Last week, China had stirred global markets as the central bank of the Asian country suddenly moved to devalue its official currency—the yuan.
The People’s Bank of China made a significant change when it comes to how it manages China’s currency. The central bank now allows markets to play a larger role in valuing the yuan and sets the daily exchange rate based on the closing level during the previous day.
In the past, the PBOC didn’t seem to be greatly influenced by the daily price movements and sometimes even push the yuan in the opposite direction. By maintaining a firm grip on the currency, the Asian country is protected during times of financial market crisis.
With the unexpected change, economists and market analysts have been debating on the real reason behind this shift. One of the possible reasons for this is that the reform will allow the market to direct the value of the yuan and give the currency a better chance to be included in the International Monetary Fund’s Special Drawing Rights basket, together with the US dollar, euro, British pound and the Japanese yen. Being accepted as part of the IMF’s basket of reserve currencies will definitely enhance the global stature of the Asian country.
China’s devaluation of the yuan came days after a huge decline in export data was reported. With this, analysts and economists think that this move to depreciate the yuan is an effort to jumpstart exports and rev up the gdp.
The shock move by China will have more repercussions beyond the previous week’s financial market turmoil. One of these is that governments and corporations in emerging economies will have more difficulty in paying the dollar-denominated debt that they have accumulated.
The devaluation of the yuan by approximately 3 percent against the greenback sparked instability and led exchange rates across emerging markets to edge lower. Last Friday, the Malaysian ringgit was down by 3.8 percent from the week before, while the Russian ruble, Mexican peso and Turkish lira declined sharply as well.
The depreciation of currencies has benefits and downsides. It might help the exports of emerging markets to remain competitive, but may also increase the debt of these countries. Over the past years, over $2 trillion in dollar-denominated debt has been amassed by borrowers in emerging economies.
When the greenback was cheap and the Federal Reserve was maintaining rates near zero, that debt appears to be a big deal. However, now that the US dollar is getting stronger against other currencies and the central bank of the United States is starting to hike interest rates, the debt is becoming more like a burden.
If investors in these emerging markets assessed that the debts are not sustainable, it is possible that they will pull out simultaneously. When this happens, there will be a vicious spiral of dropping exchange rates and stress in the financial markets, rendering viable governments and companies insolvent. Before it’s too late, regulators must try to analyze and comprehend where the losses would be concentrated, and come up with ways to alleviate the possible fallout.