The Two Faces of A Falling Currency

Why do countries devalue currencies? And its impact on the global economy

Jun 30, 2022

Source: qualityinspection.org

The rupee has been falling dramatically against the dollar in recent months. The rupee weakened to all-time low trading at nearly 79.0 (Jun. 29, 2022) to the dollar.

Overseas investors have pulled out well over Rs. 1,68,000 crores from the Indian market as lockdowns in China, and the Ukraine war & fear of higher interest rates sent a nervous jolt to the markets.

Essentially when the rupee depreciates, everything we import gets more expensive.

In April, INR hit a 9-month low of 75.4 against USD and had lost nearly 4.2 per cent over the last three weeks. This made INR one of the biggest losers in the emerging market currencies.

And then it went further down to 77.63

As soon as this happened there was a lot of panic among the retail investors.

Still, while most of us think about currency depreciation as just a bad thing, very few know that when the value of a currency drops it brings both - advantages and disadvantages with it.

Sometimes even giant countries purposefully devalue the currency just to grow their economy.

So the question arises - How is it even possible that a drop in the value of a currency can benefit a particular country? And why do countries purposefully devalue their currency in the first place?

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To understand this let's start from the basics with the meaning of devaluation.

The current situation (as of writing this) is that I have to pay Rs. 79.0 to purchase $1.

Let's say, India decides to lower this exchange rate to a fixed 85 rupees then it is said that the INR has been devalued. So now I’d have to pay Rs. 85 to purchase $1

This is what the devaluation of a currency means.

In technical terms, devaluation is an activity undertaken by the monetary body of a country to officially & intentionally lower the value of a country's currency within a fixed or pegged exchange rate usually done against the USD.

However, right now what's happening is not devaluation but the depreciation of the Indian rupee based on the demand and supply. So it's not deliberate.

But while most of us think that this fall is a disaster, it's not that straightforward to conclude because like I said before, along with disadvantages several advantages come along with it.

So let's try to understand both these aspects using a simple case study.

This is a story that dates back to 2015 (China) where for the past 10 years - from the year 2005 to 2015, the Chinese yuan (¥) grew steadily against the dollar and appreciated close to 33%.

As a result, it had created a lot of positive sentiment amongst the investors but this is when the People's Bank of China which is like the Chinese version of RBI, suddenly announced three consecutive devaluations of their currency and the Yuan dropped by 4%.

This created a panic situation amongst the investors causing a fall in the stock markets across the USA and Europe.

Why did China devalue its currency?

As we all know china was a very well-known exporter of goods and commodities to many countries, on top of that, it was a manufacturing paradise with more than 20% of the entire world's manufacturing happening in China itself.

But at the same time if you see this graph the GDP growth rate (%) of the country had been slowing down massively from 2008 to 2015.

Source: www.macrotrends.net

Thus, to boost exports, China decided to devalue its currency deliberately.

So, how does this devaluation benefit china?

To put it simply;

$1 = ¥6 in 2015

So if a company like Apple wishes to buy ¥500 million worth of raw materials from China, this would convert to about $83.33 million.

But after china devalued its currency to ¥6.12 against the USD, the same company will only have to pay $81.69 million for those goods.

Source: Think School (YouTube)

Thus when a country devalues its currency, it reduces the cost of its exports, making it more competitive and attractive in the global markets.

Impact on Imports

While export-heavy industries got benefited from devaluation, the import heavy industries got affected.

For example, if a Chinese soap manufacturer imports palm oil worth $500 million at ¥6.0 he’d have to pay ¥3 billion but post devaluation for the same $500 million worth of palm oil, the importer now would have to give ¥3.06 billion.

Source: Think School (YouTube)

And palm oil could make up to 20 per cent of the input cost of FMCG products so if a soap costs ¥10 to be made, ¥2 will be incurred by palm oil itself so after devaluation the cost of soap and every other import-based products will increase resulting into inflation.

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When import cost increases it is expected to incentivize domestic production.

For example in India, when an import duty was imposed on the Chinese products, the cost of these imports went up and thus there suddenly was a very huge demand for domestic products which eventually ended up benefiting the Indian industries.

So whenever the cost of imports increases, whether that's due to devaluation, economic crisis or even war, the domestic industries stand to benefit. The catch over here is that they will benefit only if they are ready to embrace the demand.

Impact on Global Trade Markets

Currency devaluation is nothing new. From the European Union to developing nations, many countries have devalued their currency periodically to help cushion their economies. However, China's devaluations could be problematic 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 has significant repercussions.

With Chinese goods becoming cheaper, many small- to medium-sized export-driven economies could see reduced trade revenues. If these nations are debt-ridden and have a heavy dependence on exports, their economies could suffer. For instance, Vietnam, Bangladesh, and Indonesia greatly rely on their footwear and textile exports. These countries could suffer if China's devaluations make its goods cheaper in the global marketplace.

Impact on India

For the Indian economy, 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 worldwide. The Indian currency immediately plunged to a two-year low against the dollar and remained low throughout the latter half of 2015.

Usually, 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 several industries, including textiles, apparel, chemicals, and metals. A weaker yuan meant more competition and lower margins for Indian exporters. It also meant that Chinese producers could dump goods into the Indian market, thereby undercutting domestic manufacturers. India had already seen its trade deficit with China nearly double between 2008 to 2009 and 2014 to 2015.

As the world’s largest energy consumer, China plays a significant role in how crude oil is priced. The decision to devalue the yuan signalled to investors that Chinese demand for the commodity, which had already been slowing, would continue to decline. The global benchmark Brent crude fell more than 20% after China devalued its currency in mid-August.

For India, every $1 drop in oil prices resulted in a $1 billion decline in the country’s oil import bill, which stood at $139 billion in the fiscal year 2015. On the flip side, falling commodity prices made it much more difficult for Indian producers to remain competitive.

Key Takeaways

When the value of your currency goes down there are multiple outcomes;

The cost of export decreases, so if you are in close competition with other countries you have a chance of actually winning back your lost business.
Import cost increases so the input cost of import-based products increases which causes inflation and at the same time, it is expected to promote domestic production.
International repercussions if you are a major player in the global market.

So, did devaluing the yuan help accelerate the GDP of China?

Not really. While the GDP growth of China remained sloppy, the exports increased at an extraordinary rate going from $2199 billion (in 2016) to $2655 billion (in 2018) which is an increase of seven per cent in just two years.

Source: www.macrotrends.net

The Bottom Line

China's main justification for devaluing the yuan in 2015 was the rise of the U.S. dollar. Other reasons included the country's desire to shift toward domestic consumption and a service-based economy. While fears of further devaluations continued on the international investment scene for another year, they faded as China's economy and foreign exchange reserves strengthened in 2017. The negative impact of currency devaluations on relations with the U.S. also contributed to China briefly being labelled as a currency manipulator in 2019 and early 2020.

Thank you for reading, see you in the next one.

-Aryan

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