An event that seemed round the corner for quite some time, but something that most major economies wished would not happen, has finally happened not once, but thrice in quick succession. China has allowed the yuan to depreciate; the steepest fall in several years. This development was expected—the country’s recent economic performance gave several pointers in this direction. The first is its perceptible slowing down since the beginning of the present decade; a development that President Xi Jinping had wanted the world to accept as the “new normal” of China’s economy. In the first half of 2011, the country’s GDP growth was close to “old normal” of 10%, but in less than 3 years, the growth rate fell to just over 7% in the fourth quarter of the previous year. The year 2015 opened with further dismal news as the GDP growth in the first quarter declined to below 7%, the first time since the early years of 2009 when the Chinese economy was rocked by the global economic downturn. Although the second quarter has seen the growth rate get back to 7%, the International Monetary Fund (IMF) has estimated that the Chinese economy would grow by 6.8% in 2015. Should this happen, it would the first time a sub-7% growth would be recorded since 1991.

China’s GDP growth has been severely dented by the slowing down of its merchandise trade. The centre-piece of the economic reforms that was initiated in 1978 under the leadership of Deng Xiaoping was clearly focused on firmly establishing China’s presence in the global market. Before the reforms were introduced, China’s share in global merchandise trade was just under 0.7% (as compared to India’s 0.6%). By 2014, China was occupying the place of the world’s largest trader of goods with a share of 11.3% (as compared to India’s 2.0%). China was the world’s largest exporter with 12.3% share and was the second largest importer with 10.3%. Cold statistics bear testimony to the phenomenal growth of China’s trade sector, particularly since the middle of the past decade when the sector grew by well over 20%, and its consequent emergence as the “factory of the world”.

However, since 2012, China’s merchandise trade has been decelerating rapidly; in 2014, the growth was down to barely 3.4%. During the year, imports barely grew, while exports grew by just 6%. But very few among the policy makers both in China and the world over, would have been prepared for what has been happening on the trade front in 2015. For the first time in its post-reform phase, China’s trade sector is heading for a negative growth in a “normal” year. In the first seven months of the current year, China’s imports have declined by over 7.5% and its exports are down by nearly 4%, as compared to the corresponding period in the previous year. These numbers were possibly the clearest signals that China’s economic woes had reached the tipping point.

These perceived signs of economic uncertainty were fanned by the negative sentiments emanating from the capital market. Over the past couple of years, China has been witnessing systematic outflows of capital which, according to market analysts, have only accelerated over time. There are widely varying estimates of capital outflows from China, which makes it difficult to assess the magnitude of the problems that the country is facing on this front. The worrying sign for China is that it may be facing an acute crisis of perception arising from the negative sentiments of the fund managers. According to JP Morgan, in the past four quarters, capital outflows from China were in the range of $450 billion, after adjusting for changes in the valuation of foreign exchange reserves. The Telegraph has reported two assessments by fund managers, which point to the broad magnitudes of the outflows. Charles Dumas of Lombard Street Research has made an assessment that capital outflows from China had reached $800 billion over the past year, while Robin Brooks of Goldman Sachs estimated that the second quarter of 2015 alone had seen outflows exceeding $200 billion. However, the veracity of these numbers remains doubtful—similar estimates provided for the third and the fourth quarters of 2014 were found to be considerably larger than the official statistics provided by the State Administration of Foreign Exchange. Thus, while there are no two opinions that the Chinese economy is experiencing capital outflows like never before, the precise magnitude of these outflows remains debatable.
From the aforementioned, it can be surmised that the depreciation of the yuan was the only option left for the Chinese authorities. What had made matters worse was the upward pressure on the currency caused by the appreciation of the US dollar. Although the yuan’s formal peg to the “greenback” was removed a decade back, there is nonetheless a tacit link. The yuan has been pegged to the dollar via a daily reference rate set by the People’s Bank of China and is allowed to fluctuate within a fixed band, set at 1% on either side of the reference rate. The steep appreciation of the dollar in the recent past was rubbing-off on the yuan and an appreciated yuan was eroding the competitiveness of Chinese exports. The value of its currency played a significant part when China was pushing its products in the international market and interestingly, the same factor had once again raised its head in making its products uncompetitive.

In recent months, the fact that yuan is overvalued has been accepted even by the IMF. In its report following the Article IV Consultation with China, the IMF has reported that the “REER (real effective exchange rate) has been on an appreciating trend since the 2005 exchange rate reform, gaining an average of 5% a year during 2006–14 (3% in 2014)”. According to the IMF, in all the Yuan “has appreciated … 55% since the exchange rate reform in 2005”. “Over the past year, the REER has appreciated by over 13% (April, year-on-year), in tandem with the rise in the US dollar. By May 2015, the REER appreciated by 11% against the 2014 average …”

Depreciation of the yuan should not be seen solely from the advantage that this would lend to improving the competitiveness of Chinese exports. The move could bring at least two more advantages for China, both of which are intrinsically linked. The first of these is that China now has the opportunity to silence its critics from the Western world that it does not play by the market forces as far as its currency is concerned. The US has been leading the charge that the yuan was artificially undervalued and had compelled the Chinese authorities to intervene to keep the currency overvalued through the “managed float” arrangements (some call it the “dirty float”). This regime should now be passé given the weight of evidence in favour of yuan depreciation.

The second, and the more important advantage that China could cash-in, as a result of making its currency respond to the market forces, is that yuan could be on its way to be included in the basket of currencies used to determine the value of the SDR. The yuan has been on the threshold of being included in the basket, but was found wanting on one of the two criteria used for including any currency in the basket. IMF considers a currency for inclusion in the basket “whose exports of goods and services had the largest value over a five-year period, and have been determined by the IMF to be “freely usable”.” In the previous review of the basket undertaken in 2010, yuan was not considered for its non-fulfilment of the latter criteria. Now that its currency is on its way to becoming more market-determined, China would have a strong case for the inclusion of the yuan in the SDR basket and get the recognition as a “reserve currency”.

The author is professor, Centre for Economic Studies and Planning, School of Social Sciences, JNU