The data flow from China has been weak for some time, with exports falling and the economy barely expected to achieve the government's official target of seven per cent gross domestic product growth. According to the Bank of International Settlements (BIS), the real effective exchange rate indicates that the Chinese currency is overvalued by almost 30 per cent with 2010 as the base. It is no wonder that many in the markets expect the currency to fall by as much as 10 per cent before it settles. However, expectations of a free fall need to be tempered by the fact that the Chinese economy may not be in a position to absorb the costs of unrestrained depreciation. Foreign currency debt has shot up in China amidst easy global liquidity and as of March 2015 total cross-border debt to domestic banks was a little short of US$ 1 trillion. As we write on Thursday, August 13, the Chinese central bank seems to have intervened to buy the yuan.
Besides providing a boost to exports, the PBOC's action seems to have been driven by China's desire to be included in the International Monetary Fund's (IMF) Special Drawing Rights (SDR) basket that at present includes the dollar, euro, pound and yen. In a recent report, the IMF had highlighted difficulties in including the CNY in the SDR basket until greater market reform enabled a reduction in the divergence between onshore and offshore rates. Whatever the reason for the PBOC's action, it will have widespread consequences for the global economy, particularly the Asian region. The channels through which this devaluation and further depreciation could work are complex.
There will be a direct impact on producers who compete with China in the export market. They will suffer a setback to their competitiveness unless there is a matching depreciation in their currencies. The same is true for producers, who face competition from Chinese imports, and this is most relevant for India in sectors such as chemicals, metals, textiles and consumer durables. However, the Chinese currency weakness and resultant boost to Chinese exports would be an indirect gain for companies that are a part of China's supply chain for exports. The Asian region (excluding Japan) will bear the brunt of the change in the Chinese exchange rate policy, with their currencies likely to depreciate both due to deterioration in their current account positions and a reduction in capital flows.
The Indian rupee is likely to weaken along with the Asian pack but whether it would fall more or less than the others remains a question. If one looks at nominal overvaluation (not adjusting for inflation), over the last two years the rupee has been much stickier than other Asian currencies such as the Korean won or Thai baht. On a real effective exchange rate basis, the picture improves a little if one focuses on the same time period. However if one looks at a longer horizon, say from 2010, it seems much less overvalued than most of its peers. At the moment the market seems to be focusing on valuation of the rupee in the short term and unless the Reserve Bank of India steps in to intervene, it could touch 66 to the US dollar easily.
As China depreciates, the global economy will now be importing deflationary pressures through stronger currencies vis-à-vis China and central banks could be forced to turn more aggressive in their monetary stance and pump in more money.
Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is Principal Economist, CII