The Chinese sprung a surprise on everyone with this sudden decision to devalue its currency, the yuan or renminbi. It has left a literal carnage on the trading floors of Asian currencies and the US dollar just got stronger. Let us take a quick look at the FAQs of this new global economic event to get a better perspective.

By Ruma Dubey

How is a currency usually valued?

We usually compare our home currency with another currency, meaning that we see how much of the other currency we can buy with our currency. Like Rupee to US dollar – today around Rs.64 would get one US dollar. This is what we call as our exchange rate. It changes every day with currencies gaining value or losing value over others. In simple parlance thus devaluation would mean when the home currency loses value against other currencies. But in money exchange language, such ‘natural’ fall in value of currency is known as depreciation.

What is devaluation?

Usually, devaluation is ‘forced’ as the currency is pegged or controlled by the Govt. And sometimes, when trade balance gets skewed or when economic conditions worsen, governments around the world usually resort to devaluation – value of the home currency is forcibly brought down against other major currencies. China, which was sitting tight on its currency for years, to show a robust trade figure, could no longer sit on the yuan as exports have turned weak and economic growth is struggling.

How does China’s currency work?

The US dollar and Euro are freely traded while some currencies have an anchor or peg it to the US dollar. China’s method of controlling the currency was different. Like circuit filters on our stocks, the yuan could go either up or down, within a band of 2%, preventing wild fluctuations. But then the currency was never a true indicator of the real demand and supply scenario in the country. It was all fully managed, giving its exporters an unfair price advantage.

So what did it do by devaluing its yuan?

Today morning, the central bank of China, which is The People’s Bank of China set the center point for the currency at 1.9% below Monday’s close. The midpoint for the yuan is now set at 6.2298 to $1, up from 6.1162 yuan on Monday. China has said that this is a “one-off” move to make the yuan more market oriented. But at the same time, the Bank sad that market forces would be given a bigger role in the future, which leaves open the possibility of more declines.

What is the purpose of this devaluation?

Devaluation helps a country, when in trade balance trouble, to lower the cost of its exports. The purpose of this devaluation is to thus improve trade deficit and imbalances through higher exports and lower imports.

How will it help China?

China's exports plunged by an unexpectedly wide margin of 8.3 percent in July and hopefully, exports will bounce back. For the people of China, it would mean higher prices of imported goods and overseas holiday/education costs. Though it would give impetus to the trade numbers, it truly drives home the truth – China re-engineered its growth for so long but now it needs to deliver a more balance, stronger growth, driven by domestic demand.  But it’s not all positives - A falling yuan might spur the outflow of capital. It will also put to risk China’s companies, which have amassed $1 trillion in foreign debt – they all will now have to pay more to service the debt as yuan loses ground. Also it will make imports expensive leading to cost push inflation.  

What does this mean for India and the rest of the world?

Yuan devaluation will give an impetus to Chinese exports, putting pressure on manufacturers around the world. It will put a lot of domestic companies at a disadvantage, maybe leading to an increase in import duties on various goods across the world.  It is sure to put pressure on Asian currencies which are already looking the consequences of a US Fed rate hike. Indian currency specifically is not so aligned with Chinese yuan, so there will not a direct hit to the rupee but the effect will percolate through the dollar – today, the Indian rupee fell sharply by 29 paise to 64.16 against the US dollar, post yuan devaluation. Companies exporting to China will earn lesser while imports from China will cost more, so metal companies in India could be hit. Tyre companies could also go through some anxiety as dumping is sure to increase. Yes, the dollar will get stronger and that would bode well for exporters and IT companies. For the US, where the dollar is getting stronger, it could hurt exports, lower inflation and if Fed hikes rates, the dollar could only get stronger, compounding the problem further. There is now growing talk of the probability of Fed postponing the rate hike further.

For most on Dalal Street, every event has only one relevant question – will it affect the markets?

NO. That’s the simple and short answer!