The Woes of the Chinese Currency

It is strange that the roaring dragon of emerging markets begins yelping when it comes to free floating its currency in the international market. We keep forgetting that the free floating currency is an instrument of the free market and its demand and supply is determined by a countries balance of trade and trading principles along with the ability of the Reserve Bank to be able to step in and take effective action in troubled times. For example post Brexit when British bankers had to grapple with a severe credit crunch the Reserve Bank of England as the custodian of the Reserve Account, stepped in and provided liquidity to the domestic banks.

One of the primary reasons behind the weakness of the Chinese Yuan is that traders prefer to hold assets in terms of free floating currencies like the dollar and consider the yuan as manipulated by the People’s Bank of China or PBC and therefore unreliable. As a result gains made by Chinese assets like yuan backed bonds due to a steadily growing GDP is not reflected by its own currencies the Renminbi and its primary trading unit the Yuan the former also being the official currency of PRC.

The renminbi was decoupled from the American dollar in 2005 in accordance with the desire of the Chinese government to transition from a centrally planned to a market economy. Since then the PBC has controlled the yuan through continuous devaluation in order to catalyze an export led economic growth and prevent loss of market share faced by growing competition from regional Asian countries like Korea.

Such intervention has negatively impacted the currency’s real valuation in terms of purchasing power parity of other currencies that are free floating. Under pressure from its trading partners the government has sought to up the value of the currency and since 2012 the yuan has fluctuated at very small deviations from its base value.

Today Yuan is the 8th most traded currency in the international market. The largest importer being US who has repeatedly claimed that the yuan is undervalued. If other exporting Asian nations also decide to tread the same path and devalue their currency then it may cause US trade deficit to bloat.

The political and economic effect of  continuous devaluation is tolerable for nations like the UK and US where cheap imports help to keep inflation within control but in the long run it may not be so if the Chinese continue to devalue the yuan to protect their own economy.

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