Story Of The Week

The Economics of Devaluation

China has recently created a wave of panic with its decision to devalue its currency- Yuan. Many fear it might give rise to a currency war. But why is that a cause of panic?

Competitive devaluation, also known as currency war, is a situation in which different countries compete among themselves to have the lowest exchange rate thus providing them an edge in the foreign trade markets by having lower export prices. China was in news recently for the same reason. It devalued its currency by 1.9% and 1.6% on Aug 11 and 12, 2015 respectively. In one of our previous editions- ‘The China Story’, we discussed that Chinese economy had been seeing a sluggish growth; that Yuan had fallen considerably and the yields on Chinese bonds had hiked. With the stagnation clearly visible in China’s production and economic activity, its massive debt problem, tightening labour market, China’s economy was in trouble. And then the export-led Chinese government finally decided to the much feared, yet expected devaluation of its currency to increase its competitiveness in the foreign market and boost exports to revive the country’s economic growth.

However, before discussing in detail about the recent Yuan devaluation, we need to first understand the economics behind the exchange rates and devaluation.

Exchange rate and its types

Exchange rate of a country refers to the value of its currency with respect to a foreign currency. It is of three types and is very closely related to a country’s monetary policy.

  • Fixed Exchange Rate System (Eg. China) is the exchange rate system in which the government controls the exchange rate either by buying the foreign currency when the rate becomes weaker or selling the foreign currency when the exchange rate becomes stronger. The same is done to ensure stability in foreign trade and capital movement. However, to adopt this system, the country must have huge foreign reserves so that it can buy and sell foreign currency to control the fluctuations in market prices of the currency.
  • Free-Floating Exchange Rate System (Eg. US prior to 1929 great depression) is completely determined by the market forces of demand and supply without any government intervention. As a result, the rate keeps changing with changes in the market forces or the foreign exchange market, making the currency quite unstable.
  • Managed Floating Exchange Rate System (Eg. India) is the system in which the rate is determined by the market forces of demand and supply with central banks intervening in some situations in order to avoid excessive appreciation or depreciation. It is the most common regime today with most countries having adopted the same.

Devaluation vs. Depreciation

Any change in the price of a country’s currency with respect to other currency has an impact on the economies of both the countries and rest of the world.

Parameters Devaluation Depreciation
Definition Official reduction in the value of a country’s currency within a fixed exchange rate system, by which the monetary authority formally sets a new fixed rate with respect to a foreign reference currency Reduction in price of the domestic currency with respect to the foreign currency under the floating exchange rate system
Occurrence It involves complete government regulation It takes place due to changes in the demand and supply (market forces)
Exchange Rate System It takes place under the fixed exchange rate system It takes place under the floating exchange rate system

In other words, devaluation and depreciation are just two words coined to convey the same meaning under different exchange rate regimes.

India’s History of Devaluation

India, until 1993, followed fixed exchange rate regime with government intervening by buying and selling foreign currency to maintain a fixed value of domestic currency.  Since India was under British rule till independence, the Indian rupee was pegged to pounds.

  • 1927-1966: During this period, the exchange rate was pegged at Rs. 13/pound.

 

  • June 4, 1966 (First devaluation): Following two wars (with China and Pakistan respectively) and change in prime minister’s post three times after 17 years of one man rule, along with drought were the major reasons behind devaluation. With very less foreign currency in reserves, the Government of India (GoI) devalued rupee overnight by 57% from Rs. 4.75/$ to Rs. 7.5/$.

 

  • 1980s Inflation: Rupee remained constant from 1966 till 1980. However, with the energy crisis in 1979 and gold prices shooting, the Indian rupee started to decline considerably and reached Rs. 17/$ in the year 1991.
  • 1991 Reforms (Second Devaluation): 1991 is an important year in the history of the Indian Economy and is often cited as the year of economic reforms. The country was hit by a major Balance of Payment (BOP) crisis in 1991. With just three weeks of foreign currency reserves left with the government, the country faced huge shortage and had to borrow from the International Monetary Fund (IMF). Following this, GoI introduced a set of economic reforms to slightly open the Indian market for the outside world. The exchange rate in 1991 was pegged to a basket of currencies of major trading partners. In July 1991, the currency was devalued by 18-19%.
  • 1993 Liberalisation: With the introduction of liberalisation, it was the first time when the government floated the domestic currency. The Indian rupee was made freely convertible for trading but not for investment purposes. Since then, India has managed floating exchange rate in which GoI only interferes when the currency faces excessive depreciation or appreciation due to market forces.

China’s recent Yuan devaluation and its impact on India

On Aug 11, 2015, People’s Bank of China (PBoC), China’s Central Bank devalued its currency Yuan by 1.9% against the dollar, taking the country’s currency to its lowest in three years. This had a huge impact on the commodity market with prices of various commodities falling. The move was in response to the country’s tumbling exports which was highlighted by the 8.3% fall in exports reported in July 2015.

China’s decision to devalue the Yuan caused ripples across Asia, with markets adjusting to a weaker Chinese currency and policymakers and corporate executives fearing a surge in cheap imports from the country. It is also said that the recent devaluation has given rise to currency war as the economies of all the countries are related to each other through international trade. Since China is the largest trading partner for a number of countries, the other economies fear pressure to maintain price competitiveness.

Looking at the performance of the Indian rupee, we find that there is little it can do. Indian rupee, in particular, has depreciated just 3.8% since 2014 in response to a 21.5% gain in the dollar index, making the Indian Rupee more expensive in comparison. India is increasingly losing its competitiveness as the exports decline. With Yuan devaluation, Indian exports will take a further hit. Another issue that India faces is that many Indian companies (which do not have foreign exchange cover) with dollar debt exposure will now find cost of dollar loans rise substantially.

However, India can’t do much to push its currency lower as the rupee rate is market determined. Also while the Indian currency is considered to be slightly overvalued, this is largely because of lower oil prices and steady foreign inflows in equity and debt markets.

According to Arvind Subramanian, Chief Economic Advisor (CEA) of India, the devaluation will only have a temporary impact on the Indian Rupee as the country has adequate foreign exchange reserves. The reserves touched a lifetime high of $355.46 billion in the fortnight ended June 19, 2015. Expectations are that the Reserve Bank of India (RBI) will sell dollars to prevent the rupee from weakening sharply and will not allow the currency to fall below Rs.65.50 per dollar. The same is yet to be seen.

Now the country waits for China’s decision as to till what extent China will devalue its currency, and what impact, temporary or permanent it will have on Indian exports.

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