Market forces made China devaluation inevitable

Tuesday, August 18, 2015

A technical explanation of currency pegs, devaluations, and foreign exchange reserves

By Farrokh Langdana, Director, Executive MBA Program & Professor of Finance and Economics

Faculty Blog:

Professor Farrokh Langdana dives deep into everything from pegged currencies to foreign exchange (FX) reserves, to exploding pegs and sudden devaluations.

China devaluing its currency

Image source: John Cole

In three days in August (11, 12 & 13), China did something it hadn’t done in two decades – devaluing its currency (yuan) four percent compared to the US dollar. Before that, China had its currency pegged to the dollar at 6.20:1.  Why the peg?  Three reasons.

(1) A falling currency fosters short selling and triggers a capital outflow. If a domestic currency is expected to weaken from say, 1 Domestic = 3 Foreign today, to 1 Domestic = 2 Foreign in 30 days, capital will rush out of the Domestic economy today in an orgy of hot capital outflow.

Simply, investors will take 1 Domestic today, buy 3 Foreign, and then on day 30, “come back home” at the new rate of 2 Foreign for 1 Domestic, thus coming out ahead by exploiting the currency arbitrage (which allows foreign exchange traders to make a profit with no open currency exposure).

(2) It is very important that China show the IMF that it can make a case for becoming a serious reserve status currency someday, and that it can hang in there with the US dollar.

(3) It is not in the nature of Chinese policymakers to allow their macro variables to be market-determined (endogenously driven).

The dollar started progressively getting stronger over the last 18 months.  Why?  It’s a safe haven for investors. Problems in the Eurozone, China, India, elsewhere, all result in a “flight to safety” and global capital has been parked in the US safe haven after every global crisis or every piece of bad news.  In addition, a hint of growth in the US did nothing to deter the capital inflow and the further appreciation of the greenback.

So what does this mean for the Chinese yuan?  As the dollar gets stronger (thanks to foreigners wanting to buy US$ to park their savings), the Chinese yuan has to become stronger too, in order to ensure that its peg is intact. To do this, the Peoples Bank of China (PBoC) has to artificially make the yuan stronger.  How is this done?

You artificially make the price of anything stronger by decreasing its supply, given a stable demand. So the PBoC reduced the amount of yuan in circulation by selling foreign exchange reserves (US$) and buying (sucking in) its yuan.

But pegs only work – ONLY – when both countries are in the same phases of their business cycles. As the dollar became stronger and as China artificially tried to make its yuan stronger, it hurt its own economy. The yuan was 13 percent “overvalued” in terms of effective real exchange rates. It hurt China’s exports, and the country was bleeding its foreign exchange reserves.

This could not go on, especially with the very recent numbers indicating sharper-than-expected slowdowns in output and exports, capital investment, and new car sales in China.

So the inevitable happened:  the peg was broken, devaluation of the yuan in China, and more to come.  You cannot fight markets.  You might as well try stopping Niagara Falls.

Niagara Falls

TAGS: Business Insights China Currency Executive MBA Farrokh Langdana Financial Markets