World currency markets went into a tizzy on Monday after the yuan (or Chinese renminbi) fell to 7 per US dollar, its lowest since 2008. Some in the US accused China of weaponising its currency before the Chinese set the official midpoint reference for the yuan at 6.9996 to the US dollar, calming some of those fears. Here’s a look at why this is such a big deal.
Why is the yuan falling below 7 to a dollar a big deal?
The People’s Bank of China controls the levels of the yuan. Seven yuan to a dollar is a symbolic level and it is believed that the Chinese central bank deliberately allowed the currency to fall in response to the ongoing US-China trade war. This move came days after US President Donald Trump threated to levy a 10 percent import tariff on all Chinese goods from 1 September if a trade deal could not be hammered out.
China, of course, has strenuously denied allowing the currency to fall. Its central bank put down the fall to "unilateralism and trade protectionism measures and the imposition of tariff increases on China". Economists say that allowing the yuan to fall will potentially turn the ongoing trade war into a currency war. That’s because a depreciated yuan will make Chinese exports to the US cheaper and will offset some of the raised tariffs.
What is the trade war about?
US President Donald Trump, worried over his country’s large trade deficit with China, imposed sweeping duties on Chinese imports, accusing the Asian giant of unfair trade practices. China retaliated and imposed its own tariffs on US goods. According to news reports, China has also stopped its state-owned firms from buying US agricultural products. So far, the US has imposed tariffs on $250 billion of Chinese goods while China has taxed $110 billion of US imports.
Matters reached a tipping point last week when Donald Trump tweeted that the US will impose an additional 10 percent tariff on the remaining $300 billion dollars of Chinese imports. This was a surprise since the US and China had ended trade talks just a day earlier which the White House had described as “constructive.”
Now, the Chinese allowing the yuan to fall has angered the US with Trump calling China, a currency manipulator, a stand which the US Treasury Department has endorsed.
Has that made matters worse?
Yes. Currency manipulation is defined very specifically in the US. A country is labelled a manipulator if it ticks three boxes. One, it has a significant bilateral trade surplus with the US; two, it has a material broader current account surplus; and three, it engages in persistent one-sided intervention in the foreign exchange market.
While China does have a trade surplus with US, it doesn’t meet the other two criteria. Indeed, the last time the US labelled China a currency manipulator was in 1994. Doing so this time opens the door for US tariffs to eventually increase to more than 25 percent on Chinese goods, says DBS research. it will likely escalate tensions between the two countries.
How does all this affect the rupee?
Well, the trade war is bad enough for world economic growth and stock markets. If tensions between US and China worsen, it will further hurt economic growth and fund flows. When foreign investors pull money out of emerging markets and risky assets, that will hurt the currencies like the rupee. Note that the rupee and other emerging market currencies fell in adjustment to the yuan’s depreciation in order for their exports to stay competitive. But the fall in the rupee is not entirely owing to the yuan crisis. It has also has to do with foreign investors exiting Indian stocks owing to other factors like a bigger tax burden. The fall in the rupee is not necessarily a bad thing as some believe that the rupee is overvalued.
What are other consequences?
While the fall in rupee may not be a bad thing, a currency under pressure might tie the Reserve Bank of India’s rate setting committee’s hands in cutting interest rates aggressively. For one, a weaker currency could lead to imported inflation. Second, a weaker rupee could put the foreign inflows into Indian debt in danger – these investors are attracted to Indian debt by a combination of higher interest rates and a stronger rupee. So, while the RBI might well go in for a rate cut in August, it will be interesting to watch its tone.
What now?
China has now fixed the midpoint reference range for the yuan at below seven to the US dollar. But it is not clear if US fears are assuaged. Some economists also predict that China will embark on a stimulus to boost its economy if exports falter. The effects of that will also be closely watched.
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