Beggar thy neighbour – How devaluation of currency can make or break economic growth domestically, or for trading partners

Welcome to Finance and Fury, the Say What Wednesday edition 

Today’s question comes from Jessica.

Jessica – Hey Louis, You mentioned something about a Yuan devaluation in the Tech Share episode. I’m just wondering what this is and why a country would do this?

Thanks Jessica – Does sound weird – a country choosing Devaluation – an official lowering of the value of a country’s currency within a fixed exchange-rate system

1. Chinas monetary authority formally sets a lower exchange rate of the national currency in relation to a foreign reference currency or currency basket (USD) – Beggar thy neighbour policy

Exchange Rates – Fixed v Floating

2. Floating exchange rates system — when exchange rates are determined by market forces and not by government or central bank policy actions – what we are used to in Aud, Usd, Eur – while note controlled influenced by MP
   1. The decrease in a currency’s value relative to other major currency benchmarks is called depreciation
   2. increase in the currency’s value it is called appreciation
3. A fixed exchange rate – pegged exchange rate – is a type of exchange rate regime in which a currency’s value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another measure of value, such as gold.
   1. Benefits – used to stabilize the value of a currency by directly fixing its value in a predetermined ratio to a different, more stable, or more internationally prevalent currency (or currencies) to which the value is pegged.
      1. Does not change based on market conditions, unlike in a floating (flexible) exchange regime.
      2. Makes trade and investments between the two currency areas easier and more predictable
      3. Useful for small economies that borrow primarily in foreign currency and in which external trade forms a large part of their GDP – Also gives confidence in stability – African countries that use USD rather than their own
      4. control the behaviour of a currency – limiting rates of inflation

1. Risks – the pegged currency is then controlled by its reference value
   1. when the reference value rises or falls, it then follows that the value(s) of any currencies pegged to it will also rise and fall in relation to other currencies and commodities with which the pegged currency can be traded.
   2. dependent on its reference value to dictate how its current worth is defined at any given time. In addition, according to the Mundell–Fleming model, with perfect capitalmobility, a fixed exchange rate prevents a government from using domestic monetary policy to achieve macroeconomic stability.

1. Downsides – Increasing the price of imports protects domestic industries, but they may become less efficient without the pressure of competition.
   1. Higher exports relative to imports can also increase aggregate demand, which can lead to higher gross domestic product and inflation.
   2. Inflation can occur because imports are more expensive than they were.
   3. Aggregate demand causes demand-pull inflation, and manufacturers may have less incentive to cut costs because exports are cheaper, increasing the cost of products and services over time.

Reasons Behind Devaluation and effects

1. One reason a country may devalue its currency is to combat a trade imbalance.
   1. reduces the cost of a country’s exports, rendering them more competitive in the global market
   2. But increases the cost of imports, so domestic consumers are less likely to purchase them, further strengthening domestic businesses.
   3. Because exports increase and imports decrease, it favours a better balance of payments by shrinking trade deficits – GDP includes net exports – so boosts GDP by skewing the exports higher than imports
   4. country that devalues its currency can reduce its deficit because of the strong demand for cheaper exports.
2. Devaluation usually takes place when a government notices regular capital outflows (or capital flight) from a country
3. or if there is a significant trade deficit (where the total value of imports outweighs the total value of exports)

Example Devaluation and Currency Wars

1. 2010 – Brazil’s Finance Minister, alerted the world to the potential of currency wars – Talked about this a few weeks ago – conflict between countries like China and the U.S. over the valuation of the yuan.
   1. US monetary policy has the same effect as a currency devaluation on China – QE – mass printing of money
   2. You are China – have an unofficial peg to USD – USD increases money base – to remain competitive in the global marketplace for trade, and also to encourage investment, drawing in foreign investors into (cheaper) assets like the stock market – China needed to devalue their currency –
2. China has been accused of practicing a quiet currency devaluation, trying to make itself a more dominant force in the trade market.
   8. Was fixed up until 2005, slowly devalued to 2008 from 8.5 yuan to dollar to 6.8 – flat until 2010 when QE
   9. The process of devaluation itself is related with the increase of the amount of money circulating by just printing more if your currency or by selling the reserves (mainly USD, but maybe not for long with SDRs) – China can’t dump US treasury – hurt them as well
3. 2016 – after assuming office, U.S. President Trump threatened to impose tariffs on cheaper Chinese goods partly in response to the country’s position on its currency
   1. The renminbi lost about 10 per cent of its value against the dollar last year, as the first rounds of US tariffs took effect.
4. Why china downgraded – US trade wars
   1. A depreciation would boost trade at the margin – but stability in the currency was far more important to Chinese policymakers – concerns are to contain capital flight, avoid a domestic debt crisis and pursue a rebalancing of the economy from exports to consumption. 
   2. But using the exchange rate as a tool can backfire and hurt both the US and China
      1. a Yuan devaluation could trigger defaults on domestic dollar-denominated debt, especially in the property sector – not a high proportion of total Chinese debt but doesn’t take much for bank runs
         1. Went through China bank runs currently in the Dominos ep
      2. A bigger concern is capital flight – Foreign investors taking money out – which is part of China’s massive growth – foreign inflows of money for investment – pushes up GDP as well
      3. last came under sustained pressure in 2016 net capital outflows over the year reached $725bn, and although China held foreign exchange reserves of more than $3tn USD, it depleted them at an alarming rate to stem the tide. 
      4. China is a fairly controlled economy – outflows are more manageable – Creates less panic in households and companies and lower speculation on markets when you aren’t allowed to speculate

1. The main problem is that a weaker renminbi would hurt Chinese consumers — who would pay higher prices for imported goods — more than it could help exporters
   1. This is China’s biggest fear IMO – tens of Millions of disenfranchised young men, cant find jobs or wives (one child policy) – Hong Kong protests may kick off an internal revolt
   2. If China cant print more money and fund the consumption for population = slowly lose control

Summary –

• Devaluation is the deliberate downward adjustment of a country’s currency value.
• The government issuing the currency decides to devalue a currency.
• Devaluing a currency reduces the cost of a country’s exports and can help shrink trade deficits.

Thanks Jessica for the question, If anyone else has a question go to the contact page at Financeandfury.com.au