To Reduce Sovereign Debt Burdens

3 Reasons Why Countries

Devalue Their Currency
By Adam Hayes, CFA | Updated May 8, 2018 — 6:27 AM EDT

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With a potential outbreak of a trade war between China and the US, talks of
the Chinese using currency devaluation as a strategy have been rumbling.
However, the volatility and risks involved may not make it worth it this time, as
China has made recent efforts to stabilize and globalize the Yuan.

In the past, the Chinese denied it, but the second largest economy in the
world has time and time again been accused of devaluing its currency in order
to advantage its own economy, especially by Donald Trump. The ironic thing
is that for many years, the United States government had been pressuring the
Chinese to devalue the Yuan, arguing that it gave them an unfair advantage in
international trade and kept their prices for capital and labor artificially low.

Ever since world currencies abandoned the gold standard and allowed their
exchange rates to float freely against each other, there have been many
currency devaluation events that have hurt not only the citizens of the country
involved but have also rippled across the globe. If the fallout can be so
widespread, why do countries devalue their currency?

To Boost Exports
On a world market, goods from one country must compete with those from all
other countries. Car makers in America must compete with car makers in
Europe and Japan. If the value of the euro decreases against the dollar, the
price of the cars sold by European manufacturers in America, in dollars, will
be effectively less expensive than they were before. On the other hand, a
more valuable currency make exports relatively more expensive for purchase
in foreign markets. (See also: Interesting Facts About Imports and Exports.)

In other words, exporters become more competitive in a global market.

Exports are encouraged while imports are discouraged. There should be
some caution, however, for two reasons. First, as the demand for a country's
exported goods increases worldwide, the price will begin to rise, normalizing
the initial effect of the devaluation. The second is that as other countries see
this effect at work, they will be incentivized to devalue their own currencies in
kind in a so-called "race to the bottom." This can lead to tit for tat currency
wars and lead to unchecked inflation.

To Shrink Trade Deficits

Exports will increase and imports will decrease due to exports becoming
cheaper and imports more expensive. This favors an improved balance of
payments as exports increase and imports decrease, shrinking trade deficits.
Persistent deficits are not uncommon today, with the United States and many
other nations running persistent imbalances year after year. Economic theory,
however, states that ongoing deficits are unsustainable in the long run and
can lead to dangerous levels of debt which can cripple an
economy. Devaluing the home currency can help correct balance of payments
and reduce these deficits. (See also: Current Account Deficits: Government
Investment Or Irresponsibility?)

There is a potential downside to this rationale, however. Devaluation also

increases the debt burden of foreign-denominated loans when priced in the
home currency. This is a big problem for a developing country like India or
Argentina which hold lots of dollar- and euro-denominated debt. These foreign
debts become more difficult to service, reducing confidence among the people
in their domestic currency.

To Reduce Sovereign Debt Burdens

A government may be incentivized to encourage a weak currency policy if it
has a lot of government-issued sovereign debt to service on a regular basis. If
debt payments are fixed, a weaker currency makes these payments effectively
less expensive over time.
Take for example a government who has to pay $1 million each month in
interest payments on its outstanding debts. But if that same $1 million of
notional payments becomes less valuable, it will be easier to cover that
interest. In our example, if the domestic currency is devalued to half of its
initial value, the $1 million debt payment will only be worth $500,000 now.

Again, this tactic should be used with caution. As most countries around the
globe have some debt outstanding in one form or another, a race to the
bottom currency war could be initiated. This tactic will also fail if the country in
question holds a large number of foreign bonds since it will
make those interest payments relatively more costly.

The Bottom Line

Currency devaluations can be used by countries to achieve economic policy.
Having a weaker currency relative to the rest of the world can help boost
exports, shrink trade deficits and reduce the cost of interest payments on its
outstanding government debts. There are, however, some negative effects of
devaluations. They create uncertainty in global markets that can cause asset
markets to fall or spur recessions. Countries might be tempted to enter a tit for
tat currency war, devaluing their own currency back and forth in a race to the
bottom. This can be a very dangerous and vicious cycle leading to much more
harm than good.

