Saturday, 29 August 2015

Currency Wars: Why Did China Devalue Its Own Currency?

China's 3% devaluation of its renminbi currency in relation to the dollar over the 11th and 12th of August was the largest single shock to the currency since 1994. The question is, though: why would a country devalue their currency?

Doesn't it make more sense for a country's currency to be stronger than everyone else's? Is a strong currency not a sign of a strong economy?

Well, in a way it is. One of the major factors in a currency's strength is the amount of foreign trade attracted by the country using it. For example, if India is exporting far more produce than it imports, the demand for the Indian Rupee will increase as countries seek to use it to import from India. As demand increases, the value of the Rupee will also grow. In this sense, the strong Rupee would be a positive sign that India's foreign trade is going relatively well.

Having a strong currency means your citizens have a greater deal of purchasing power when travelling internationally. If the pound is much stronger than the dollar, for example, British citizens will be able to buy most goods more cheaply in the USA than at home.

But it's not all rosy- a strong currency has other implications on a country, particularly with regards to foreign trade, that make it not so appealing.

History is a great teacher, so let's take a look at a past example of when a strong currency has led to an economy's downfall: Britain, in the 1950s and 60s. Though the time of Empire was coming to a close, Britain's Pound Sterling currency remained strong. This was primarily due to the 1944 Bretton Woods Agreement, which artificially tied the value of the Pound to $4.03.

The Pound's strength brought a decade or so of general prosperity for most of the British public. A strong currency enabled British businesses to import goods far more cheaply, and these benefits were passed onto citizens primarily in the form of a consumer goods. Appliances we take for granted, like fridges, freezers, and washing machines were introduced into the British household for the first time, as was television- the first major broadcasted event being the Coronation of Queen Elizabeth II in 1953. Car ownership also increased, as parts became easier to import for British factories- by 250% between 1951 and 1961.

Go forward to 1967, however, and under-pressure PM Harold Wilson announced that the value of the Pound was to be lowered to $2.40. This was an incredibly difficult move to make- reducing the power of the nation's currency was a politically damaging move for any Prime Minister, and Wilson's predecessors had all shied away from doing it. And after all this prosperity brought about by a strong currency, why did he make this difficult decision?

Devaluation in 1967 sent a shockwave throughout Britain.
It turned out the prosperity was more short-term than most believed it would be. The strong Pound boosted imports to Britain to such an extent that Britain was importing far more than it could export. This gap between the value of exports and imports is called a balance of payments deficit- and while it is not necessarily harmful for a country to have such a deficit, Britain's had grown too large to sustain.

Imports from other countries had become cheaper for the British, but on the other side of the coin, imports from Britain became more expensive for other countries. This meant British business had lost a lot of foreign trade due to being just too expensive, meaning reduced profits in Britain and thus wages for workers. This effect began to kick in particularly in the 1960s. The lack of British exporting dug the economy deeper into the balance of payments crisis.

Therefore one of Prime Minister Wilson's primary motives in devaluing the Pound was to make the Pound more accessible, and China's motivations this August were pretty similar.

Chinese exports in July 2015 were 8.3% lower than in July 2014, and according to many, China's economic prosperity in the past decades has damaged its ability to provide cheap labour to other countries, as the value of the currency has increased, along with wages and regulation. Countries like Bangladesh and Vietnam have begun to emerge as competitors to China with regards to providing cheap labour- and China's devaluation of its currency is a move to undercut them.
Mohammad Lone Editor