The Chinese renminbi (yuan) has lost close to 4 percent against the US dollar in the last days after the People`s Bank of China (PBOC), Chinas central bank changed the way it calculates the reference rate around which the yuan is allowed to trade.
A currency war, fought by one country through competitive devaluations of its currency against others, is one of the most destructive and feared outcomes in international economics. It recalls the 1970s, when the dollar price of oil quadrupled because of U.S efforts to weaken the dollar by breaking its link to gold. Other events such as the UK pound sterling crash in 1992, Mexican pesos in 1994 and the Russian ruble in 1998 are all well remembered outcomes caused by the devaluations of a Nations currency.
At the heart of every currency war is a paradox. While currency wars are fought internationally, they are driven by domestic distress. In most cases currency wars begin because of insufficient domestic growth in a given country. In case of China and its recent effort to devalue the renminbi is caused by declining growth in GDP and the recent weak exports data.
Under such circumstances it is difficult to generate growth through purely internal means and the promotion of exports through a devalued currency becomes the growth engine of last resort.
To see why, it is useful to recall the four basic components of growth in GDP. These components are consumption ( C ), investments (I), governments spending (G) and net exports, consisting of exports (X) minus imports ( M). This overall growth definition is expressed in the following equation.
GDP = C + I + G + (X-M)
In an economy where individuals and businesses will not expand and where government spending is constrained, the only remaining way to grow the economy is to increase net exports (X – M) and the fastest, easiest way to do that is to cheapen one`s currency
However, it is difficult to avoid problems and unintended consequences related to currency wars. When a manufacturing country has both large foreign exports sales and also large purchases from abroad to obtain raw materials, its currency may be almost irrelevant to net exports compared to other contributions such as labor cost, low taxes and good infrastructure.
Higher input cost are not the only downside of devaluation. How confident is the Chinese manufacturer that the renminbi will stay at the post devaluation level? Other countries such as the United States may defend its domestic manufacturers by cheapening their currency (USD) as well, by either reducing interest rates or by launching another round of Quantitative Easings (QE4).
Quickly explained, while devaluing the renminbi may have some immediate and short term benefit, that policy can be reversed quickly by for instance the U.S if it decides to engage in its own form of devaluation.
Sometimes these competitive devaluations are inconclusive with each side gaining a temporary edge but neither side ceding permanent advantage.