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The Impact of China

Devaluing the Yuan
By Investopedia | Updated October 16, 2017 — 10:37 AM EDT
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On Aug. 11, 2015, the People’s Bank of China (PBOC) surprised markets with
three consecutive devaluations of the yuan renminbi or yuan for short (CNY),
knocking over 3% off its value. Since 2005, China’s currency has appreciated
33% against the U.S. dollar, and the first devaluation marked the largest
single drop in 20 years. While the move was unexpected and believed by
many to be a desperate attempt by China to boost exports in support of an
economy that was growing at its slowest rate in a quarter century, the PBOC
claimed that the devaluation is all part of its reforms to move towards a
more market-oriented economy. The move had serious repercussions around
the world.

Surprised Markets
After a decade of a steady appreciation against the US dollar, investors had
become accustomed to the stability and growing strength of the yuan. Thus,
while a somewhat insignificant change in the grand scheme of Forex things,
the drop – which amounted to 4% over the next two days – had investors
rattled.

U.S. stock markets and indexes, including the Dow Jones Industrial Average
(DJIA) and the S&P 500, as well as European and Latin American markets,
fell in response. Most currencies were set reeling as well. While some argued
that the move signaled an attempt to make exports look more attractive, even
as the Chinese economy's expansion was bogging down, the PBOC indicated
that the devaluation was motivated by other factors. (For more, see: China’s
Economic Indicators, Impact On Markets.)

Effect on the IMF

China’s president Xi Jinping had pledged the government’s commitment to
reforming China’s economy in a more market-oriented direction ever since he
first took office over four years ago. That made the POBC’s claim that the
devaluation was the result of measures taken to allow the market to be more
instrumental in determining the yuan’s value more believable. The devaluation
announcement came with official statements from the PBOC that as a result of
this "one-off depreciation," the "yuan's central parity rate will align more
closely with the previous day's closing spot rates," which was aimed at “giving
markets a greater role in determining the renminbi exchange rate, with the
goal of enabling deeper currency reform."

At the time, one professor at Cornell University indicated that the move was
also consistent with China’s “slow but steady” market-oriented reforms. And in
fact, the currency devaluation was one of many monetary policy tools the
PBOC employed in 2015, including interest rate cuts and tighter financial
market regulation.

There was another motive: China's determination to be included in

the International Money Fund (IMF)’s special drawing rights
(SDR) basket of reserve currencies.The SDR is an international reserve
asset that IMF members can use to purchase domestic currency in foreign
exchange markets in order to maintain exchange rates. The IMF re-evaluates
the currency composition of its SDR basket every five years, the last time
being in 2010. At that time the yuan was rejected on the basis that it was not
"freely usable.” But the devaluation, supported by the claim that it was done in
the name of market-oriented reforms, was welcomed by the IMF, and the yuan
did become part of the SDR at the end of the year.

Within in the basket, the Chinese renminbi has a weight of 10.92%, which is
more than the weights of the Japanese yen (JPY) and U.K. pound sterling
(GBP), at 8.33% and 8.09%, respectively. The rate of borrowing funds from
the IMF depends on the interest rate of the SDR. As currency rates and
interest rates are interlinked, the cost of borrowing from the IMF for its 188
member nations will now in part hinge on China's interest and currency rates.

Skeptical Views
Despite the IMF response, many doubted China’s commitment to free market
values, arguing that the new exchange-rate policy was still akin to a
“managed float"; the devaluation was just another intervention and the yuan’s
value would continue to be closely monitored and managed by the PBOC,
they charged. Also, the devaluation occurred just days after data showed a
sharp fall in China’s exports – down 8.3% in July from the previous year –
evidence that the government's slashing of interest rates and fiscal stimulus
had not been as effective as hoped. So, skeptics didn't buy the market-
oriented-reform rationale, instead interpreting the devaluation as a desperate
attempt to stimulate China's sluggish economy and keep exports from falling
further.

China's economy still depends significantly on its exported goods. By

devaluating its currency, the Asian giant makes exports cheaper and gains
a competitive advantage in the international markets. A weaker currency also
makes China's imports costlier, thus spurring production of substitute products
at home and so aiding domestic industry.

Washington was especially incensed, as many U.S. politicians have been

claiming for years that China has kept its currency artificially low at the
expense of American exporters. Some believed that China’s devaluation of
the yuan was just the beginning of a currency war that could lead to increasing
trade tensions.

