The Ups and Downs of the Yuan

On August 11, 2015, the People’s Bank of China made world headlines with its 2% devaluation of the Chinese currency.  Although the figure of 2% pales in comparison to other countries that have used devaluation as a means of economic revival, China plays such a huge role in the world economy that such a shift is significant.   The yuan is now worth fewer dollars, thus bringing down the prices of Chinese exports.  However, these are just numbers; the lessening of the purchasing power of the yuan has had a ripple effect throughout the world.  To better understand the global impact of the situation and to be more prepared for the future, we must examine China’s economic history and the economic situation that led up to the Chinese central bank’s weighty decision.

Since Chinese leader Deng Xiaoping introduced economic reforms and trade liberalization in 1978, the Chinese economy has been in a rapid upward trajectory. Over a period of 30 years, 500 million people have risen out of poverty – a tremendous feat- and the per-capita income has increased four fold since 1990.  Because of  the success of China’s net export  due to cheap labor, enormous capital investment, and economies of scale that provide cost advantages, China now possesses the second-highest nominal GDP in the world and the largest economy based on purchasing power parity (PPP).

The Chinese economy rapidly became a prominent one, but the Jenga tower is teetering more and more. The demographics of China are changing. The One Child policy has significantly slowed population growth and has detrimental consequences. As the workforce ages, the labor pool will decrease, and the elderly population won’t have enough young people to support it.  The cheap labor that China’s export economy relies on will be thwarted with rises in wages, which will in turn cause a rise in commodity prices. Additionally, the level of investment in China is unsustainable. China stretches its economic might at the expense of pollution in water, soil, and food. Such consequences may threaten its financial return in the future and resources could also be affected.

China’s economy has been trying to move away from growth based almost solely on exports to one energized with more consumer spending. The devaluation of the currency was part of the government’s plan to move toward a market economy, to be coupled with policies allowing greater international access to its securities and loosening the grip of the central bank on interest rates. China has faced pressure from the United States and the International Monetary Fund (IMF) to drive out any traces of the command economy model and let the market determine the value of the currency to increase domestic consumption (of US products, which at the moment provides 1.13 billion dollars worth to the States). And the US dollar’s appreciation has caused the Chinese economy to slow, making the Chinese government’s decision to back the yuan with the dollar less justifiable.  It has become increasingly difficult for China to purchase US dollars and goods, and easier for US citizens to buy Chinese imports with the higher purchasing power of the dollar. Essentially, the Chinese central bank resorted to the 2% devaluation because that was the direction the market was pulling it. The economy was slowing, and China needed other countries to buy more of their exports, as they were having internal problems. The cheaper the price of their goods, the more competitive they would be in the world markets and more countries would buy from them.  More money would be in circulation, which would promote domestic spending.

So far, the devaluation of the yuan has caused psychological as well as financial panic – stock markets fell globally soon after, especially European stocks and the Dow Jones. Fortunately, markets soon rebounded when traders realized the Chinese government was not going to devalue the currency any further for the time being. China’s lower prices will especially affect businesses competing with China, which will have to drop their prices to compete, and businesses that sell to China, which will have no choice but to lower their prices to increase consumption. Canada, Australia, New Zealand, Korea, Thailand, and Malaysia are likely to be the most hurt. As China is the second largest importer in the world, each of these countries relies on exports to China, and now that the yuan has less purchasing power, they will see a decline in the demand for their goods. Unfortunately for Korea, Thailand, and Malaysia, who export heavily, it will now be much harder for them to compete with China’s now-cheaper goods. Korea, Thailand, and Malaysia could potentially be in serious trouble. Many fear an all-out currency war, where countries will want to depreciate their currencies to compete with the yuan. This depends on how much further the yuan depreciates. China’s decreased consumption of oil and other commodities has, however, driven prices down on those goods. The implications for the US are varied.  US companies that export to China wouldn’t be in a good position. Fewer Chinese people would have the purchasing power to buy American stock. However, the US dollar would strengthen if a currency war were to take place. The US would be able to import cheap items, have lower interest rates, and take more comfortable vacations abroad.

Only time will tell us exactly how the global economy will react and how China’s unique economy progresses. Hopefully not too many people will suffer.