How the Chinese Yuan Devaluation Will Affect India

by Swarajya Staff - Aug 13, 2015 06:14 PM +05:30 IST
How the Chinese Yuan Devaluation Will Affect India

China stunned the world’s financial markets again on Wednesday by devaluing the yuan for the second straight day. The currency hit a four-year low after the People’s Bank of China (PBoC) set the yuan’s daily mid-point even weaker than Tuesday’s devaluation. With the PBoC saying that Tuesday’s move was a “one-off depreciation”, the rapid drop in the value of China’s currency – around 4 per cent in the last two days – dealt a blow to the appetite for risky assets, and markets across the region plunged amid concerns that China has embarked on a damaging currency war.

While the devaluation is aimed at boosting China’s exports, it is expected to have a direct impact on economies competing with China on that front. While the United States and the United Kingdome have started recovering, the turmoil in the Eurozone and weak global demand have shaken the Asian model of export-oriented growth.

While India is already struggling on the domestic front with legacy issues like infrastructure and stalling of key legislation, a loss in currency competitiveness against the yuan will further hurt its ailing exports.

However, the global hysteria behind the China’s currency devaluation is grossly exaggerated. That China’s economy is slowing down is already accepted and the trend will continue as the domestic GDP is more aligned to consumption, reducing the investment component possibly by reducing the share of export sector.

Will a 4 per cent devaluation correct anything?

As per the latest data by BIS on nominal and real effective exchange rate basis, the yuan is valued at 125.95 on a nominal basis and 130.08 on a real effective basis. The REER (real effective exchange rate) valuation of the yuan is the highest among 60 countries (if Venezuela is left out). The Indian rupee, in comparison to China, is valued at 78.06 on a nominal basis and 89.02 on a real basis. Hence a 4 per cent devaluation achieves nothing in terms of improving the long term prospects of exports, which will continue to decelerate.

Hence, the only explanation lies in the PBoC intent to effectively migrate the yuan to a market-determined exchange rate and ensure the central rate does not diverge from the market expectations. Although, given the trade balances, the yuan should appreciate, the recent deficit in capital account due to capital outflows warranted depreciation in the short run. Since the PBoC central rate did not factor short term pressure on the yuan, this one-time adjustment in the central rate was needed. Another possible explanation is the PBoC’s efforts to contain any damage due to carry trades in yuan which PBoC is undoubtedly worried about.     

Impact on India’s Trade

India and China officially resumed trade in 1978. In 1984, the two sides signed the Most Favoured Nation Agreement. India-China bilateral trade, which was as low as $2.9 billion in 2000-01, reached $72.3 billion in 2014-15 (exports: $11.9 billion and imports: $60.4 billion), making China India’s largest goods trading partner. India has a whopping trade deficit with China close to $50bn in 2014-15 on account of rising imports coupled with weak export dynamics.  

The devaluation of the yuan will not have a significant impact on Chinese exports, as the currency is still highly overvalued. In addition, the Indian rupee also lost some value against the US dollar following the decline in yuan, thereby supporting a modest short-term impact on India.

However, if this adjustment of the currency continues then as per the J-curve effect, Chinese exports will only increase as they become more competitive. This, in turn, will have a negative impact on Indian exports. Further, there will be an influx of Chinese goods into India, which will result in widening the already rising trade deficit with China.

India’s major export items to China consist of primary commodities with cotton, copper and mineral fuels alone constituting more than 45 per cent of the total exports. Meanwhile, India’s major imports from China are electrical machinery and nuclear appliances (45 per cent of total imports).  

A reduction in the cost of Chinese goods can also exacerbate the problem of dumping into India from China. Tyre makers, steel industry and organic chemicals, petrochemicals industry are already reeling under the increasing dumping cases from China as lower currency incentivizes the country’s exports.

In the joint statement between India and China during Prime Minister Narendra Modi’s visit to China in May 2015, it was agreed that both sides will take necessary measures to remove impediments to bilateral trade and optimally exploit the present and potential complementarities in identified sectors, including Indian pharmaceuticals, Indian IT services, tourism, textiles and agro-products. The two sides resolved to take joint measures to alleviate the skewed bilateral trade so as to realize its sustainability.

The impact of this devaluation will depend on the horizon one takes. The short term impact can be negative in some sectors like tyres, pharmaceuticals, textile and capital goods due to a sudden change in terms of trade and fear of dumping. However, in the long run there will not be material impact particularly in services till such time China dismantles the state monopoly over services. However, India has all options at its disposal under the WTO frame-work to tide over the short run impact.

If the yuan continues to lose value, then it might create pressure for the Reserve Bank of India governor to intervene to provide relief for the exporters and cut the key interest rate else the Indian goods would become less competitive.  

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