Consistent with Market Fundamentals

Despite the fact that a lower-valued yuan does give China somewhat of a
competitive advantage, trade-wise, the move wasn't totally out of line with
market fundamentals. Over the past 20 years, the yuan had been
appreciating relative to nearly every other major currency, including the U.S.
dollar. Essentially, China’s policy allowed the market to determine
the direction of the yuan’s movement while restricting the rate at which it
appreciated. But, as China’s economy had slowed significantly in the last
number of years while the U.S. economy has done relatively better, a
continued rise in the yuan’s value no longer aligned with market fundamentals.

Understanding the market fundamentals allows one to see the small

devaluation by the PBOC as a necessary adjustment rather than a beggar-
thy-neighbor manipulation of the exchange rate. While many American
politicians may grumble, China is actually doing what the U.S. has prodded it
to do for years—allow the market to determine the yuan’s value. (For more,
see: What Causes A Currency Crisis?). And, while the drop in the value of the
yuan was the largest in two decades, the currency still remained stronger than
it was the previous year in trade-weighted terms.

Impact On Global Trade Markets

Currency devaluation is nothing new. From the European Union to developing
nations, many countries have done so to help cushion their economies from
time to time. That said, China's devaluations could spell trouble for the global
economy. Given that China is the world’s largest exporter and its second-
largest economy, any change that such a large entity makes to
the macroeconomic landscape tends to have serious repercussions.

With Chinese goods becoming cheaper, many small- to medium-sized export-

driven economies may see their trade revenues reduced. And if these nations
are debt-ridden and have a heavy dependence on exports, their economies
could take a beating. For instance, Vietnam, Bangladesh and Indonesia
greatly rely on their exports of footwear and textiles. They could be in serious
trouble should China's devaluations make its goods cheaper in the global
marketplace.

Impact on India
For India in particular, a weaker Chinese currency had several implications.
As a result of China’s decision to let the yuan fall against the dollar, demand
for dollars surged around the globe, including in India, where investors bought
into the safety of the greenback at the expense of the rupee. The Indian
currency immediately plunged to a two-year low against the dollar and
remained low throughout the latter half of 2015. The dollar-to-rupee exchange
rate referenced by the global currency markets strengthened more than 5%
since mid-August. The threat of greater emerging market risk-off as a result of
the yuan devaluation led to increased volatility in Indian bond markets, which
triggered additional weakness for the rupee.

Normally a declining rupee would aid domestic Indian manufacturers by

making their products more affordable for international buyers. However, in
the context of a weaker yuan and slowing demand in China, a more
competitive rupee is unlikely to offset weaker demand going forward.
Additionally, China and India compete in a number of industries, including
textiles, apparels, chemicals and metals. A weaker yuan means more
competition and lower margins for Indian exporters; it also means Chinese
producers will be able to dump goods into the Indian market, thereby
undercutting domestic manufacturers. India has already seen its trade
deficit with China nearly double between 2008-2009 and 2014-2015.
As the world’s largest energy consumer, China plays a significant role in
how crude oil is priced. the PBOC’s decision to devalue the yuan signaled to
investors that Chinese demand for the commodity, which had already been
slowing, would continue to crumble. In fact, global benchmark Brentcrude has
declined more than 20% since China devalued its currency in mid-August. For
India, every $1 drop in oil prices results in a $1 billion decline in the country’s
oil import bill, which stood at $139 billion in fiscal year 2015.

On the flip side, falling commodity prices are making it much more difficult for
Indian producers to remain competitive, especially
highly leveraged companies operating in the steel, mining and chemical
industries. In addition, it is reasonable to expect the yuan depreciation will
lead to further weakness in the price of other commodities that India imports
from China, making it all the more difficult for India to remain competitive both
domestically and internationally.

The Bottom Line

Despite being critiqued for exchange-rate manipulation, China had a good
reason for the 2015 devaluation of the yuan. With slower exports and a
stronger U.S. dollar, allowing the yuan to depreciate was in line with market
fundamentals and the desire of the nation's leaders to shift to a more domestic
consumption- and service-based economy. While fears of additional
devaluations continued on the international investment scene for another year,
they faded as China's economy and foreign exchange reserves strengthened
in 2017. But one lesson is ongoing: China's moves will likely keep sending
ripples across global financial systems, and rival economies should brace
themselves for the after-effects

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