factory near Yangtze River

Wages in China have increased dramatically over the past few years, denting much of the competitive edge that China once had in manufacturing. Exports last month fell by 8.3% from a year earlier. In addition, more emerging countries are attempting to emulate the Chinese model within the past decade.

China has become a victim of its own success. Officials in China are becoming desperate to provide a new stimulus for growth. There is a need to find new markets to help ease industrial overcapacity which have held down both prices and profits in China.

The real estate market in China is overbuilt and speculation has driven prices far beyond what is practical. The stock market after spectacular growth of 124% in a year, peaked in June and is now down 30%. Much of this growth was financed through expanded margins (debt), monetary easing and the hope of more economic restructuring. The government already heavily in debt can no longer maintain massive stimulus spending, without creating an even greater financial distortion in the Chinese economy.

This is how the Chinese government arrived to the conclusion, that devaluation of the yuan was the least painful option still available. It will no doubt cause inflation in the Chinese economy and create an additional burden on those companies within the country, that owe money in USD. However the leadership in China has determined for now, that the rewards outweigh the risks.

Brazilian Finance Minister Guido Mantega, who made headlines when he raised the alarm about a Currency War in September 2010.

Brazilian Finance Minister Guido Mantega, who made headlines when he raised the alarm about a Currency War in September 2010.

Devaluation will help China recapture the competitive edge in exports, that it has been losing to its Asian neighbors and elsewhere. Of course, this action in turn may force these countries to follow suit. Officials abroad may well decide that they have little choice, but to devalue as well. Thus the war in currency, will now intensify. Each nation will have to decide, if further debasement of their currency will make the products of that country more competitive in the global marketplace.

The Chinese devaluation the largest in two decades against the American dollar, instantly make American and European exports less competitive in world markets. In addition to the political outcry the action has created, it also hampers American efforts in the Trans-Pacific Partnership (TPP) trade negotiations. Bilateral trade talks between the United States and China have totally stalled.

It does not help that the Chinese move was actually welcomed by the IMF, which feels that the Chinese yuan is overvalued at present. To this institution the devaluation of the yuan is a positive development. It allows the currency of China to reflect more closely, what is happening in the world economy. It is important to note that the yuan had appreciated in value by 30% against a basket of currencies in recent years.

1 RMB to US dollar, since 1981

1 RMB to US dollar, since 1981

China has already cut interest rates four times in the last year and has enacted other quantitative easing practices in an effort to foster additional growth in the domestic economy. Devaluation was the obvious next step in monetary policy as other avenues for stimulation had become increasingly hazardous.

However, there will be consequences elsewhere. The United States for one, will find that raising interest rates at this juncture will be more difficult. An appreciating dollar will make it more difficult for American manufactures and exporters to sell their products both at home and abroad. American goods will become increasingly more expensive. The Federal Reserve may find that rising interest rates will be a determinate for growth in the United States and delay action once again.

Japan and South Korea may well be forced to proceed with a further devaluation of their own currencies. The currencies of Indonesia and Malaysia are already at 17 year lows in valuation. Indonesia has seen its currency drop some 60% and Malaysia 33% in the last four years alone. In 2015 these two countries experienced a devaluation 8.4% and 9.8% respectively. The Thai baht has witnessed a decline of 6.4% this year and the Philippine peso 2.2%.

This chart display the consumer price inflation in China

This chart display the consumer price inflation in China

These developments signal that policy makers in this region of the world as elsewhere are now looking for any tools they can to restart more sustainable growth. Although in comparison, the Chinese insist that their devaluation is far more moderate than most other countries. Although this is true given the size of the Chinese economy and its impact on the world economy give many investors pause.

The real fear is that the Chinese government will continue to allow the yuan to fall even further in value. This would almost force other nations to match this process step by step. The debasement of currencies around the world would then continue unabated with disastrous results. One thing is for certain, the present Chinese government values stability above anything else. They will do what is necessary, to keep the economy moving forward regardless of the consequences.

The IMF has already downgraded the projected global growth for this year from 3.5% to 3.3%. It may be reduced even further, in light of the latest economic developments. Anticipated growth for 2016 remains at 3.8%, but this looks increasingly unlikely given current events.

How China can be expected to grow twice as fast as the rest of the world, will become increasingly problematic. This is not just an issue for the Chinese government. The slowdown in economic growth is not confined to just Northeast and Southeast Asia. It is a phenomena that is occurring in other parts of Asia, Africa, Europe, Latin America and North America.

Global distribution of Chinese exports

Global distribution of Chinese exports

Central banks around the world have been operating on an unofficial agreement. Devaluation when it occurs, is permissible as long as it is not being directly and intentionally done by the government in question. If it is an effort to gain advantage in global trade it becomes a major issue. This is why the actions of the central bank in China has caused such a disturbance.

The Chinese in response point to the actions taken by the Eurozone, in the spring of 2014. The actions taken by the ECB (European Central Bank) did allow a devaluation of the Euro against the American dollar by more than 20% within a year. The United States itself has engaged in policies to weaken the dollar, since the financial panic of 2008.

China and other major developing economies by GDP per capita at purchasing-power parity, 1990-2013. The rapid economic growth of China (red) is readily apparent.

China and other major developing economies by GDP per capita at purchasing-power parity, 1990-2013. The rapid economic growth of China (red) is readily apparent.

If China continues in devaluation efforts, the first nations to feel the biggest impact will be those nations in Asia that export large amounts of goods to China. It is also many of these nations that compete with China for the same markets overseas.

Asian currencies have already tumbled on the news,since it is seen as a forgone conclusion, that further monetary easing will occur in these countries. In order to maintain their present competitive edge, they are almost for certain to take preventive action.

Slow growth has been an ongoing problem in the past year already with the almost collapse in commodity prices. This is especially true in the emerging markets, even before the latest move by China. Domestic demand in these economies grew at less than 2% in the first half of 2015. This is a 50% reduction from last year and is lower than the present rate in the developed part of the world.

The fear of many investors and bankers is the unforeseen movement of capital and market instability caused by forced devaluations. It is hypocritical to blame this situation on China alone. They are just the latest to take these kinds of actions. It is the size of the Chinese economy and the role of the government there in formulating economic and monetary policy, that makes it a more critical situation. This is in addition to the huge impact China has in global trade and the huge foreign exchange reserves that have been accumulated over the years. The total amount is in the trillions.

Whether it has been declared or not, a low level global currency war has been initiated in the past few years. This is just a new front opening up, that will need to be dealt with one way or another. Historically, the world has been here before, as recent developments remind some economists of the move towards protectionism in the 1930’s and the catastrophic results to global trade and the world economy. One can hope that history will not repeat itself, with a full blown international monetary war in currency valuations. This week saw an escalation in the battle to maintain some semblance of order in global finance. The currency wars are heating up.

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