By: Christine Tun
On August 5, 2019, the People’s Bank of China (PBOC) devalued the Chinese yuan below its 7-to-1 ratio with the US dollar for the first time in a decade. The currency then weakened to 7.0391 to the dollar by late afternoon, making one yuan worth 14.2 cents.
While most economies possess a floating exchange rate, China has traditionally pegged the yuan directly to the dollar. The yuan was pegged to the US dollar at 8.28 for more than a decade starting in 1994. Following pressures from China’s key trading partners, the yuan appreciated by 2.1% against the dollar. However, due to the possibility that the yuan may appreciate significantly against the dollar if it were to float freely on the exchange rate, China prevents its rise by buying dollars and selling yuan.
This article will examine the key advantages and disadvantages of currency devaluation, and the potential implications.
Advantages and Disadvantages of China’s Currency Devaluation
By devaluing the yuan (or renminbi), China obtains a competitive advantage in the international markets as it boosts exports, thereby stimulating economic growth and offsetting the tariffs imposed by Donald Trump as part of his “America First” economic policy. While the effects of China’s currency revaluation allow US consumers to access cheap manufactured goods, US exports into China becomes more expensive and inaccessible for Chinese citizens. This widens the US trade deficit in which the cost of the country’s imports exceeds the value of its exports.
Thus, a weak domestic currency has the potential to shrink China’s trade deficit and increase the country’s GDP. While the option of currency devaluation may seem an attractive option to most countries, a large devaluation also has the potential disadvantage of scaring off international investors. Indeed, a large devaluation can increase the risk of capital flight, whereby foreign investors rapidly move assets or money out of a country. This occurred in August 2015, when the People’s Bank of China (PBOC) devalued the yuan for several days in a row, consequently leading international investors to pull their capital out of China. Per the Federalist, China has reportedly spent U.S $1trillion in foreign reserves to combat capital flight since 2015.
Furthermore, the devaluation could also affect China’s own companies that have borrowed significant amounts overseas in US dollars. As a weaker yuan makes paying the debt off more expensive, defaults on dollar-denominated debt can be triggered. This is especially a concern in the property sector; a key driver of China’s economic growth. Indeed, following the devaluation, the Chinese real estate sector took a hit – the S&P China 500 Real Estate index tracked by S&P Dow Jones Indices shed over 4% on Aug. 5, falling to a seven-month low. The Wind Data has also reported that the volume of offshore bond issuance of mainland real estate enterprises has also increased significantly in 2019 compared to 2018. It has been stated that soon-to-expire debts of Chinese real estate companies from August to October 2019 will exceed 40 billion yuan ($5.8 billion). China’s currency devaluation could thus strain Chinese real estate companies, especially if they have failed to hedge currency risk.
Mitigating Risk and Impact on Law Firms
To mitigate currency risks stemming from devaluation, companies may employ currency hedging strategies, including forward contracts and future contracts. A futures contract is a legal agreement to buy/sell a certain commodity or asset at a predetermined price at a fixed date in the future. For example: A Chinese company is required to pay USD$300,000 to a U.S supplier in two years’ time. To safeguard against the yuan’s potential devaluation in the interim period (which may increase the company’s overhead costs), the company can purchase a futures contract which would lock in the current exchange rate until the payment is due. As lawyers are often perceived as “risk managers”, they may be required to draft and negotiate such contracts to hedge against currency risk.
The Controversial Nature of Currency Devaluation
Devaluation is controversial for a number of reasons. It boosts exports and facilitates the dumping of cheap goods in foreign countries. It also reduces sovereign debt repayments as the nominal value of the debt remains the same but the real value has decreased. In addition, when demand of domestic products fall from decreased imports, companies are forced to downsize to cut cost. Therefore, there is an increased risk of unemployment as an indirect consequence of decreased demand. Per EPI Senior Economist Robert E. Scott and Assistant Zane Mokhiber, the US’ growing goods trade deficit with China has costed 3.4 million jobs between 2001 and 2007, particularly in manufacturing.
Impact of China’s Devaluing Yuan
The price of oil is significantly affected by supply and demand. As China is the world’s largest energy consumer, the country plays a significant role in how crude oil is priced. A devaluing yuan could reduce China’s ability to purchase crude oil as oil prices are denominated in dollars. This may trigger a reduction in demand and simultaneously lower oil prices, which is bad news for oil exporters/OPEC countries, such as Kuwait, Qatar and Nigeria, whose economies are heavily reliant on oil.
A few emerging market economies, such as India, have cut interest rates following the devaluation. China and India compete in several industries in terms of exports – this includes textiles and apparels. A weaker yuan, which would boost China’s exports, translates to more competition and lower margins for Indian exporters, who are competing in the same industries.