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Chinese Yuan Devaluation & US Interest Rate Hike- Impact on India

Posted in Finance Articles, Total Reads: 2156 , Published on December 22, 2015

Before looking into the impact of Yuan devaluation, we will look at the reasons behind this devaluation move by the Chinese government. China has the tradition of keeping its exchange rate relatively low to make its exports competitive. But, the Chinese currency has become stronger when compared with other Asian currencies in the last 12 months (prior to devaluation) by more than 10 percent. This has made Chinese goods more expensive abroad. Because of this, the exports declined by 8.3 percent in July 2015 on a year on year basis . This decline will eventually affect the jobs of millions working in Chinese factories. So, the devaluation can be seen as a move to increase the exports.

In addition, China wants Yuan to be in the IMF’s Special Drawing Rights basket of elite currencies. The International Monetary Fund (IMF) has already instructed china to have a flexible exchange rate if it wants Yuan to be included in the elite club. China’s central bank stated that they will try to keep the yuan stable and let the market forces determine the currency rate. So, the devaluation serves two purposes for China.

Image: pixabay

Let’s see what it has for India. China is the second largest trading partner for India. India’s imports from China are four times more than its exports to China. We buy more and sell less. With devaluation, Chinese products will become competitive in the Indian market and its exports to India will increase. In the past few months, we have already seen a surge in the dumping of tyres, steel, organic chemicals and Petrochemicals into India. On top of that, Indian exports to China will decrease because of the decreasing demand in China. Domestic automobile manufacturers like Tata motors for which China is a growing market for its JLR will be hit hard. This is increasing the already high trade deficit between the two countries further. However, the recent rate cut by Reserve Bank of India (RBI) is a relief for the Indian exporters as it would make the Indian goods more competitive.

China accounts for 40 percent of the global copper consumption. But, with slowing economy, Chinese factories now are in the mood of reducing their inventories. This has resulted in decrease of demand and eventually the price of copper has gone down. Aluminium is also trading at record low prices. This is a great news for us since the cost of improving the infrastructure has greatly reduced. In other words, we will get the smart cities at a cheaper price.

Also, China is the largest consumer of gold. So, the meltdown in China will create a huge volatility in the prices of gold. The immediate notion is that the price of gold will go down but there is also a possibility that investors will bet on it as it is the safest investment available. So, it is very difficult to predict whether the prices go north or south.

The Chinese government has the reputation for manipulating the growth figures something it has been doing for a long time. It bothered none until the devaluation. But, the devaluation actually raised some serious doubts about the health of the Chinese economy. It has spooked foreign institutional investors (FIIs) and as a result they are pulling out their money from the Chinese stock market. This has caused the market to bleed since 12 June 2015. On 24 August 2015, which was termed as Black Monday, Shanghai main share index lost 8.49% of its value . This left investors searching for other emerging markets. Brazil and Russia are in recession. The Eurozone economy is in crisis, thanks to Greece. Amidst the global crisis, the only economy which is relatively stable and is poised for a healthy growth rate is of India.

But, can we take for granted that FIIs will queue up to invest in India? To a great extent, it depends on the interest rate decision of the US Federal Reserve. The Fed has kept the interest rates low as of now but signalled a rate hike before the end of this year. But, in the hope of a rate hike, the foreign investors sold a net of $2.6 billion in the Indian shares in September quarter, the most since the three months ended 31 December 2008, when they sold a net $3.3 billion . Why Fed rate hike fuels sell-off of Indian, or for that matter, emerging markets, shares.

To recover from the 2008 financial crisis, the US Federal Reserve tried to increase the liquidity in the economy by making the availability of credit easier. In other terms, it started giving loans at near zero interest rates. The rationale behind this step is to enable the businesses to increase the investment and revive the economy. But, most of this money went into equity markets and mostly into equities which are risky. So, a rate hike will reduce your access to this easy money. This will in turn prevent an investor betting on the risky assets. So, he will consider safe options like Government securities. With present rates of interest, he will get a return of around 7.5 percent if he invests in Indian bonds compared to less than 1 percent with the US bonds. Therefore, he will be inclined to Indian bonds. But, a rate hike will also strengthen a country’s currency which eventually fuels investments into the country.

Hence, if US Fed increases its interest rate, outflow of money from both the equities and government bonds markets to the US government securities market will take place. Had there been a rate hike by the US Fed, RBI would not have aggressively cut the interest rates by 50 basis points. Since the Fed maintained the status quo, RBI now can increase the demand in the economy without sparking the sell-off in debt and equity markets.

This article has been authored by Vaddi Sudheer Kumar from IIM Rohtak

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