Just as markets were beginning to adjust to relative calm in China’s equity markets after a fortnight of turmoil, the People’s Bank of China (PBC) on Aug. 11, surprised by effectively “devaluing” the Chinese yuan by cutting its daily reference rate by 1.9%.
As might be expected, the impact on global markets was quite huge, with the initial reading of the move as a signal of weakness of China’s economic metrics.
In India, bond yields rose 405 basis points and equity markets sold off close to 3%. But the biggest impact was on the Indian currency, which lost almost a rupee to the US dollar at opening of trading hours.
There is little doubt that China’s growth has slowed, and that measures to boost consumption and rebalance growth engines from exports and investment have not gained traction. But, it is difficult to gauge how much the action was a response to the proximate unexpected drop in China’s July exports and to the equally recent message from the International Monetary Fund (IMF) expressing reservations on the renminbi’s inclusion in the special drawing rights (SDR) basket. (The SDR is a reserve of foreign currency assets created by the IMF and the basket comprises four key international currencies—the US dollar, euro, British pound and Japanese yen.)
Was the de facto devaluation China’s entry into the currency wars or was it more reflective of structural changes in the process of currency management for making a stronger case for inclusion as an SDR currency? The case for inclusion in the SDR basket is an important component in China’s strategy of internationalising the renminbi, by providing it a multilateral legitimacy as a benchmark currency.
Getting a sense of the underlying motive is important to be able to gauge the extent of further depreciation. Statements from the central bank indicated that China’s strong economic fundamentals and large currency reserves provided “strong support” to the renminbi. While currency and equity markets are likely to remain volatile for some time, and policy intentions remain ambiguous, it might be a useful to look at impact channels of both a slowdown in China and the policy responses.
The immediate impact is likely to be capital inflows, if continuing volatility in China’s markets lead to a deeper emerging markets risk-off. Selloff in Indian bonds, in the absence of any significant buying interest, typically results in enhanced price volatility of Indian bonds and a commensurate move in the rupee.
But the impacts go beyond markets into the real economy. China’s role in the global economy has increased rapidly and disproportionately in trade. Its share of world gross domestic product was over 10% in 2014.
In exports, its share is over 15% and in imports—although a bit lower than in 2014—is over 11%. China accounts for close to half of the global consumption of copper, aluminum and steel, and more than 10% of crude oil.
The first, and an overwhelmingly positive, impact therefore of a slowdown in China’s commodities demand on India is through lower commodity prices. India imported $139 billion worth crude and petroleum products in the 2015 fiscal, and as a rough rule of thumb, every $1 drop in crude prices results in a $1 billion drop in the country’s oil import bill. India also imports $3 billion of copper and copper products.
However, there is a flip side to falling commodities prices—the effects on companies in India operating in the minerals space, including steel, mining, selected chemicals, and some trading companies. Many large companies in the production space are quite leveraged, with debt-funded production capacities built up in the high-growth years. Stress on debt servicing ability is already high, and a further drop in commodities prices and a slowdown in exports will add to this.
In addition, it might be reasonable to expect that the renminbi depreciation will lead to a further drop in prices of commodities China exports to India.
Indian manufacturers have already complained of non-market prices—maybe even dumping below cost—of China’s exports to India, and a further drop in China’s capacity utilisation in segments like iron and steel, bulk drugs and chemicals will lead to a further drop in prices.
Besides imports, India’s exporters will also lose out on currency competitiveness to China in segments it competes directly with China—particularly textiles and apparels—as well as chemicals and project exports.
India’s trade deficit with China has almost doubled from $25 billion in 2008-09 to $50 billion in 2014-15. And China’s share of India’s total trade deficit is up from just under 20% in 2009-10 to 35% in 2014-15.
There are indirect consequences as well.
China holds about $1.5 trillion of its reserves in US securities. Another half a trillion is held by Russia and OPEC countries, whose resources too will be under stress with falling crude prices. This has implications for US sovereign yields, already on the way up with expectations of a rate hike by the Federal Reserve in 2015.
A move up in developed market rates will have consequences, via reduced capital flows on emerging market yields as well and the ability of central banks of these countries to cut rates significantly, despite slowing growth.
We welcome your comments at email@example.com.